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Growth uncertainty prompts bonds vs equities debate

Growth uncertainty prompts bonds vs equities debate

05 October 2010 / by Paul Dicken

The uncertainty around whether growth in the UK economy will be sustained is fuelling expectations that the Bank of England will step in to boost the economy and pushing investors towards bonds.

Despite a growing consensus that the UK economy will not sink back into recession, there are concerns that the economic growth seen in the first part of this year is faltering, leaving economic output low and unemployment high.

Only one member of the Bank’s Monetary Policy Committee (MPC) has voted for raising interest rates, with the majority of the committee wary enough on economic growth to maintain a loose approach designed to stimulate growth.

Economic uncertainty increases the perceived risk of investing in company equity, with the market seeing investors buying up government and corporate bonds as a safer bet. Bonds have also been popular amid expectations that further quantitative easing will mean central banks buying-up bonds.

Inflation concerns

Rather than concern over high inflation, the strength of the economic recovery and prospects for low inflation or deflation seem the more pressing item for policy makers.

Economist at the Centre for Economics and Business Research, Owen James, said the CEBR view was that ‘growth certainly won’t keep pace with the show-stopping figure we saw for the first half of 2010.’

Rather, he believes growth for 2010 will be around 1.7 per cent higher than 2009, which is stronger than some forecasts.

He agrees with many, including the MPC, that inflation is being affected by the VAT increase and rises in food and cotton prices caused by ‘shocks to supply’, rather than a trend towards higher prices.

James said the bank will probably use further quantitative easing to put a ‘bit more life in the system’, into the first quarter of 2011and the second quarter and then gradually reduce that every year and finally divesting itself of these assets by 2016.

 “We are coming round to the view that if you have a bad few months of data, the government may have to reconsider the VAT increase set for 2011,” he added.

Investing: bonds vs equities

The big debates on macro-economic policy are running alongside interesting developments in the market with growth fears and quantitative easing rumours making bonds increasingly popular, but fund managers flagging-up the potential in equities.

Bill Dinning, head of strategy at Aegon Asset Management, said: “On the face of it, it seems a little bit strange that the Bank of England should be worrying about deflation. Having said that, the market clearly shares some of this concern.”

“Investors have been more attracted to government bonds and corporate credit because there is less risk than equity and the yield pick-up is attractive in a low-yielding world,” he said.

Despite this, Dinning says there is an ‘interesting situation’ developing between bonds and equities.

“We haven’t consistently had equity yields higher than government bonds since the 1950s. That is a reflection of the great uncertainty about the future sustainability of this recovery.”

That said, Dinning believes that the price of equities reflects this, with benefits available from high-yielding equities.

European opportunities overlooked

Head of European equities at F&C Asset Management, Paras Anand, said recently that some shares in Europe are being overlooked due to the ‘bleak macro economic outlook’.

He said there were real risks to ongoing high-inflation and future quantitative easing could have a higher than expected inflationary impact. This would have a negative effect on the yields offered by investments in bonds or cash.

“We believe there is clear value both in particular areas of the market and in Europe as a whole, particularly among large-cap companies. This is where we see the best investment opportunities on a long-term basis,” Anand said.

Talking-up the prospects in smaller companies across the Atlantic, co-chief investment officer at Legg Mason asset management affiliate Royce & Associates, Whitney George, said the market pessimism had led to some very cheap valuations in the equity market.

“We believe that the next decade will be a lot more pleasant for equity investors than the last and we’re seeing value across the equity spectrum regardless of market cap,” he said.

Royce & Associates invest in small and micro-capital stocks in the US, with Whitney George pointing to merger and acquisition activity as a driver of returns, and performance in specific areas, such as natural resources and some areas of financial services.

© Fair Investment Company Ltd