Inflationary headwinds key risk to bond investors

Updated: Jan 28 2013, 08:01am hrs
Managing Director, Chief Investment officer Asia and Middle East, RBS Wealth Division

Even as India is likely to gain its fair share of capital flows coming to emerging markets in 2013, international investors will be somewhat wary of India at the end of the year, says Gary Dugan, MD & CIOAsia and Middle East, RBS Wealth Division. In an interview with FEs Devangi Gandhi, he talks about a possible end of the 30-year-long bull run in the US bond market and the likelihood of investors who shunned the equity markets in 2008 in favour of bonds reversing their strategy.

You have argued that the 30-year long bull run in the US bond market may be close to an end. Can you tell us why

Inflationary headwinds are the key risk to bond investors total returns in the years ahead.

At the core of the bond rally were the deliberate anti-inflation policies of the US Federal Reserve in the late 1970s and early 1980s which sowed the seeds of rising bond prices and declining yields.

However, the worlds central banks current inflationary policies look set to derail the bond marketleaving fixed-income investors exposed to the prospect of lower, and in some cases negative, returns. Even as short-term interest rates remained lower, we see long-term interest rates rising, in turn pushing the bond prices lower. The huge demand for government bonds in recent years has pushed yields down and prices up (yields move inversely to prices) to such an extent that bonds have never been so expensive.

Equities, on the other hand, remain cheap compared to long-term averages, even following a modest rally in 2012. Equities have yet to fully respond to the recent improvement in economic news, suggesting that investors are more focused on near-term risks than long-term prospects.

In case of a shift in investor interest from bonds to equities what kind of inflows can be expected in equity markets, including of emerging markets

Over the last three years approximately $1.3 trillion has flowed into bond mutual funds and $350 billion has been withdrawn from equity mutual funds. We expect some reversal of this trend in the coming year. Most likely that around $300 billion will flow into equities this year of which potentially $50 billion could be earmarked for emerging market funds.

While the Chinese market underperformed that of India in 2012, with an economic revival in sight for Asias biggest economy, can India lose out to China in attracting substantial FII inflows in 2013

We believe that China will attract a significant part of the flows given the very low valuations and the good news flow. China has the more immediate good news given the recent upgrades to GDP forecasts, given the stronger than expected end to last year. India has a building long term story with the recent spate of economic reforms. International investors will however be somewhat wary of India at the end of the year given the likely general elections in 2014. International investors will be hoping that whoever the government is that they will follow the current path of significant reform.

How would India fare compared to other EM members like Brazil and Russia in drawing capital flows this year

India is relatively more attractive than Russia or Brazil. Although the Russian equity market is cheap, investor concerns over corporate governance and government interference could still hold the market. In Brazil domestic growth is weakening however higher than expected inflation is holding the central bank from easing.

As the US economy strengthens its recovery, can similar developed markets that are likely to see a revival in economic growth eat into investor interests in EMs

Even if the US delivers greater than expected economic growth we still expect investors to favour emerging markets over developed. The only exception might be the Japanese equity market where the depreciation of the yen and active economic policies to drive growth should be very supportive of the corporate sector.

Which factors can pause or reverse the prevailing risk on sentiment amongst investors, in the order of their importance

The key risk to the markets is a resurgence of inflation or further problems with budget policy discussions in the United States. Inflation should not be a problem for much of the year however if growth remains strong as we end the year, a likely spike in inflation could bring interest rate increases in Asia.

If the US does not resolve its political differences between the Republicans and Democrats then there is the prospect of government policy sending the US economy into a recession.

What is your outlook for the global crude oil prices

Geopolitical risks bias oil prices higher. In the very term the inability of Mr Netanyahu to gain a strong mandate to form a government probably means that some of the risks of Israel attacking Iran have fallen back. However problems in Iraq, Syria and Kuwait still pose potential upside risk for the oil price. We expect the oil price (Brent crude) to trade in a $100-120 a barrel range with an upside risk to $150.

How has been the progress of policy action in containing the Eurozone debt crisis, can things still go wrong

The Euro zone still poses a long term risk to the market. It is still very unlikely that many of the Eurozone governments will hit their deficit reduction targets. However the markets have been more forgiving recently so the Eurozone is still likely to muddle through. A general election in October in Germany poses a risk for the market particularly if the current Chancellor Angela Merkel was to be removed from office. In the very near term pending elections in Italy with Mr Berlusconi in the ascendency also poses a near term risk to markets.