The good news, in sum, is there is little imminent risk of bond rates heading back to more normal levels and inflicting capital losses in the near term. There is also a school of thought that believes we could be moving into a new era of permanently slower growth and lower inflation, which would reduce the risk of higher bond yields and capital losses over the medium to long term as well. And as market moves year to date have shown, bonds have proven an effective asset to hold through episodes of equity market volatility.

However, there are also significant risks. Current exceptionally low yields are predicated on the global economy growing very slowly and generating very little inflation, and are very vulnerable to any improvement in the global economy. Any signs the major central banks have, in fact, started to work inflation back up to the target levels they would like to see—generally around the 2% mark— would leave bond yields exposed as incongruous.
The second main risk is that, as yields on standard higher quality fixed interest assets such as 10-year government bonds have dropped to ever-lower levels, investors have taken two routes to try to maintain income levels. One is to extend their maturities: governments have found ready demand for ever longer maturities. Latvia, for example, has just issued its first 20-year bond, while Switzerland has issued 42-year debt, France and Spain have issued 50-year debt, and Belgium and Ireland have even managed to place 100-year debt with investors. The other route is to take on more credit risk and to venture into sub-investment-grade assets.

Both of these tactics have their dangers. Mathematically, for any given interest rate rise, longer-maturity debt is more exposed than shorter-maturity debt to capital loss, while credit risk premia for lower-quality debt are there for good reason as they need to compensate for the risks of default. Currently, those risks are rising. On the latest count by ratings agency Standard & Poor's, there have already been 62 defaults this year, the highest year-to-date number since the late global financial crisis period of 2009.

At the moment, corporate and government treasurers are issuing huge quantities of debt, at ever longer maturities and ever lower yields. Investors are buying them, because that's all there is available to generate income without running the equity volatility of dividend income. But the treasurers think this is an unusual window of opportunity to raise exceptionally cheap funds. The treasurers' view looks the better one.

International Equities — Outlook

As the J.P. Morgan Global Services Business Activity Index (produced with Markit) for April showed, the world economy is growing, but "the rate of expansion remains weak by historical standards." The U.S. looks the best out of the major developed economies, with more uncertain prospects for the eurozone, Japan and the U.K. As an overall group, the emerging markets look set for rather more substantial rates of economic growth, albeit with very large differences at an individual country level, and with higher degrees of political risk involved for investors minded to access their better economic prospects.

U.S. economic data has ranged from mixed to good. The most important statistic for the financial markets at the moment is the jobs numbers, and the latest data (for April) were a mix of good and bad. On the plus side, there were new jobs (160,000), but not quite as many as the forecasters' consensus had expected (200,000), and the unemployment rate was steady at 5.0% rather than declining a bit to 4.9% as forecasters anticipated. Many analysts drew the "glass half empty" conclusion that the U.S. economy was not quite strong enough to cope with a series of interest rate increases by the Fed, but more recent data is more consistent with a "glass half full" view.

Retail sales increased by a strong 1.3% in April, a much larger increase than expected, and the data was still impressive even after correcting for the volatility that car sales and petrol prices cause: ex cars and petrol, sales were up a solid 4.4% on a year ago. There was also a very strong rise indeed in the May consumer sentiment index compiled by the University of Michigan, where "Consumer sentiment rebounded in early May due to more frequent income gains, an improved jobs outlook, and the expectation of lower inflation and interest rates." It was notable there was an especially large rise in households' expectations about the coming year, which bodes well for economic growth in coming months.

The outlook in the eurozone and Japan is less upbeat. The latest data in the eurozone has not been strong: German industrial production, for example, unexpectedly dropped in March (negative 1.3% compared with expected negative 0.2%), and year on year was up only 0.3% compared with the 1.1% expected in a Bloomberg economists' poll. France has also underperformed against expectations with a year to year with 0.8% drop in industrial production in March, compared with the 0.5% gain forecasters had been picking. The European Commission's latest (May) set of forecasts says the eurozone will grow this year and next, but at rather modest rates, with eurozone GDP growing by 1.6% this year, and by 1.8% in 2017.

Japan's prospects are unclear. In theory, the economy should be benefitting from easier fiscal and monetary policy, and from "structural reform" aimed at making its industries perform more effectively. In practice, the payoffs have appeared distinctly modest: the Japanese economy did not grow at all in 2014, and grew only marginally in 2015. Forecasters are uncertain whether this year will be much better with the range of views in the Economist's latest (May) poll of international forecasters ranging from a GDP fall of 0.4% to an increase of 1.0%, with an average forecast of modest 0.5% growth.

The outlook for emerging markets is mixed. China has assorted problems, notably high levels of corporate debt and a shaky financial sector more generally, but is still expected to grow (on the consensus view in the latest Economist poll) by a substantial 6.5% this year and by 5.9% next year. The forecasters also expect India to do very well with 7.5% growth this year, 7.1% in 2017, and this year's recessions in Argentina, Brazil and Russia are expected to turn around to modest growth next year. But there are also some very weak economies, notably Venezuela, which is close to economic collapse, and some seriously underperforming economies. South Africa, for example, saw its unemployment rate rise to 26.7% in the March quarter, worse than forecasters had expected. Even if the overall economic performance of the emerging markets delivers for investors, the level of political risk remains high. A good example is Brazil where the currency, the share market and local bond yields have experienced dramatic day-to-day levels of volatility in the wake of the twists and turns in the ongoing impeachment process of President Dilma Rousseff.

The outlook for international equities is for a slowly growing world economy with modest overall growth in corporate earnings. But this outlook is expensively priced, mostly because ultra-easy monetary policies have inflated the values of all kinds of financial assets, and comes with what the European Commission's forecasters called "considerable downside risks." They were particularly concerned about "the risk that slowing growth in emerging market economies, particularly China, could trigger stronger spillovers or turn out worse than currently forecasted remains particularly significant for growth in Europe and the world," and they also mentioned high levels of geopolitical tension, and potential adverse surprises from commodity prices or financial shocks. We could well see the year-to-date pattern of equity markets persisting in coming months: shares do well for a time, but are subject to recurrent reality checks as investors reconsider the likelihood of downside risks eventuating.

Performance periods unless otherwise stated generally refer to periods ended 13 May 2016.