There is a great debate, as there always is at this time of year, as to whether global growth forecasts will indeed materialize after years of uneven growth. There is more optimism in 2014 that the global economy has turned the corner than at any time since the 2008 financial crisis.

But investors are advised to be cautious. There is still a lot of potential for market volatility, as global economies begin to gain strength. Global bonds are ideal to offer diversification as a hedge against US inflationary pressures as a result of Federal Reserve tapering. They provide exposure to higher yielding fixed income in higher growth economies. They also preserve capital while new trends in equities markets become apparent.

The World Bank on Dec. 14 released its latest global growth forecast, whereby the bank’s economists projected overall growth to increase from 2.4 percent last year to 3.2 percent in 2014 and to maintain that level for the next two years.

“The performance of advanced economies is gaining momentum, and this should support stronger growth in developing countries,” Jim Yong Kim, the president of the World Bank, said in a statement.

Combined with the Federal Reserve’s upgraded economic forecasts for the US, this report is good news. But it’s also a sign to be cautious, because any transitory environment offers greater risk. It’s yet another sign for caution when respected money managers begin to argue that permanent changes have occurred in the way markets operate, such as in the early 2000s when some contended that the market had evolved beyond business cycles.

This type of hubris has recently reemerged in the realm of fixed income. KKR’s Global Macro & Asset Allocation Team has become so bullish as to tell investors to overweight their positions in developed economy equities and to target a “massive underweight” to government bonds and investment grade debt, in a recent report.

“Central to our thinking is our strong belief that traditionally ‘safe’ fixed income investments can no longer fulfill their long-held role as either income producers or shock absorbers in a diversified, multi-asset class portfolio,” argued the firm’s strategists.

Investors should take grand claims such as these as a contrarian signal, particularly when a high-risk, uni-directional position is advocated in a highly uncertain environment. KKR isn’t alone. Some have argued a more nuanced point that rates are too low this time around to offer the same protection as in prior periods, rather than making a sweeping indictment of fixed income instruments as wealth preservers.

However, these statements overlook the advantage of a rising-rate environment, in which one can reinvest interest income at ever-higher rates and, therefore, achieve steadily increasing total returns on their bond investments. And since rates are low, there really is no reinvestment risk.

Global bonds offer two very strategic advantages over other fixed income and equities investments this year. If a strong economic rebound fails to materialize, bond investors will at least preserve their principal, as other asset classes presumably decline, while if growth does occur, income increases as rates rise. But there are risks in each scenario.

Morgan Stanley, in a recent report, says the first risk “is the Fed begins to taper and growth disappoints, fears of deflation rise and long-end rates drop back toward 2 percent. In this scenario, we see investment-grade credit outperforming high yield for a short period of time, but persistently lower yields would likely pull investors back into high yield and the selloff may be short-lived.”

The second risk, according to the bankers, is basically the opposite of the first: Growth is much stronger than expected and the Fed is slow to reduce accommodation. Rates rise rapidly in this scenario, potentially breaching 4 percent as inflation fears surge.

As a result, investment-grade credit would underperform high yield, and the selloff in long-dated bonds could persist for some time as the Fed struggles to rein in inflation without choking off growth. That’s why investors should have a decent balance between high-quality, high-yield global bonds and investment-grade fixed-income investments.

If All Else Fails, Bonds

If the risk scenario where growth fails to appear proves to be the case, there could be a sharp market correction sometime in the early part of the year, and the only protection is bonds. A protracted selloff accompanied by other signs of a deteriorating economy could prompt the Fed to pause or even reverse its taper, which could lead to significant loss of principal for those that are unprepared.

And as mentioned earlier, there is still a lot of disagreement among market forecasters as to whether current valuations will be supported this year. Adding to this quandary is the fact that valuations do indeed look rich according to the Shiller P/E ratio, a metric created by Nobel Prize-winning economist Robert Shiller.

This indicator, which is also known as the cyclically adjusted P/E ratio, uses a 10-year average of inflation-adjusted earnings to value the stock market. Historically, the S&P 500′s Shiller P/E has averaged 16.5 over the long term (see Chart A). At current levels, the market is priced about 50 percent above its long-term average.

Chart A: The S&P 500 Looks a Bit Rich

Created with Y Charts

Additionally, the market typically suffers a correction of 10 percent or more about once every 7.6 months, but it’s been more than a year since that’s happened, leaving some investors wondering if a sudden drop is imminent.

