LONDON, 4 August 2003 — Just a short time ago, the headlines in the most widely read newspapers were filled with gloomy economic forecasts and the specter of deflation. These alarming scenarios also found support in periodic pronouncements by US Fed Chairman Alan Greenspan. For some time now he has been using monetary policy to try and put the economy back on the strong growth track and to prevent deflation. As a result of this aggressive, expansive monetary policy, interest rates have been cut dramatically, most recently in May of this year.
Behind this policy is the idea that the population should save less and consume more, thereby stimulating the economy. This goal is also supported by generous fiscal policy measures such as tax cuts. Worries about the feared deflation scenario have pushed yields on government bonds to new lows, allowing bond holders to enjoy hefty price gains — all during a period in which equities were recovering (e.g. April to mid-June)
June 13, 2003 may turn out to be an important date with long-term implications for the financial markets. On this day, key government bonds tumbled to new lows. Yields on ten-year US government bonds closed at 3.11 percent mark, while German government bonds closed at 3.46 percent. From this date on, yields could only move in one direction: Up.
Around a month later, Alan Greenspan surprised the markets by offering a more upbeat view of the US economy than in the past. The bond markets reacted immediately with a veritable sell-off, with yields soaring by two-digit basis points in a single day. Long durations, which were responsible for generous gains were hit hardest, losing between 1.3 percent and 1.6 percent in a single week. Particularly the news that the Fed was going to do everything in its power to prevent deflation, no matter what the cost, pushed the bond deflation premium described above lower, causing yields on ten-year US government bonds to hit the 4.2 percent threshold in no time.
Further bad news struck the bond market when Greenspan said the use of unconventional monetary policy tools such as a buy back of government bonds was not very likely. And, last but not least, the mortgage market and its refinancing exerted additional pressure on the bond market.
Greenspan’s optimistic statement along with the more promising macroeconomic figures make it appear more likely that economic growth will pick up in the second half of the year as had been forecasted at the beginning of 2003.
For this reason and because we think that the aggressive monetary and fiscal policies will spark inflation expectations in the US over the medium to long term, we consider the prospects for the bond market to be unfavorable. Although we do not expect inflation to increase in Europe in view of the weak macroeconomic picture, we think that the European bonds markets will not be able to fully escape the US trend and European yields will also move upward over the medium to long term. Over the short term, however, we expect a technical correction following the strong sell-off on the bond markets.
We intend to exploit this technical recovery to reduce bonds and to underweight them in our investment policy. The funds freed up as a result will be invested in the stock market where we also expect a correction following the most recent rally. At the appropriate time, we will then report an overweight position in equities. The risk premium, which despite a slight narrowing remains clearly above its historic average, the attractive dividend returns and the positive trend in earnings revisions, all favor this move.
Some changes have also taken place at the sector level. Following the strong performance of the IT sector, in which we were overweight up to now, we think it is time for profit-taking and will return to a neutral stance. The currently high valuation also supports this view.
Our underweight in the consumer staples sector paid off last month as the sector reported below-average results. In view of the interesting valuation and attractive dividend yield (e.g. Unilever with a return of 3.4 percent), we have decided to upgrade this sector and to weight it as neutral.
In connection with the forthcoming reduction of the bond component, we recommend selling bonds with long durations and good ratings as they will be hit particularly hard by the expected increase in yields. A look at the behavior of various bond markets during the most recent yield increase shows that bonds of poorer credit quality held up better, as the increase in yields was compensated by an ongoing narrowing of the risk premium vis-à-vis government bonds. We expect government bonds to consolidate following the spectacular narrowing of the risk premium vis-à-vis government bonds since October 2002. In view of continuing strong demand and the expected improvement in macroeconomic data, the risk premium will continue to narrow.
We are, thus, sticking to our recommendation to invest a smaller part of the bonds portfolio in the high-yield bond sector. Owing to the heterogeneity of the bonds world, our pessimistic assessment of the bond market should not be understood as a blanket judgment.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)