Bosses at Fidelity, Britain’s biggest fund manager, are backing bonds over shares and commodities this year as the global economy heads for a slowdown.

Their stance is bound to raise eyebrows because bonds have produced such poor returns recently and most analysts are still loath to bet against the equity and metals markets after three years of exceptional returns.

Global bonds have dropped 4.5 per cent since 2004, compared with a return of 40 per cent from global equities and a staggering 163 per cent from commodities.

However, Trevor Greetham, asset allocation director at Fidelity, thinks bonds are set to come back into fashion based on a rigorous analysis of how different assets perform at various stages of the economic cycle.

In its first fund launch of the year, the Multi Asset Strategic Fund, it will use this analysis to switch between shares, bonds, commodities, property and cash depending on prevailing economic conditions.

Greetham, who will manage the fund, said: “Right now, our model indicates that the world economy is set to decelerate in 2007, which suggests that global bonds will perform better than equities or commodities.”

Greetham splits the economic cycle into four distinct phases: reflation, when growth is below trend, inflation is falling and central banks cut interest rates to boost growth; recovery, when growth picks up but inflation continues to fall and central banks cut rates more aggressively; overheat, when growth rises above trend, inflation begins to pick up and central banks start to raise rates; and finally stagflation, when growth slows but inflation continues to rise.

Fidelity has analysed returns from a variety of assets since 1973 to work out which produce the best returns at each stage of the economic cycle.

When economies have overheated in the past, commodities have led the way with an average return of 20 per cent, followed by shares at 6 per cent, cash at 1 per cent and bonds at just 0.4 per cent, according to the research.

Greetham thinks we have been in an “overheat” stage since March 2004, when global growth started to accelerate and the oil and metals boom began. Since then, Brent crude has soared 66 per cent and industrial metals, including copper and aluminium, have jumped 132 per cent.

However, he thinks that phase is probably over and the world is probably entering into a reflation stage. “Interest rates are likely to peak over 2007, falling energy prices are causing the rate of inflation to slow and the global economy is weakening,” he said.

His view may seem odd after a week when inflation in Britain leapt to a 15-year high and analysts predicted a second quarter-point rise in interest rates to 5.5 per cent within months.

However, oil has dropped 32 per cent since its peak of $78 in August, even slipping below $50 last week, and inflation could fall back as this feeds into lower petrol and energy costs.

In America, recent data suggest consumer price inflation is already slowing and markets are betting that the Federal Reserve may even cut interest rates this year. Greetham stresses he would prefer US over British bonds, given the different interest-rate outlook.

Bonds are the asset of choice in a reflation stage, according to Fidelity’s research. Since 1973, they have produced an average return of nearly 10 per cent in such periods, against 6 per cent for shares, 3 per cent for cash and a loss of 12 per cent for commodities.

Bonds perform well in a reflationary environment because they pay a fixed level of income, which becomes more attractive to investors when inflation and interest rates are falling. When the Bank of England slashed rates between 2000 and 2003, for example, bonds provided a safe haven while shares plunged.

The dire performance of many industrial metals since the start of the year suggests the Fidelity research may be right. Copper, which is widely seen as a barometer of the strength of the economy, has dropped 7 per cent in just three weeks.

Fidelity’s analysis drilled down even further into which stocks you should buy at various stages of the economic cycle. In the overheat phase, technology, industrial and oil and gas stocks should be the equities of choice. Indeed, energy shares have jumped 33 per cent since March 2004.

In a reflation phase, though, banks and retailers tend to do well as lower interest rates encourage consumers to borrow and spend more.

Advisers agree that bonds have a place in every portfolio and have probably been unfairly ignored over the past few years.

They say a typical investor should have about 40 per cent of his or her fund in bonds, while someone drawing an income could have as much as 80 per cent.

However, other analysts question whether bonds will beat other assets. Foreign & Colonial, the fund manager, cut its holdings in equities last summer, but it has recently upped its weighting again because it believes shares will beat other assets this year.

Jeremy Tigue at F&C said: “We would agree that inflation and rates could peak in 2007, but we think this will prove to be a better environment for equities than bonds.”

For fund prices visit www.timesonline.co.uk/funds

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