Lessons from Japan

Increasingly it looks like developed western nations are following the path set by Japan. Overburdened by debt, growth remains low, deflation rather than inflation becomes the major pre-occupation for central bankers and interest rates remain low.

What's the message for fixed income?

Short JGBs remains the graveyard of global bond managers over the last decade and the message is that fixed income performs well in this environment. The precise question is: what sort of fixed income?

Government bonds should perform well. The major competitor to governments are cash rates, going nowhere anytime soon and inflation, where the risks are tilted towards the downside as commodity prices fall.
The year 2008 could be a good guide here. Oil peaked in July 2008 at $160 per barrel, falling to $60 per barrel by year end with dramatic consequences for inflation.

Likewise any bond that has a significant element of interest rate risk, investment grade credit, covered bonds etc, should participate in this rally. Conversely, inflation linked bonds, with breakeven inflation rates at elevated levels, look vulnerable.

More debatable are those areas of the bond market that rely on growth such as high yield (HY) and emerging market debt (EMD). Here there remains a tension between the growth outlook and valuation. By committing to keep rates low for a few years (albeit conditionally) the Fed's view on economic growth is pretty clear and generally this is an environment where corporate profitability could come under pressure. Against this, valuations for both HY and EMD are now looking pretty attractive.

Two issues need to be highlighted:

Firstly, a low growth environment is one where differentiation between issuers will increase and security selection becomes paramount. The gap between the best and worst performing bonds in HY and EMD is likely to be large going forward and we have the resources in place to score well here. Our large, global EMD team covers all sectors of that market:  local, external and corporate and our army of career corporate credit analysts will come into their own in this environment. In fact, joining the corporate credit army this week is veteran high yield manager Bill Healey as part of the Euro high yield team.

Secondly, systemic risk. With central banks starting to respond to the lower growth environment, and with other tools at their disposal, the Fed for example, could cut interest rates paid on negative reserves, extend the duration of holdings on its balance sheet as well as launching QE3, does offer some reassurance to investors.

Offsetting this, events in Europe are by no means solved. The EFSF proposals remain unratified, the ECB is reluctantly buying Italian and Spanish bonds and political tensions are increasing. Any spill over that causes a double dip and genuine growth scare would be detrimental for HY and EMD prices.

What does this mean for portfolios?

Bond investors have two enemies, high interest rates and higher inflation. Both are unlikely to present much of a challenge for a while.

This is an environment where fixed income returns are likely to continue to (positively) surprise investors. Portfolios remain well positioned with a modest long duration bias and low risk levels.  As we get greater clarity on the evolution of the Eurozone response we will also look to tentatively deploy our cash pile into riskier assets.