Friday Highlight  

Bonds show lots of promise

There is growing evidence that a similar pattern is now unfolding in other developed markets. Even with incredibly low yields at the beginning of the year, German government bonds have produced a total return of 4.5 per cent so far this year and UK Gilts have returned just over 12 per cent.

For equities, the Japanese template suggests returns will be much less impressive with greater volatility.

While lower interest rates imply a higher present value of future discounted cashflows, if those low interest rates reflect depressed nominal growth expectations, then disappointing earnings will weigh on equity performance.

Within stock markets, banks are clear losers due to weak loan demand and low interest margins. Japanese banks were partially able to mitigate difficult domestic conditions by becoming increasingly internationally focused, but that avenue is no longer available given low interest rates and weak loan demand globally.

Investors need to understand changes that could upset this low growth, low inflation and low interest rate equilibrium.

There is growing recognition that monetary policy alone is unable to reverse declines in growth and inflation in a balance sheet recession.

A radical shift in policy such as aggressive fiscal expansion would ease downward pressure on bond yields and should benefit equities, particularly banks.

However, history has shown that it takes a crisis to prompt policymakers to make profoundly different choices.

As a global downturn takes hold, interest rates are likely to remain under downward pressure and low interest rates will remain an essential part of any fundamental shift in policy.

In this environment, bonds should outperform equities, interest rate sensitive sectors such as banks should continue to struggle and alternative assets to cash should benefit.

Sebastian Mackay is a fund manager at Invesco