I sense the year ahead will be one of big action in global bond markets. Last year bond yields fell consistently. This was despite significant shifts in investor sentiment as a consequence of concerns with global debt imbalances, inflationary pressures and tepid economic growth.
2005 may see a number of these influences converge and something will have to give. The outcomes for investors will be critical.
A dominant global theme in 2005 will be the pace of the continued unwinding of stimulatory interest rate polices in leading economies. But things are unclear and expectations have shifted significantly from a tightening bias to a more incongruent relaxed stance.
The prospect of inflationary pressures remains a shadowy doubt in the minds of investors and there is a sense that an absence of explicit evidence of price increases, due to labour tightness, record oil prices and a bull market in other commodities, has underwhelmed many.
Currency movements reflecting trade deficit and relative gross domestic product (GDP) growth forecasts between regions will be increasingly notable. Clearly, prolonged US$ weakness will have a fairly direct effect on the competitiveness of US trading partners in Europe, Asia and Australia, and both their export performance and appetite for US bond holdings. That these may put downward pressure on interest rates in those countries will be keenly watched.
In Australia, there seems to be a growing split between a clear market agreement that global and Australian growth will moderate — supported by treasurer estimates of 3 per cent domestic GDP growth in 2005 — and emerging signs of strong economic fundamentals notably business confidence, household consumption, employment growth and company profits.
The domestic economy is in a slowdown but recent recent evidence suggests the economic cyclical peak is now being pushed into 2006. The economic flow-on effects of a slowdown in housing construction and a negative wealth effect from an easing in house prices takes time to show up in slowing consumption but this may be amplified by the historically high level of household indebtedness.
The prospect of increasing business investment reducing the economy’s reliance on fading household consumption also looks questionable. The time lags involved in bringing new labour and capital capacity online in resource and other export related industries means that Australia has failed to fully capitalise on recent global buoyancy and is vulnerable to any pause in global growth.
On the home front, the bond and equity markets appear to be going in different directions on prospective economic fundamentals. The ongoing flattening of the yield curve is occurring during a period of very positive sentiment in the stock market. The relative balance and magnitude of pricing differences between each market may appear to be a bit more incongruous as the year plays out.
There seems to be a growing perception that local interest rates may continue at historically exceptionally low levels for a while yet. But there are slight signs of sustainability in global growth which may trigger local rate rises and yields to go higher. Bond yields are expected to drift upward in 2005 but the trend may be moderate.
Investor return expectations shouldn’t be unreasonably high. Diversified portfolios will generally go underweight in bonds with duration bets being relatively modest.
Domestic cash rates appear to be on hold, save any surprise return to boom conditions in housing which is unlikely. However, given low inflation, the amplitude of any potential reversal to trend levels is historically narrow, which may constrain investors’ ability to profit consistently from rate changes.
This may focus additional attention on security selection at a time where the valuation pendulum has swung both ways in recent years and the market is now quite over-bought.
— Guy Hutchings is chief investment officer with Tower Australia
