Bond Outlook April 7 2010

For almost as long as we have been writing this Weekly, a dominant theme has been that the USA cannot continue spending more than it earns at household, government and national level, and that rebalancing the US economy, as part of the rebalancing of the world economy, was an essential and inevitable paradigm shift. Today we can rejoice that the process is well underway. “The Economist” has devoted many pages to this analysis and its sub-heading provides an excellent summary: “America’s economy is set to shift away from consumption and debt and towards exports and saving. It will be its biggest transformation in decades”.

In comparison to pre-recession levels, the current account deficit has halved (from 6% to 3% of GDP), household savings have moved from -2% to +4%, private sector debt is declining even faster than government debt is expanding, and new houses are being built to more modest dimensions. The economy is of course still very much dependent on government spending, a reduction of which, in the short term, could leave a GDP gap, with private sector activity failing to make up the difference. That would lead to a new recession. Over the longer term, the massively increased level of government debt will act as a huge drag on the economy, sucking in funds that would otherwise be directed to more productive investments.

The overall picture corresponds well to the “L-shape” to which we so often allude. The days of heady growth in the USA are over; at best, GDP growth might keep up with the expansion in population. Nevertheless, if the trends representing rebalancing continue, the recent gentle recovery should continue.

We have explored both sides of the argument as to whether the end of Q.E. will mean an increase in longer–term interest rates. Government yields are now increasing, and the only thing that could stop their rise is a return to economic decline. Nevertheless, after weighing again both arguments, we feel that we lengthened government maturities too soon and by too much in our recommendations a fortnight ago.

Two lessons we have learnt from this experience are:

• to set a target yield for entry at longer maturities, e.g. lengthen when 10-year US T-bonds reach 4%
• make a clearer distinction between our recommendations for government vs. corporate bonds

Our Recommended Maturity table below has been amended accordingly.

Our moderate optimism about the US economy does not of course mean that we believe its problems are essentially solved. In the medium term, weaning the economy off government stimulus will be very difficult (and will also be a huge headache for a new government in the UK). In the longer term, a combination of health care and pension (both public and private) entitlement programmes, exacerbated by a continuing deterioration in demographics, will be a millstone of such consequence that the present problems of government indebtedness will look quite benign!

However, these problems may be beyond most investors’ time horizon, just as China’s own demographic and pension problems may not yet be denting that country’s expansion. But in due time, they will!

The world inflation situation is quite bizarre: very low inflation in the West, deflation in Japan, and considerable inflation in emerging economies (with a question mark over China’s ‘official’ figure of 2.6% per annum in February). Commodity prices are also continuing to rise. How long the West can keep cost-push inflation at bay remains to be seen.

Focus

(+) USA: 162,000 net increase in jobs in March – not seen in three years. Unemployment remains stable at 9.7 %. The ISM moved up to 55.4, an indicator of strong expansion

(+) UK: the purchasing managers’ index (PMI) rose to 53.1 vs. 48.5 in February, passing for the first time in two years the 50 mark, the pivot point between contraction and expansion

(–) Euro zone: in February unemployment was 10%, up from 9.9% in January. Inflation, at 1.5% per annum, was the highest since December 2008

(!) Switzerland: inflation accelerated in March to 1.4% per annum, vs. 0.9% in February, mainly because of hydrocarbons

(+) Germany: the number of unemployed declined in April by 75,000 to 3,568,000 (8.5%)

(!) Greece: 120,000 new jobs announced by the Government to help offset high unemployment (How this contributes to reducing Government debt is anybody’s guess !)

(+) Russia: monthly inflation continued to decline in March to 0.6% over February, bringing overall price rises over Q1 to 3.2%

(?) Argentina: USD 204 million of debt reimbursed with Central Bank reserves – a first

(!) Australia: an increase of the overnight interest rate from 4% to 4.25%

 (+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds (corporate/government)

Current market conditions suggest a different maturity for corporates and government bonds.