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The bond plays on

Global bond markets had a turbulent 2000. With the interest rate picture often far from clear, equity market sentiment having an impact on corporate bonds on several occasions and a multitude of factors influencing supply and demand, volatility was inevi table. But overall the trend was positive and bond markets, especially government bond markets, performed well over the year.

During 2000, securities markets were principally concerned with whether or not a soft landing will be achieved in the US and other Western economies. In the first half of the year, US growth was str ong and the fear was that inflation would become a problem. But inflation behaved well and third-quarter economic data indicated that the predicted and desired slowdown in global growth had started. More recent US economic data continues to back this up.

Falling yields good news

This slowing growth and the increasing likelihood of a soft landing have been good news for bond markets. Already low yields edged down further in December, reaching the lowest levels of 2000 in the US, UK and Con tinental Europe.

If a soft landing is ach ieved, there is an opportunity for yields to continue to fall. For existing investors, this means capital gains can be made.

A soft landing would be good news for bond markets as it would imply an end to the tightening cycle for short rates, low inflation and, most import ant, no serious upset to the continuing pattern of improving Government finan ces.

Government bond markets, particularly in the US and UK, are shrinking but the economic backdrop will ens ure there is ongoing demand for bonds.

There are additional sound investment reasons for inc reasing bond exposure at present, not least the more stable inflation outlook.

Over the last decade, central banks have been able to deliver lower, more stable inflation and this is something we expect to continue. Not only is it fundamentally supportive for bonds but it should also undermine the relative attractiveness of other assets such as equities.

For equity markets, slowing global growth means the outlook for profits has deteriorated – many high-profile companies have issued profit warnings in the last few months. Equity markets now require further positive news about interest rates to offset the gloom that the profit outlook has caused.

US calls the shots

As ever, the outlook for the US economy will be the key to determining the mood of bond markets in 2001. While the econ omy is slowing, it is the extent to which it is slowing that remains in question.

Last week&#39s 0.5 per cent rate cut by the Federal Reserve without an official meeting suggests that the economy may be weaker than first thought although it also emphasises that the Fed is ready to prevent a hard landing occurring.

Soft landing positive for gilts

If our view that the US slows but avoids recession is bro adly correct, then the outlook for global government bonds in general is positive.

Japanese bonds remain fundamentally unattractive to non-Japanese. In the US, the one factor that we can rely upon will be the lack of government supply. Regardless of politics, or even the extent of the slowdown, the fiscal situation will remain healthy and the Government will continue to reduce national debt. If we combine this very bullish factor with our view of the US economy, then the environment for US government bonds will stay positive and yields can continue to trend lower as oil effects wash out of the inflation data.

The UK is our favoured market, however. The supply situation is similar to the US and the economy is positive for bond investors – growth is around trend, there is no inflationary concern, no further rate rises are predicted and strong domestic demand exists for bonds.

UK is favoured credit market

The outlook for UK corporate bonds is also more positive than it is for US or European corporate bonds. Domestic demand is a clear driver here, with pension funds in particular keen to increase weightings in this market.

The higher-yield end of the corporate bond market was rocked several times in 2000. Many have been issued by technology companies and suffered as new economy companies fell out of favour. This even filtered through to high yield industrials, which were impacted further by negative stock specific news. Conversely, investment-grade corporate bonds generally performed well. This pattern is likely to continue in 2001.

What if a hard landing occurs?

Summing up, bond markets are likely to perform well if a soft landing is achieved. So too are equities. The UK gilt and investment-grade corporate bond markets appear to provide the best opportunities in the year ahead if a soft landing is achieved.

Of course, a hard landing cannot be ruled out entirely. The good news is that it is a bit of a win-win situation for fixed-interest inv estors whatever the outcome as, unlike equities, bonds are also well placed to perform well under a hard-landing scenario. Their defensive qualities are already proving attractive to many investors and their safe haven status should continue to underpin the market in the short term.

But it should be remembered that any fixed-interest outperformance to result from a hard landing will be difficult to sustain in the long term as the key fiscal driver is negated.

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