Investors’ risk appetite has continued to improve in recent months as the major developed economies seem to be emerging from recession and signs of a stabilisation in global economic activity increase.
While improvements have been significant, central bankers are warning against overreacting to positive data. Most policymakers remain cautious and warn against the dangers of an early exit from stimulus programmes.
Against this backdrop, global non-government bond markets have generated significant positive returns year to date. High yield corporate bonds, corporate bonds issued by financials, particularly subordinated issues, and US dollar-denominated emerging market debt generally outperformed the other major sectors, although non-financial investment grade corporate bonds and mortgage-backed securities also gained significantly.
Looking ahead, investors have shifted their focus from short-term concerns over economic and market developments to assessing long-term trends alongside short-term vulnerabilities across the global economy. Given the sharp contractions in GDP in the US and Europe over recent quarters, these economies now have the potential to grow above trend for a few quarters as part of a cyclical rebound following what we consider excessive corporate cost-cutting measures.
However, we would warn against expecting a continuation of robust GDP growth after the next few quarters and believe it is more likely to be subdued for years to come.
We see a number of challenges for investors going forward. Although we remain more sanguine than the market on the outlook for inflation, we recognise that uncertainty remains unusually high. While the destruction of productive capacity during the recent financial crisis is likely to put upward pressure on inflation, as the global economy picks up, weak household spending is likely to have the opposite effect on inflation. A further challenge for global investors is to identify lasting impacts from the financial crisis across regions and markets where central banks are likely to hold rates lower for longer.
Despite the strong gains in non-government bonds year to date, we continue to see value in many credit sectors. Indeed, we expect spreads on corporate bonds generally to narrow, although issue selection and subsector rotation are becoming increasingly important as investors have started to differentiate more between bond issuers. We continue to focus on corporate bonds issued by financials, although we are shifting exposure out of subordinated issues into more senior bonds. Elsewhere, high yield corporate bonds have become less attractive as market pricing has improved significantly.
Mike Zelouf is a product specialist at Western Asset Management – an affiliate of Legg Mason
