The US economic picture brightened as policymakers announced additional steps to stimulate the economy. Bond yields rose, causing many sectors of the bond market to lose ground in the final quarter of 2010, though high yield bonds, selected currencies and equity markets roared ahead.

In 2010, government and investment grade sectors earned returns of 4% to 9% while high yield and emerging markets posted double-digit gains. The modest rise in yields and spread tightening forecast by our macro and sector teams suggest returns will be less generous in 2011.

Return forecasts are constrained by the low level of yields and our anticipation that yields could trend higher. Using Barclays Capital Indices, yield levels include 1.9% for US Treasurys, 4.0% for investment grade corporates, and 7.4% for high yield corporates. We worry that the sovereign crisis in Europe could deteriorate and spawn a global banking crisis, causing a flight to safety to US markets and lower yields. But that is not our baseline view. Outside of a banking crisis or other exogenous event, we do not see a lot of room for yields to decline sharply and boost returns.

Low current yields are particularly problematic for government and investment grade sectors. The 10-year Treasury could earn 3.3% in one year if rates are unchanged, but lose 1.8% if rates rise to just 4.0% (the peak in 2010). The corporate market offers more yield, and we like that many company balance sheets are generally in good shape, with strong cash balances and growing profits. We anticipate that economic trends will remain supportive of credit quality, allowing the sector to earn higher returns than Treasurys, but we see the sector’s low 4.0% yield as capping its upside. In addition to shopping the investment grade corporate market, we see the securitized sector as offering attractive opportunities. Many managers are underweight MBS due to the government’s involvement in the sector, but we see recent improvements in valuations as a chance to reduce those under weights. Selected securities in the non-agency markets have particular appeal.

The speculative grade market yield of 7.4% also may limit the upside, as the sector typically offers more generous yields. High yield bonds remain one of our favored sectors though, as we believe the incremental income may shore up returns in an environment where yields may be flat to rising. High yield loans, too, will become even more attractive when yield increases are more worrisome. Equity markets (and their proxies, convertible bonds) could earn higher returns than high yield in 2011 as investors reduce overweights to fixed income. But for those who prefer a potentially lower volatility strategy, with income, we believe the high yield market remains very attractive.

Our market views are based on the output of our sector teams, each of which relies on our macro teams for guidance. The forecast of our economist and macro team is for US real GDP growth of 2.9% in 2010, followed by stronger growth in 2011 and 2012. This is sufficient to support credit quality trends, including lower default rates. In judging the US economy, we see progress being made, but challenges remain. For example, households appear to be in better shape. Fed statistics show households have pared down debt (though levels remain high) and rebuilt wealth in a partial recovery from the 2008 crisis. Consumer expectations have risen and the tax situation was resolved favorably (Bush-era tax cuts did not expire on January 1st but were extended, with a reduction in the payroll tax a pleasant surprise). If quantitative easing boosts asset prices, confidence may improve for both consumers and businesses. Businesses also were thrown a carrot at year-end when the tax package included incentives for capital spending in 2011. Thus, there may be upside risk to our forecast, but the weak housing market and persistent high rate of unemployment keep us on the bearish end of consensus forecasts.

In our view, growth may be 3% or higher for the next two years and core inflation may remain subdued as wage pressures remain manageable. This dynamic underlies our expectation that bond yields may be range bound for much of 2011. However, we also expect that the Fed will end quantitative easing in the spring as planned. As monetary conditions become less accommodative, bond yields could be biased higher. Our yield curve team is forecasting bond yields to be marginally higher by year-end 2011, but is not calling for a major bear market in bonds while growth and inflation remain relatively low.

Another trend from 2010 that we anticipate will continue in 2011 is the continuation of China as a growth engine for the world, with faster growth and higher yields in developing countries than in developed nations. While we have a slight preference for US dollar over euro or yen, we are not enamored by any of them and continue to see emerging markets as having greater return potential. We see both Asia ex-Japan and Latin America as benefiting from China’s commodity demands. Our sovereign analysts are forecasting, for example, growth near 4% for commodity exporters like Australia and Brazil. This faster growth and higher yields continues to attract investor inflows, boosting the return potential for both the bonds and currencies.

(c) Loomis Sayles

www.loomissayles.com