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Investment Strategy
Wednesday, August 1, 2007
Waking up

The poor performance of the bond market has finally hit the headlines. As is often the case with these things, public awareness has been slow to follow. Although some bond markets did not peak until 2005, many (including the UK) actually peaked as long ago as 2003.

Comments global investment strategist for Ashburton, Peter Lucas, “This has been a stealth bear market. In contrast to the bear markets of 1994 and 1999 when bond prices plunged in dramatic fashion, this time around prices have steadily ratcheted lower – death by a thousand cuts, one might say.”
When bonds hit their peak in June 2003, they were undoubtedly overvalued. This was due to unfounded (as it turned out) fears of deflation and a general reluctance to consider the main alternative, namely equities, following the painful 2000-2003 correction. “The world we have seen in the last four years has been very different to that discounted by bonds at that time: deflation was avoided, the global economy has bounced back strongly and interest rates have risen substantially (particularly in America),” he notes. “The ponderous response of the bond market to this striking regime shift can be ascribed to three supportive tailwinds that have slowed the bond market’s rate of descent.”

Pension funds

Pension funds were squeezed in a painful pincer movement in 2000-2003. Not only was their asset base depleted by the fall in equity markets, but the net present value of their future liabilities (calculated using prevailing long-term interest rates) went through the roof as the bond market rallied. This experience, reinforced by tougher regulation, triggered an asset allocation switch out of equity into bonds. Looking ahead, this source of demand for bonds should wane as companies close ‘defined benefit’ schemes in favour of ‘defined contribution’ schemes.
As Japan has emerged from the trauma of the post-bubble period, investor risk appetite has returned. Unimpressed by the paltry yields available at home, Japanese investors have eschewed their own bond market in favour of higher yielding alternatives abroad. Japan is home to the biggest savings pool in the developed world and this flood of money abroad has supported bond prices in Britain, America and elsewhere, as well as undermining the yen substantially. These flows are not limitless, however. As Japanese interest rates bottom, so these flows will dry up. An increase in market volatility might also persuade some of this money to stay at home.
The Chinese authorities have done a pretty good job of steering the economy through a period of rapid change. More than anything, they are keen to maintain economic and, by extension, social stability. They recognise the benefits of a stronger currency but are keen to control its ascent. To achieve this end, the Bank of China has been buying US dollars for renminbi, thereby building up the country’s foreign exchange reserves. These reserves have subsequently been invested in bonds, thereby keeping yields lower than they would have been otherwise. In fairness, it’s not just China doing this but they are the most important player. This source of support for bonds is already on its way out. The soaring stock-market has increased the need to tighten policy further (a stronger currency would certainly help) and the country is exploring more productive uses for its foreign currency reserves. This is an ominous sign for bonds.
Says Mr Lucas, “The recent sell-off in bonds has been part cyclical, part secular. It is cyclical in the sense that investors have woken up to the fact that US interest rates are unlikely to fall in the way that had previously been discounted. But it is also secular given the way in which the aforementioned tailwinds are starting to dissipate.
“Indeed, as huge countries like China and India continue down the path of economic development, it seems inevitable that the global cost of capital will have to rise. Whatever the near term outlook for Western bond markets (we are actually neutral/negative for the next few months), we can’t shake the feeling that we are currently in the early stages of a secular bear market.”
 

Copyright © Insurance Times and Investments® Vol:20.7 1st August, 2007
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