Bond Outlook by bridport & cie, September 8th 2010

In the current sad state of Western world’s economies, many are the arguments as to which side of the Atlantic is in the worse state. Without trying to convince readers one way or the other (we have already committed ourselves in recent Weeklies), we stress that the problems are very different between the USA and the Euro Zone, with the UK sharing the problems (and solutions) of both.

The USD is world’s main reserve currency. This basic fact makes all economic analysis of the USA different from everywhere else. The dollar’s status has both caused (or at least encouraged) profligacy in the USA, and also offers the Americans the choice of continuing down the same road of spending beyond their means. It is an option that can bring about temporary relief in terms of GDP growth and employment. Of course it increases indebtedness to ever higher levels, which is why there are voices against it, even within the USA. Nevertheless, the majority opinion seems to be in favour of further stimulus. The announced USD 50 billion infrastructure spending is following that route, even though Obama carefully avoids using the word “stimulus”.

In economic terms there may be alternatives, like withdrawing all artificial aid to the housing market and increasing taxes to balance the Federal budget. In political terms, however, these are non-starters. There will surely be more stimulus and more quantitative easing. Addressing the inherent problems of inflationary build up and a future need for even more drastic rebalancing is again delayed. Proponents of additional stimulus go so far as to hope that government-led growth will lead to private sector traction.

The EUR is no more than a fledgling reserve currency. Doubts over its continued strength led to the flight into the USD earlier this year and the continuing flight to the CHF. It is very sensitive to relatively minor rumours, like inadequate banking stress tests, and to major issues, notably doubts about the creditworthiness of peripheral members of the Euro Zone. The stimulus route is simply not open to the Euro Zone or indeed to other EU countries. The overwhelming need is for confidence, first in sovereign debt. That is why austerity programmes have been introduced almost everywhere, despite the labour unrest over such unavoidable measures as raising retirement age. There is however a second area for which confidence must be restored: the banking sector. To quote “Lex” of the FT: “the sector is undercapitalised, over-exposed to sovereign risk and dependent on the ECB for liquidity”. Already UK, US and Swiss banks have returned to health. Most other countries and the Basel Committee are addressing the problem. However, one is resisting change, viz. Germany. We are all so used to see Germany as the motor of the European economy that is hard to recognise that in banking reform, it is the barrier.

Lex goes so far as suggesting that the European Financial Stability Facility will need to deploy its resources not to sovereign debt but to bank rescues.

With the obvious exception of the Euro Zone peripherals, the recent flight to quality has pushed government yields to lows previously unimaginable. We have to suspect that sovereigns are now overbought. Fixed-income investors have, naturally, sought yield in corporates, and corporations have not been slow to issue bonds at very favourable terms to themselves. We suppose that some corporations will take the opportunity to lock in low interest costs well into the future by retiring short-term bonds and refinancing long term. Our firm will soon publish more detail on this concept, but, in the meantime, the time is ripe to shorten average maturities for corporates (but not government debt, except for the UK).

Focus

USA: despite fears of a decline in the manufacturing sector’s ISM, it rose to 56.3 in August, against 55.5 the previous month. Home purchase preliminary contracts rose 5.2% in July

UK: house prices fell 0.9% in August compared to the previous month, posting the second consecutive monthly decline, bringing down the increase in the year to date to 3.9%

Europe: GDP in the euro area and the EU increased by 1% Q2 over Q1

France: the unemployment rate dropped in Q2 to 9.3% in France

Sweden: the Riksbank raised its repo rate by 25 basis points to 0.75%

Spain: the unemployment rate rose 1.5% from July, reaching over 20% in Q2, the highest rate in the euro area

Switzerland: economic activity grew 3.4% in real terms in Q2 yoy and 0.9% quarter on quarter, thanks mainly to domestic demand, as exports slowed

Brazil: the country is experiencing a rebound after a short recession last year. GDP grew by 1.2% over the previous three months and 8.8% over one year

Russia: inflation stood at 5.4% in the first eight months of the year, reaching 0.6% in August due to higher food prices in the wake of the drought

Germany: industrial orders fell 2.2% in July over June

positive for bonds

negative for bonds

watch out

begs the question

Recommended average maturity for bonds (corporate/government)

Continue long in Governments except for GBP, but shorten selectively in corporates, except in CHF.

	GOVERNMENT				CORPORATE
Currency	USD	GBP	EUR	CHF	USD	GBP	EUR	CHF
08.09.2010	2017	2014	2017	2017	2014	2014	2014	2017
09.06.2010	2017	2017	2017	2017	2017	2017	2017	2017

Dr. Roy Damary

Bond Outlook by bridport & cie, September 8th 2010

Whether or not Europe or the USA are in worse shape economically, their problems and therefore their solutions are quite different. Stimulus versus austerity.

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