Asset purchases – a form of quantitative easing – have been one of the supports that central banks have used alongside low interest rates to stimulate the economy by holding down financing costs. Commentators argue that it is too early for the Fed to be considering lessening its support when the economic recovery is still fragile.
Pessimists about the US economy point to a still high unemployment figure, but this focus is ignoring the flow of new jobs. In the past 18 months the US has created about 200,000 new jobs every month – a figure similar to the levels in the middle of the last decade when the economy was growing solidly. The housing market and the auto market are also showing signs of vigour, as reflected in the chart below. In my view, many parts of the US economy are now experiencing a fairly conventional cyclical recovery.
At a more anecdotal level, when was the last time that you heard anyone talk about the banking crisis in the US? Even the US fiscal deficit has faded as a topic as it declines faster than expected.
Given the prospect of tapering, bond markets are pricing in higher yields in recognition that a stronger US economy could lead to higher interest rates in the future. The yield on the benchmark 10-year US Treasury rose to around 2.5 per cent in late July, up from 1.5 per cent a year earlier. Even at 2.5 per cent I believe this yield does not offer long-term value. My preference within fixed income is for high-yield corporate bonds.
In recent previous interest rate cycles, high-yield bonds have significantly outperformed government bonds in a rising interest rate environment as their higher yields offer a cushion against interest rate risk. Add in low default rates among companies and the fact that a recovering economy could spell reduced credit risk, and high-yield bonds appear to offer a better risk/reward profile.
I remain wary of emerging market debt. Put simply, the fundamentals appear to be deteriorating just as the developed markets start to look more attractive. If developed markets outperform this could drain the capital flows to emerging markets. Moreover, there appears to be a gentle unravelling of the China story. In such an environment, it seems unnecessary to take risks on emerging market debt when high yield corporate bonds in developed markets are offering similar yields.
Gold has been seen as a hedge against systemic fears, so one might argue that wobbles in emerging markets might make it seem attractive. Yet, it is concerns about developed markets that seem to dominate the gold price. Another camp of investors favours gold as an inflation hedge.
Yet extensive QE by both Japan and the US has failed to ignite inflation. That does not mean it will not ultimately be inflationary – at this stage no one can be sure because – but in the near term the markets do not see inflation as a threat.
Paul O’Connor is director of multi-asset at Henderson Global Investors