And it does appear that the smart money seems to be ignoring lofty promises of high growth and taking a more risk-on, wait-and-see position at the start of the year. Fund investors poured money into bond portfolios and cash while selling equities in the first full week of 2014, in contrast to the apparent start of the “great rotation” at the beginning of last year.

In fact, since the start of the year, emerging-market sovereigns have sold almost $19 billion of bonds, three times what was sold at this stage last year and the fastest start to the year since Dealogic started compiling records in 2000. And with respect to bond funds, bond data provider EPFR Global found that bond funds captured a net $5.2 billion of new money during the week ending January 9, while equity funds were hit with a collective redemption of $427 million. Money market funds took almost $23 billion.

Within the fixed-income space, European bond funds benefited from their largest inflows since late April 2013 while US bond funds took the most money since the middle of November, according to EPFR Global.  Furthermore, the data provider found emerging markets local currency bond funds broke a 14-week outflow streak to capture new money.

Bonds Have More Fun

Emerging markets bonds are expected to outperform those in developed nations (see Chart B).

Chart B: Emerging Markets Bonds will Continue to Outperform



However, there are headwinds to consider.

Emerging-market growth came in well below expectations in 2013, headlined by weak showings for the key BRIC (Brazil, Russia, India, and China) countries. If growth remains sluggish in the year ahead, emerging-market bonds are unlikely to offer substantial upside but will offer protection. By the same token, stronger-than-expected growth—if not accompanied by rising inflation—could lift up the asset class to outperform.

Notwithstanding, some market watchers note that for each year that various emerging market bond indexes have posted losses, as in 2013, they have been followed by high growth performance (see Chart C).

Chart C: Emerging Markets Bonds May be Ready for a Rebound



Created with Y Charts

The iShares JPMorgan USD Emerging Markets Bond Index (NYSE Arca: EMB) has finished with a loss in four years prior to 2013: 1994 (-18.9 percent), 1998 (-14.4 percent), 2001 (-0.8 percent), and 2008 (-9.7 percent). Each time, the index rebounded to close with a robust gain in the following year: 26.8 percent (1995), 26.0 percent (1999), 14.2 percent (2002), and 26.0 percent (2009).

Moreover, when looking at specific regions, most bets are that Asian high yield bonds will perform admirably this year. But within the region, most analysts agree that Australia will make a superior fixed income investment over Japan and China, though all three countries are expected to benefit from a global uplift in trade in 2014.

According to a Russell Investments research note, “In stark contrast to the strong performance of Japanese equities in 2013, that country’s government bonds have yet to respond at all. They’ve shrugged off the combination of stimulatory monetary and fiscal policies, a weak yen, and a return to strong GDP growth to do…nothing. They remain the outlier of the developed world, with the 10-year rate, in mid- December 2013, trading at a skinny 0.7 percent. If our expectations are correct, and 2014 sees a second year of meaningful recovery in Japanese growth and inflation, then rates can move higher, notwithstanding the ‘anchor’ of a 0.1 percent cash rate.”

But at present all eyes are on Australia, according to the Russell Investment research note, where 10-year government bonds are trading at 4.4 percent as of December 6, 2013, and where growth rates are beginning to lag northern hemisphere counterparts for the first time in a decade.

“Weaker economic growth would be a positive for Australian bonds. On the other hand, foreign holdings of Australian debt rose to record highs through the years of global crisis. As Australia’s ‘safe haven’ status fades, there is some risk of a rush for the exits. Hedging costs are also high, and we regard the Australian dollar as overpriced,” according to the research note.

Moreover, in general emerging markets’ corporate and local currency bonds should be the focus, because they offer higher yields, which provides them with a more favorable starting point for total return, and excellent diversification. Furthermore, corporate issuers as a group are in robust financial health, and with much better credit ratings than bonds with similar yields issued by companies in the United States, according to various credit rating agency reports.

We advocate a portfolio balanced between equities and fixed income—and global fixed-income investments will take on greater importance in 2014.

As noted above, iShares JPMorgan USD Emerging Markets Bond Index is best positioned to offer protection, diversification and income growth in what is still a very uncertain environment with respect to growth projections throughout various developed economies in 2014. EMB is a buy up to 110.