Bond Outlook by bridport & cie, August 3 2011

“The first step towards America living within its means”. Undoubtedly an encouraging comment from Obama, but not exactly convincing. The budget deficit will still expand, and the burden of future Social Security and Medicare is no lighter. What deficit cutting has been imposed falls on the low and middle-income members of society, which can but reinforce the slowdown of growth? The argument that tax increases on the rich and on corporations would be economically damaging is entirely bogus in a country where tax rates are so low.

When the recession first began, we wrote that it would be L-shaped, i.e. a drop in GDP would be followed by a long period of negligible growth. For the USA we had estimated a 6-7% drop, but it turned out to be 5.1%. Money printing by the Fed delayed “flatness” for a couple of years, but it is now well installed, and, in terms of GDP per capita, even earlier than expected.

Austerity has now been recognised as unavoidable in the USA. That represents a major step forward in the ability of politicians to face reality. Yet they remain stubborn in their belief that they can achieve economic growth despite austerity. We have our doubts, although there may be degree of austerity which still allows modest growth.

The UK is at that point, showing just how difficult it is to find the right balance. While the determination of the Coalition to achieve a balanced budget can only be admired, the squeeze may be overdone. That is obviously the view within the UK, and it is now finding support from the IMF.

With the distraction of watching the USA go to the brink over the debt ceiling now over, the spotlight has returned to the euro zone, and particularly to Spain and Italy. The economic performance of Germany remains the saving grace of the euro zone, with all the responsibilities – some suspect ambition – of dominating Continental Europe in economic terms via EU fiscal centralisation. Just as the dollar is fundamentally weak, so the structure of the euro zone is fundamentally unstable. Both require radical treatment to overcome a chronic condition. Very slowly this is dawning on the authorities concerned: a balanced budget, including tax increases, for the USA, and a fiscal and transfer union for the euro zone.

Will the authorities in the euro zone act firmly and quickly enough? 10-year yields on Spanish and Italian government debt are now over 6%. 7% marks the level at which the country is deemed to have lost the support of international markets. Bail-outs have been granted for Greece, Ireland and Portugal, but the EU would have a real struggle dealing with Spain and Italy.

With a resolution of the US Debt ceiling debate, we had hoped that our clients would once again return to active position taking, but, alas, so far that has not happened. We also thought the rise in the CHF would halt, yet it has gone still further, prompting the SNB to this morning cut interest rates, and to state that they would intervene in currency markets following a ‘substantial deterioration’ in the economic outlook. If these actions are not successful, Switzerland is facing the prospect of severe job losses, and a potential exodus from the country as a manufacturing base.

Market Focus

• US debt: the compromise deal will raise the debt ceiling enough to fund the government until 2013. The goal is to cut the deficit by $2.4 trillion over the next 10 years with automatic spending cuts to ensure that targets are met. Moody’s and Fitch affirmed their AAA ratings for the U.S. but warned that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens. Moody’s outlook for U.S. debt is now negative

• USA: consumer spending fell in June for the first time in almost two years and savings climbed. Manufacturing expanded at the slowest pace in two years. The economy grew less than expected in Q2; GDP rose at annual rate of 1.3% and the Q1 number was revised lower to 0.40%. Orders for durable goods were weaker than anticipated, falling 2.10% after a 1.9% rise in the prior month. Mortgage closures, in excess of 200,000 per month, are still running at four times the pre-recession level

• Euro zone: unemployment held steady for a fourth month in June, at seasonally adjusted jobless rate of 9.9%. Spanish unemployment held above 20% for the third consecutive quarter. German unemployment dropped in July for a 25th straight month. However, confidence in the economic outlook weakened more with a fall in an index of executive and consumer sentiment to 103.2 from a revised 105.4 in June

• Spain: Moody’s stated that Spain faces possible downgrade as its regions struggle to cut budget deficits and the new Greek bailout increases the risk that bondholders will have to pay for further European rescues. Moody’s is reviewing the country’s Aa2 classification. A cut would probably be “limited to one notch,” Moody’s said. Spain has the same credit rating as Italy, which Moody’s also has on review for downgrade

• UK: the CBI expects GDP to rise 1.30% in 2011 compared with their estimate of 1.70% in May, and expects the BoE will remain on hold until Q1 2012. Consumer confidence fell in July, a sentiment index reaching minus 30, from minus 25 the previous month, the lowest since April. The IMF stated that the UK may need to increase stimulus through tax cuts or QE if weak growth and high unemployment persist. Figures showed that the government cut administrative costs by £3.75 bln in its first 10 months in office by curbing use of consultants and renegotiating supply accords

• Switzerland: the KOF Swiss leading indicator fell in July; the monthly gauge that aims to predict the economy’s direction about six months ahead fell to 2.04 from 2.23 in June

• Australia: Governor Glenn Stevens held rates steady at 4.75% but signalled he will hike again once global risks dissipate

Disclaimer
This document is based on sources believed to be reliable, accurate and complete. Any information in this document is purely indicative. This document is not a contractual document and/or any form of recommendation. Expressions of opinion herein are subject to change without notice. We strongly advise prospective investors to consider the suitability of the financial instruments, based on the risks inherent to the product and based on their own judgment. It is not intended for publication. This document may not be passed on or disclosed to any other third party without the prior consent of bridport & cie s.a. © bridport & cie s.a.

August 3 , 2011

Dr. Roy Damary