5 Reasons Bonds Have Been Strong This Year – But Will It Last? At the start of the year, very few investors would have chosen bond markets as one of the best places to put their money over the next 12 months. Positive economic news coming out of the UK and US as well as the increasing risk of interest rate rises from the Bank of England and Federal Reserve suggested that the Fixed Income sector was in for another tough year. But, with less than 3 months to go until the end of 2014, returns from bond markets have so far beaten most other asset classes with yields retracing much of the rise that they saw in 2013. We discuss the five main reasons why bonds are doing so well this year and end by asking whether it will last. Year-to-date returns UK Index-linked Gilts 10.6 UK Corporate Bonds 8.4 US High Yield Bonds 8.1 UK Gilts 7.6 Global Sovereign Bonds 5.0 Emerging Mkt Debt 4.1 -5 % 0 5 10 15 Source: Bloomberg and JP Morgan, total returns to 6th October, in GBP terms, unhedged 1) Disappointing economic growth While UK-centric investors would be forgiven for thinking the news has been pretty good this year, the truth is that we have been the exception rather than the rule as far as the global economy is concerned. US GDP growth, for example, was negatively impacted by the bad winter and although recent data has been fine, the economy is only on course to grow by around 2.1% this year. The Eurozone also continues to struggle with the core economies of Germany and France faring no better than Spain and Italy. Lastly, there is considerable angst about the state of the Chinese economy, where growth levels are in steady decline as the government tries to rebalance away from a dependence on investment and exports towards more domestic consumption, posing the risk of a ‘hard-landing’. 1 2) Low inflation Not only has growth disappointed this year, there has also been a complete absence of inflation pressures, even in economies which are doing reasonably well like the UK and US. Falling unemployment rates have not yet fed into higher wages and the drop in food and energy bills has helped push CPI in the UK down to a 5-year low of 1.5%. In the Eurozone, there is a significant risk of outright deflation with CPI of only 0.3% in September. UK and Eurozone Inflation Source: Bloomberg as at 6 October 2014 3) Dovish Central Banks Given the combination of low inflation and disappointing growth, it is no wonder that most major central banks remain fairly dovish, with policymakers like Mark Carney and Janet Yellen stressing that any rise in rates will be gradual and limited. Bond markets have taken them at their word, driving long-dated yields back down to historic lows – 30 year gilts, for example, only yield just above 3%, which is roughly where they were during the dark days of the Eurozone crisis. The European Central Bank is also in full-blown stimulus mode as they try to head off the threat of deflation and have recently cut interest rates, pumped cheap liquidity into banks and launched their own particular version of QE. These measures have helped to push European bond yields down to incredibly low levels – German 10 year bonds are at just 0.9% - increasing the relative attractiveness of gilts and treasuries for global investors. 2 30 year UK Gilt Yields Source: Bloomberg as at 6 October 2014 4) Geopolitics The least predictable driver of this year’s bond rally has probably been the steady stream of worrying geopolitical news, especially the tensions with Russia over Ukraine which increased demand for safe haven assets like gilts. The move to impose sanctions on the Russians has also come at a cost to German exporters and is partly behind the recent poor data out of Europe’s largest economy. 5) Investor Positioning Last but not least, one of the reasons for the strong returns in bond markets has been that a lot of investors started the year significantly underweight in favour of other asset classes, such as equities. If you look at asset allocation surveys for fund managers, the percentage of investors saying they were underweight bonds was at its highest level since 2007, with overweight equity positions at extreme levels – in other words, being negative on bonds was the consensus trade. There has also been continued strong buying from pension funds, possibly looking to lock in previous gains from equity holdings. Will it last? There is no doubt that most areas of the bond market look expensive by historical standards, with limited scope for long-term returns and we are maintaining a defensive approach. However, a number of the factors mentioned above are unlikely to go away soon, suggesting any rise in bond yields is likely to be a gradual process. For example, geopolitical risk, a slowdown in China and a dovish European Central Bank look like being just as big topics in 2015 as they have been this year. The key worry for bond investors is inflation – particularly any concrete sign that diminishing slack in the US and UK jobs market is leading to a rise in wage growth. The Bank of England and the Fed would then have to turn more hawkish, likely pushing bond yields up from current levels. If that happens, the pressure point could well be the credit markets where years of strong demand 3 from retail investors has left valuations looking particularly stretched even as worries about liquidity have increased. As we approach the end of the year, bond markets look set to remain as challenging as ever. Richard Carter, Head of Fixed Income Research For more information or to talk to one of our discretionary investment managers, call us now on 020 7150 4005 or visit www.quiltercheviot.com. Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future returns. You may not recover what you invest. This document is not intended to constitute financial advice; investments referred to may not be suitable for all recipients. Quilter Cheviot is the trading name of Quilter Cheviot Limited, a private limited company registered in England with number 01923571, registered office at One Kingsway, London WC2B 6AN. Quilter Cheviot has established an office in Dublin, Ireland with number 904906, is a member of the London Stock Exchange, is authorised and regulated by the UK Financial Conduct Authority, is regulated by the Central Bank of Ireland for conduct of business rules, under the Financial Services (Jersey) Law 1998 by the Jersey Financial Services Commission for the conduct of investment business in Jersey and by the Guernsey Financial Services Commission under the Protection of Investors (Bailiwick of Guernsey) Law, 1987 to carry on investment business in the Bailiwick of Guernsey. Accordingly, in some respects the regulatory system that applies will be different from that of the United Kingdom. October 2014 4