The future actions of the Federal Reserve, whose latest meeting resulted in a no-change stance on interest rates, at least for the time being, looks set to plunder bonds into a bear market, says Chris Barclay, fixed income analyst at Commerzbank in London.
In the short term the outlook is bearish." says Barclay, naming the two main reasons as "a risk of an unwinding of long treasury positions fund-ed in yen," and the state of the US economy, which will "probably continue to be stronger than expected by most economists. As a result of that, the Fed are likely to continue tightening policy."
Short term returns will prove less than satisfactory, and in fact, says Barclay "less than if you held them in cash". And in the long term, returns will be no more than "average". "Probably within that time we will have a major turning point in the treasury market. When that will be will depend on the Fed, and how quickly they move to tight-en."
An area which he feels is being largely ignored is the Japanese influence over the bond market, notably the trend for a stronger yen and rising Japanese interest rates and bond yields. The effect on US bonds will be "very negative" he says.
Barclay anticipates a quarter of a per cent rise in rates by year end which would imply a slightly better return on bonds. Todd Rupert, managing director, T Rowe Price has overall slightly more optimistic predictions for bonds, though he disagrees on the interest rate front. "Our forecast would be that rates would remain the same or decline this year as the economy slows in which case long-duration bonds would be quite attractive."
If the economy continues to stay healthy, Rupert thinks that the market will see "very good corporate earnings and that will manifest itself in good shareprice appreciation." adding though that the major growth of the year has happened already. "The Dow's up 13% this year, and that's a pretty healthy return. I don't see it going up much more than that."
While the favoured sectors are named as technology, pharmaceuticals and healthcare, both Rupert and other analysts pinpoint the small caps as the ones to look out for.
"Small cap stocks in general have essentially been in a bear market for almost three years," says Rupert, "despite the fact that they have had strong earnings gains and very attractive relative valuations compared to the larger cap stocks."
"Valuations may play a greater role in individuals' institiutions anaysis of where the attractions are and the small caps sector on a valuation basis is far more attractive than the large cap sector today."