LONDON, 2 August 2004 — The world economy is now recovering. Although in the US, the pace has slowed from the 6 percent growth rate in the second half of 2003, economists believe that the expansion process there, and elsewhere in the world, is established enough for the Fed to embark on a “measured” series of interest rate hikes.
Our basic assumption is that US short-term rates rise to around 2.5 percent-3 percent over the next 18 months. That, of course, is not good for bonds as an asset class! On the other hand, rising rates reflect economic improvement, which should also be mirrored in lower corporate default rates and ratings’ upgrades.
High yield bonds have been one of the best performing asset class over the past 18 months. A commitment now, however, is not highly justified if it is based on past performance. Rather, if analyzed from an overall risk/return perspective, then high yield bonds continue to be attractive to include in investment portfolios. Thus, a 300-350 basis point spread on high yield bonds, in both the euro and dollar bond markets, is reasonably secure
Investors should look for high yield bonds to provide an overall return of around 5 percent over the next 12 months. Obviously, incremental return does not generally come without incremental risk. At the individual security level, high yield bonds are much more risky than investment grade bonds. But a lot of this can be diversified away via a well-managed fund.
A second risk is that the entire high yield market might fall out of favor. This could simply be a result of volatility, in which case declines should be short-term. If, however, investors begin to anticipate a serious slowdown, or indeed the next recession, then high yield bonds could fall substantially. Although we do not expect such a development over the next twelve months, if it occurs then there will probably be a lot more downside in a portfolio of blue-chip equities than in a diversified high yield bond fund.
A move by the Fed from an expansive monetary policy to a “neutral” or “balanced” stance does not imply a desire to break the expansion process. Nevertheless, the experience of similar points in previous business cycles suggests that markets might overreact.
As it happened in 1994, markets are expected to shift in the direction and to anticipate slower growth. Other factors also point to some slowdown: China has yet to cool off, and any meaningful attempt to restrain the US budget deficit probably had to happen in the early part of the next presidential term. Thus, “stable” — earnings sectors, such as health care and consumer staples are included in the investment portfolio.
As for energy, whilst it is difficult to tell what spot oil prices will be in the near term, the strong demand in Asia and the vulnerability of several oil producers, for example, Venezuela or Iraq, means that securing oil supplies will remain a top priority. A steady move upward in medium-term oil price expectations argues positively for a decent commitment to the energy sector.
A cautious asset allocation, especially with respect to equities is warranted these days. Even though the forthcoming rise in US interest rates will probably be modest, the markets may well respond negatively. Government bonds are unlikely to do well in the near-term and would preferably be included in a well-diversified portfolio of corporate bonds offering higher income. Consequently, and because of low return projections for both bonds and equities, it behooves fund managers to commit about 25 percent of cash to a diversified range of alternative investments in the portfolios.
Finally, with the US economy now growing strongly and US interest rates set to rise, the dollar’s trend to decline has largely run its course. Elsewhere, the British pound is expected to outperform all major currencies, especially if allowance is made for higher sterling interest rates.
(Habib F. Faris is vice president at Clariden Bank, London.)
(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.)