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Now for the good news

Since markets were hit by the credit crisis last summer, bonds have priced in a lot of bad news, both real and that which was expected but never materialised. Having suffered considerably more than equities, corporate bonds now look excellent value from an historical perspective. Investment-grade bonds are pricing in four times the last worst period for defaults in 1984.

It is not surprising that investors have been expecting a recovery in bond markets from the deeply depressed levels. We know from past cycles that a recovery in credit precedes one in equities but is impossible to time. Bond prices have been kept low by inflationary concerns which have led to higher interest rate expectations. We are inclined to agree that the situation could get worse over the rest of 2008 but an interest rate hike looks less certain as economic indicators deteriorate.

UK inflation reached 3.8 per cent in June, accelerating at the fastest pace in 11 years. Food prices are 10 per cent higher than a year ago.

The collapse in the US sub-prime mortgage market has so far cost financial institutions globally about $470bn in losses and write-downs and is inevitably affecting the health of global economies. Understandably, central banks are worried.

Bank of England governor Mervyn King says the UK must expect “an odd quarter or two of negative growth” and there are concerns that the possibility of longer-term high inflation could lead to increased wage demands. boosting inflation further.

We would not agree fully with those sentiments. There is little if any evidence that inflation presents a long-term threat. Rises in inflation have been due mainly to a combination of supply issues rather than an increase in domestic demand which is actually declining in the slower growth environment.

The oil price fell in July in line with reduced petrol consumption in the US. Even if the new bearish trend in commodity markets is short-lived, it is unlikely that they would be able to keep rising at the pace seen in the last year.

Neither do we think that concerns about wage inflation are wholly justified. Some workers in important areas of the UK economy have won increases in their salaries but the overall rise in wage inflation should not be significant as sectors such as financials, manufacturing and construction are in recession. It is more likely that wage inflation will be driven by the public sector. Council workers have been on strike over pay but will face growing pressure as the Government struggles with the mounting budget deficit. Recent rises in unemployment should discourage whispers of discontent. The retail prices index, used to determine wage increases, looks set to fall due to falling house prices.

We believe that inflation concerns are temporary and when considered against falling consumer spending, should not prevent rate cuts in the UK over the medium to long term. Our expectations are for inflation to fall over the next six to 12 months and interest rates to fall to about 4 per cent in response to recessionary risks.

Bond markets should benefit from lower inflation and interest rates. We are finding opportunities in selected new issues, such as in the financial sector where many areas look underpriced following the credit woes. Banks’ shrinking capital bases will lead not only to lower earnings but also to reduced leverage which should help corporate bonds.

The Government’s need to raise cash is becoming more acute as revenues slide on weaker receipts in a slower growth environment. To cut the UK’s huge budget deficit, we think the Treasury will issue an avalanche of longer-dated gilts, spurring a rally in shorter-dated bonds. The yield curve should normalise, with a better outlook at the short rather than the long end due to supply issues.

Stephen Snowden manages the Old Mutual corporate bond fund


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