Five investment themes for 2014 from Investec

Developed market government bond yields are still too low, says John Stopford, portfolio manager of the Investec Diversified Income Fund and across the Investec Managed Solutions Range.

The consensus looks wrong on the pricing of US growth and Federal Reserve policy

To us, the consensus looks most wrong on the pricing of US growth and Federal Reserve policy. The FOMC are certainly dovish, but they are also data dependent. Markets do not currently appear to believe in the scope for a significant acceleration in US growth. Economists have forecast this before, but growth has disappointed, and so they are once bitten, twice shy. We think this ignores the impact of fiscal policy which has been substantial. In some ways growth in 2013 of between 1.5-2% is quite impressive given the severe impact of sequestration on government spending.

In 2014 the swing away from fiscal tightening will be bigger than the tightening seen in 2013. This alongside improving capital expenditure and consumer spending helped by lower gasoline prices should allow the US economy to grow much more strongly than for a number of years. This should cause markets to rethink the speed of policy normalisation pursued by the Fed. It will still be very gradual, but perhaps not quite as gradual as suggested by forward market pricing. The dollar, which has been held back by QE, should receive a strong shot in the arm as a result.

The dollar looks cheap
Last year, our view was that the dollar bull market would continue to be postponed. Although growth in the US economy is picking up, the Federal Reserve is determined that it should not be threatened by tighter monetary policy. Very loose monetary policy means a weak dollar, which has provided support to emerging economies and their markets. However, dollar pessimism is extreme, the currency is cheap and growth is likely to surprise on the upside. This means that the surprise is likely to be in the direction of tighter monetary policy. The dollar may not be ready to rally yet but further weakness looks unlikely and it is likely to strengthen in the year overall. The suggested investment implication for investors is to position with a moderate overweight in dollars initially with the probability of raising exposure during the year.

Developed market government bond yields are still too low
Yields on 10 year government bonds in the US and the UK rose to almost 3% and in Germany rose to nearly 2% but have since backed off. Real yields are close to zero, assuming that inflation remains low. This remains unattractive; as economic growth picks up, we expect real yields to rise at the longer end of the yield curve, even if inflation remains subdued. The time to return to a full weighting in government bonds will be when central banks are tightening monetary policy, which is unlikely anywhere before the end of 2014. Bond yields in Japan remain well below 1%, suggesting that domestic investors do not expect the government’s strategy of raising inflation to a sustained 2% to succeed. With the yen likely to remain weak, we are avoiding this market also. For investors, we would look at this as a time to avoid strategic positions in government bonds in developed markets, but consider buying into weakness.

Steady commodity prices and rising employment could lead to some inflation disappointment
Consensus opinion about commodity prices has been a lot more volatile than actual prices. With demand for energy and metals growing steadily but supply also, we expect them to continue to trade sideways. This means that commodity prices will cease to put downward pressure on inflation.

Employment growth continues to be strong in developed and most emerging markets; before long, this will feed through into higher earnings. This should sustain economic growth but limit the potential for higher profit margins and may result in moderately negative inflation surprises.

The suggested implication for investors is not to take current low inflation rates for granted. Higher inflation than expected means caution towards interest rates everywhere, and underlines the importance of looking for strong, sustainable real yields.

Opportunities in credit and emerging market debt
In our view, 2014 looks like being a difficult year for corporate credit and a modest one for emerging market debt, but there may be an attractive long term buying opportunity later in the year.

While yields on government bonds remain unattractive, those on investment grade corporate bonds offer a modest pick-up in yield and those on high yield a more significant one. However, the additional yield offered by credit is unlikely to be sufficient to compensate for a rise in government bond yields. Issuance of both investment grade and high yield bonds has been significant, implying no shortage of supply. The opportunity for credit upgrades is diminishing as companies with the potential to improve balance sheets have mostly done so.

Credit may be a disappointing investment until government bonds have adjusted. The opportunity in EMD looks better, with many currencies having weakened significantly, yield spreads over developed market bonds reasonable and opportunities for adding value more extensive, though emerging market currencies may need to weaken further in the short term.

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