Bond Outlook by bridport & cie, August 18th 2010

Let us begin this week by nailing our colours clearly to the mast, especially on the issue of whether the Western economies are likely to fall into a renewed recession, a question which is so determinant at present in lowering bond yields across the board:

• GDP rates will not decline, except in rare cases like Greece. Economies will, however, grow only slowly following the scenario of an L-shaped recession/recovery
• What modest growth is achieved is very dependent on exports and “internal devaluation”, i.e. on lower costs due to declines or stagnation in salaries (witness USA call centres becoming competitive with Indian equivalents, or Estonia turning its economy around)
• Standards of living have declined in the West, a priori a problem for economies based on domestic consumption, but a major step towards rebalancing the world economy as emerging economies grow richer
• Despite the problems of the periphery countries, which we see as gradually being brought under control, the overall situation in Europe is more favourable than in the USA
• The UK is a different case from other Western economies in having a radical programme of budget balancing and decentralisation, with its own currency, and inflation back at 3% (see The Economist)

Overall, we are moderately optimistic, or certainly less pessimistic than the bond markets in general. We expect yields to rise as the moderate recovery continues, governments borrow extensively and quantitative easing is reversed. As we wrote last week, we wish we knew when. There may be a few weeks left of further “depressive lowering of yields”, but bond markets are now vulnerable and shortening may soon be appropriate. Given the very low yields in sovereign bonds, there is a case for protecting gains by gradually moving to bills and a few high-yield bonds to provide some continued return. We recognise that this is not an attractive scenario, but it may well avoid capital losses when, inevitably, yields rise.

Political leaders and economic commentators, especially in the USA, are still unable to shake off the assumption that GDP growth can be achieved only by an expansion in household spending. Yet they lament the low savings rates. In fact, the marked increase in savings rates during the recession translates into both investments and exports. Be grateful that China requires manufacturing equipment and infrastructure, alongside its demand for raw materials. The “workshop of the world” is slowly becoming the “consumer of the world”. Imagine the favourable impact of increasing domestic consumer demand in China, alongside industrial demand! The West has to work off its past excesses before standards of living can return to growth.

On the subject of China, one of our long-term dreams – the emergence of a trading and reserve currency built on the RMB (or indeed the RMB itself) has taken another tentative step forward. Just when China has returned to diversifying its reserves (this time by buying Korean bonds), it has begun allowing foreign central banks and overseas lenders to invest in the domestic interbank market. “China is encouraging the use of the RMB for trade and to promote its role as a reserve currency” (FT).

Focus

USA: jobless claims totalled 484,000. Building permits for housing fell by 3.1% in July to 565,000

UK: unemployment, according to ILO measures, recorded a decline of 49,000 during the three months through June, the sharpest decline in three years, bringing the total to 2,457,000, or 7.8% of the workforce. Inflation in July was 3.1% against 3.2% in June

Euro zone: the GDP of the 16 countries rose 1.0% from Q1 to Q2 and by 1.7% compared to Q2 2009. Inflation tending to increase, as in Spain and Italy

Germany's economy grew by 2.2% from Q1 to Q2, the highest figure recorded since 1987. However, the ZEW index of investor confidence declined to the low figure of 14 in August

France: the economy grew in Q2 by 0.6%, with business investment and household consumption returning to moderate growth

China: The index of consumer prices, the main gauge of inflation in China, rose to 3.3% in July YoY, against 2.9% in June

Greece: GDP shrank 1.5% in Q2 compared to Q1. The unemployment rate reached 12% of the labour force in May

World: youth unemployment in the world has reached the highest level ever (81 million between 15 and 24 years) and likely to increase in 2010 (ILO). The rate increased from 11.9% in 2007 to 13% last year

Recommended average maturity for bonds (corporate/government)

Continue fairly long across the board, so long as the deflationary atmosphere pertains. Watch this space!

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09.06.2010

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19.05.2010

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Dr. Roy Damary