Nedgroup Investments Global Market Outlook: October 2006
Traditionally low-risk government bonds are priced for dull returns, but the largest western equity markets now offer brighter prospects, says Rowan Williams-Short, Chief Investment Officer at Nedgroup Investment Advisors (UK).
Commenting on the global market outlook for investors, Williams-Short says the big equity markets in Europe, the UK and the USA are trading at very attractive price: earning multiples. He is, however, bearish about the outlook for government bonds, "unless or until they sell off aggressively and produce interesting buying opportunities."
"Corporate and emerging bonds look expensive against even those already expensive benchmarks. Most large equity markets are attractively priced. Within the wider array of hedge fund opportunities, we are despondent about the outlook for fixed income arbitrage but excited by distressed debt, convertible bonds and event driven funds."
To elaborate further, Williams-Short said, "We'll begin with sovereign bonds, as they both form a natural default asset class for many investors and set the theoretical levels of prospective equity returns, through the mechanism of yields-to-maturity on bonds plus the equity risk premium. Nominal yields are at desultory levels. Given that, unlike equities, bonds offer no inherent protection against unexpected increases in inflation, one must also examine the prospective real yields on bonds. Again, these are at low levels. Presently, the average of the real yields of ten-year bonds issued by the four countries comprising the majority of the various world bond indices, namely Japan, USA, Europe and UK, is a little under 2%. As asset managers, we cannot get excited about toiling away to provide our clients with a real return of around 2% per annum over the next ten years!
"What then of the prospects for good, active bond managers? Again these seem lacklustre. The extreme flatness of yield curves currently negates traditional strategies to enhance yield while remaining neutral to duration exposures. Finally, yield curve shapes, especially in the west, make the outlook for fixed income arbitrage look bleak. In such environments, many traditional fixed income arbitrageurs tend to either leverage their funds massively, or to drift into more exotic interest rate instruments, such as Brazilian bonds, where they have little or no proven expertise. As investors we wish to encourage and to be exposed to neither of these practices.
"So, continuing the quest for yield, we turn to corporate bonds and to emerging market bonds. Sadly though, we are once again disappointed. Spreads (or the yield differences between such bonds and the relevant government issues) have contracted so much that the markets appear to be treating these instruments as virtually infallible. The truth is far removed from that. Just because we have come through a period of some 18 months of extremely low levels of default by such issuers is no reason for complacency. On the contrary, corporate defaults rates (both at the investment grade level and the speculative or so-called junk bond level) are mean reverting. That, coupled with a considerably higher level of the Fed Fund rates and the imminent maturity of a mountain of debt issued during the "TMT" debacle, seems to indicate that a sharply higher default rate is looming. So, to be compensated at historically low levels for these impending risks is perverse. In fact, for a while, we may find that "high yield" funds are no more than a misnomer. Conversely, troubled times for corporate bonds imply that the outlook for "vultures" is good: after a long drought, distressed debt buyers are anticipating rich pickings.
"Other brighter prospects include the largest western equity markets, which are rading at very attractive price: earning multiples. In both the USA and the UK, these levels are at or near multi-year lows, where they last traded in the early nineties. It is worth recalling that subsequent returns were superb. Another behemoth of an equity market, Japan, is also intriguing. There, the well-documented prioritisation of employee and other interests over those of shareholders is without question undergoing a sea change. This can be observed in share buy-backs, retrenchments and sharply higher dividend payouts.
"Two other asset classes that currently interest us deserve a mention: convertible bond arbitrage funds and event-driven hedge funds. The former looks promising because levels of implied (and in many cases realised) volatility, are almost as low as they have been since reliable indices such as the VIX began; this in spite of considerable geo-political turmoil. Consequently, the options embedded within convertible bonds are available cheaply. Lastly, after several years of restraint (occasioned by the hangover from over-indulgence at the turn of the millennium)corporate activity is increasing quite dramatically. In particular, mergers and acquisitions in Europe have begun to soar. In this cycle, cash rather than over-priced scrip, is the buyers currency of preference. "
