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Investment view

Last year’s big – and pleasant – surprise was the resilience of the bond market, says Brian Tora.

So, it is official. Christmas was the worst for retailers in more than a decade. Some suffered spectacularly. Should such shocking news lead us to revise our views on what might happen to the equity market as the year unfolds? Does it indicate an end to economic prosperity in this country?Share prices have certainly been unsettled by what is perceived to be downbeat company news. It seems likely that there will be more than a few profit warnings around as we approach the results season. Indeed, the prospect of softer earnings performance has kept the lid on Wall Street. It may have been a year of more robust economic growth than many expected but it will not be without the odd sting in the tail.

Of course, markets thrive on surprises and 2005 will doubtless have its upsets. Hopefully, not all the shocks will be on the downside. They weren’t last year, after all. Even oil eased in price as the year drew to a close. But perhaps last year’s big – and pleasant – surprise was the resilience of the bond market. Few expected to make money out of this asset class in 2004.

The smart money was on an increase in yields for 2004, given that economic activity was on the rebound and central banks appeared certain to instigate tighter monetary policies. They did but bonds held their own, perhaps driven by continuing investor demand. Plenty of portfolios can no longer afford not to have a fair sprinkling of fixed-interest securities to deliver forecastable returns over the period to their maturity, regardless of what might happen in the shorter term.

On the plus side for the bond market is that this trend is far from over. Pension funds and insurance companies are still constrained in how they can construct their portfolios. Perhaps equities will deliver superior returns over the longer term but tighter regulation demands an asset mix that minimises risk. Providing for a future income or capital sum is easier to achieve on a guaranteed basis by buying appropriate bonds.

A further plus is that the interest rate cycle may have peaked. The Bank of England will be concerned about rising inflation but you only have to look at the statements that retailers are making to realise that economic activity is likely to slow. Moreover, the housing market has demonstrably calmed down so one of the monetary policy committee’s greatest concerns appears to be moving to the backburner. We appear close to the high point so far as interest rates are concerned.

The extent to which the Chancellor can keep the economic ball rolling by pumping money into the public sector is debatable. He will be conscious that this is likely to be an election year. There are those who believe he is running out of road in terms of keeping UK plc on a continuous upward path, so going to the country in May remains favourite. Records may have been broken, so far as growth is concerned, but some of the pressures that are arising – particularly in public sector pensions – are likely to demand drastic action.

The signs are that the bond market is likely to face a two-way pull as the year develops. An economic slowdown and the end to interest rate increases will encourage buyers but the credit risk is likely to rise, resulting in a widening of interest rate spreads. Corporate bonds could prove a tricky area and not just at home. As for the sovereign debt market, perhaps that will still see a steady flow of money, particularly if worries over economic performance develop.

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