Bonds
, we noted that both gilts and corporate bonds remained an attractive "parking space" for investment funds pending an improvement in the outlook for other asset classes. With inflation low and still falling, the fixed returns from bonds continue to look attractive, and prices for investment grade corporate bonds have improved somewhat as the perceived risk of default eased.
The outlook for gilts remains fair in the short term, helped by the Bank of England's buying, but a growing number of observers are starting to express concerns about the prospect of massive new issuance in the years ahead. Such pessimists say this oversupply will depress prices and force up yields.
Optimists argue that while the headline numbers sound big, in the context of global capital markets, they are not – and so far, there has been no let-up in global investor appetite for safe assets. Also, there is a precedent: during the massive expansion of Japan's debt in the 1990s, there was no attendant collapse in the price of Samurai bonds.
Investment Grade Corporate Bond Index - last six months
Inflation expectations and risk appetites will be the other key influences on bond prices. Inflation is back in the box for now, but any sign of its re-emergence would be bad for bonds other than index-linked ones. A moderation in risk appetite – for instance, if investors start to become more nervous about the sustainability of the recovery – would be good for gilts but bad for high-yielding (non-investment-grade) corporate bonds.
Conversely, if investors become more gung-ho, riskier bonds would be expected to benefit at the expense of gilts.
Given our expectation that markets generally will remain jittery over the summer, we still think bonds are an attractive asset class – but keep an eye on inflation data.
Ten-year gilt price - last six months
Shares
Our last call on shares generally was that the market did not look attractive enough to merit an overweight position in equities, and that the market bounce was a euphoric "dash for trash" bear market rally. For much of the past few months, that has looked very much like the wrong call. Between March and May, share prices rose sharply, especially in the US.
However, that rally has run out of steam in the past few weeks. The FTSE 100 has remained stuck in a broad range between 4000 and 4500. If economic and corporate news through the summer disappoints, support for equities will falter. This is especially true in the US, where share price are markedly higher in relative terms than they are in the UK, and where even in March, valuations were nowhere near the depths they reached in previous downturns.
In these circumstances, defensive sectors – food producers and retailers, pharmas, health care equipment shares and utilities – would normally perform better than cyclical ones, and large-caps would outperform mid-caps.
That said, companies are generally in much better shape now than they were in previous downturns. Outside the financial sector, profitability has held up remarkably well. In the first quarter of 2009, UK non-oil and non-financial companies made a net return on capital of 11.4 per cent. Although this is down from the cyclical peak of 13.7 per cent posted back in the fourth quarter 2006, it's a better return than firms made during the recession of 1990-92 or even the mild downturn of 2001-02. And it's much better than in the 70s and early 80s.
The second-quarter results season in the US has been dominated by forecast-busting numbers from bellwethers like Goldman Sachs and Intel. Corporate profits don't look like they're about to collapse. The question is more about whether they can grow as strongly in coming years as they have in previous years.
A key risk factor there is the state of the banking system. We've had banks' recapitalizations, but we haven't yet seen the full losses on loans caused by the recession. Normally, banks' capital would be eroded as such losses rise. It's this prospect that is holding back lending – which, as the Confederation of British Industry has volubly complained, is still sluggish.
So, our view on shares remains that, while there may well be individually attractive opportunities, the FTSE 100 may need to drop below 4000 before the market in aggregate starts to look attractive. That level has provided solid support so far. If it does breach 4,000, a bounce off the March lows (3,512 on the FTSE 100) would be a very positive signal.
FTSE 100 - last 12 months
