AFTER a US “fiscal cliff” deal, equity markets have made a good start to 2013.

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Although US politicians still have to face up to spending cuts, the debt ceiling and the issue of a sustainable budget position, the mini-deal allows the global economy to gather more traction rather than falling flat. Of more significance was the market reaction in the deeper fixed income markets where yields have continued to rise (i.e. prices have fallen). Although it is too early to say that a switch from “safe-haven” bonds to equities is underway, there are some early signs that the 30-year bull market in fixed income is over.

In the UK 10-year gilt yields have risen to over 2% and this compares with a 2012 low of about 1.44%.

The last CPI reading was 2.7% which is well above the 2% inflation target. UK inflation is going to remain at high levels for most of 2013 because of higher rail fares, university fees, energy bills and food prices look set to soar after the extreme wet weather.

Inflation has been above the 2% target for over three years. A new governor of the Bank of England is likely to adopt different policies and there is a possibility of an increase in gilt issuance. Charles Stanley expects 10 year gilt yields to end 2013 between 2.5%-3%.

Apart from possible cuts to sovereign credit ratings and inflation, a key threat to fixed income prices may come from a global economic recovery. Global economic growth could accelerate in the second half of 2013 and financial markets could begin to look forward to better times in 2014-15.

The other ingredient in the bond/equity mix is the relative attractiveness of equity dividend yields. Normally, equities are regarded as a higher risk asset but the additional return required by equities over bonds remains near historic high levels which could trigger a large asset allocation shift from bonds to equities.

In 2012, equities (FTSE All Share +12% total return) outperformed bonds (UK gilts +2.8% total return). This was achieved without any major reversal in asset flows, but could 2013 finally be the year when investors begin to switch from fixed income to equities?

With a more positive outlook for growth and corporate earnings beyond the current reporting season, equities appear not only a safer investment than gilts but also have more long-term wealth creation potential.

: : Charles Sylvester is a stockbroker with Charles Stanley & Co in Ipswich.

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