Blog: You, us, everyone

Some are questioning the general optimism regarding the strength of economic activity, and in particular the impact of rising short-term interest rates on bonds, which many view as a warning signal for long-term growth prospects. Why are niggling doubts beginning to emerge? For a start, lower overall revenues from fixed income vehicles are currently reflecting the recent change in economic growth figures and inflation expectations, which both came in lower than expected for the first quarter. 

But what about the future?
Short-term factors, mainly negative ones, in particular climatic conditions in developed countries during the first quarter as well as time delays in rehabilitating budget deficits and public debts should have an ever decreasing impact on the market, and in particular on interest rates. This should help to normalize the situation for interest rate related investment vehicles, which in turn is expected to drive worldwide economic activity. Viewed in this way, global growth (notwithstanding a few pockets of resistance like France, which is only now starting its self-adjustment process) should further accelerate, and valuations increase further; this bodes well for investing in the stock markets.

We hope that the message coming from the bond markets is correct. Global growth prospects and better financial conditions are clearly supporting a new economic cycle; however, considering the high surplus in the labor market, particularly in developed countries, it appears that a quick and strong acceleration of the world economy, and thus inflation rates, is rather unlikely. This is primarily because the purchasing power of “the average Joe" has not followed suit in recent years! This means that some central banks will continue to enjoy a high degree of freedom in their monetary policy.
What concerns us more though is the increase in US interest rates, particularly in view of the oncoming quantitative easing (QE) termination. The end of QE could become a reality in the third quarter of this year, and it may very well be the case that the market digests this poorly.

At present, the market is anticipating the US interest rates for a 10-year bond will be in the region of 2.6% by November 2014.  Even if it is still this low, an increase in US interest rates will add volatility, particularly for equity markets as well as to overall monetary flows. We expect that vast amounts of US denominated assets will continue to flow from peripheral regions and developing countries to the United States. 

In Europe, the analysis is different: There are signs that in the next 12 months a further narrowing of the spread, by about 90 to 100 bp, between Italian and Spanish bonds, will take place. This bodes well for bond and equity investors, particularly given the recent statements issued by the ECB.  Obviously, there is a clear commitment to these markets. 

Finally, there is another interesting point to note. The decline in the interest rates for the European peripheral countries will result in better public debt sustainability, thus achieving a level of self-healing in these markets.

So where are the risks?

Be aware of risks in the following areas: 

• Geopolitical tensions (the Ukraine crisis, the negative effects of the European elections)
• Macro-economic conditions both in the US and China:

1. a)In the United States: 
   a) an unexpected increase in inflation
   b) overestimated growth prospects
2. In China:
   a) emerging market countries’ failure to adjust quickly enough to the growth slowdown in China
   b) the high level of private debt.