Bond Outlook by bridport & cie, September 28 2011

Market sentiment (with which we scarcely disagree) appears to reflect a choice for the West of either stagnation, or a new recession. The obvious preference would be for the former, which would seem to tally with our long-term view of the recession/recovery for which we chose the description “L-shaped”.

In the recession vs. stagnation debate, the main problem is said to be the euro crisis. We are not totally convinced, because the economic problems of the USA are both chronic, and largely unaddressed, whereas the euro zone’s are acute and are being addressed, albeit too slowly and inadequately. At least the Germans have said that they will defend the euro and bail out Greece, and the debate has moved to the level of haircut that owners of Greek sovereign debt will have to accept. However, before a huge sigh of relief can be justified, we would look for at least three things:

• that the ECB, German Government and EU authorities agree on the necessary moves and cease their public disagreements
• that a move to centralised bond issuance and a degree of federalisation be clearly underway
• that an honest assessment of the degree to which banks are carrying toxic assets be made , together with an appropriate plan for write-downs and refinancing

European banks are currently seeking new ways of issuing asset-backed bonds that go beyond traditional covered bonds. Yet this is to address the symptom rather than the cause, which is inadequate capital vs. the real value of their assets. A solution to the banking problem will have to include separation of retail banking from investment banking. This is taking slightly different forms on the two sides of the Atlantic. In the USA retail banking is easily identified by the FDIC system. A bank can choose between benefiting from FDIC deposit insurance or it can trade and invest on its own account. In the UK, the separation will be via self-standing legal entities. In Switzerland, the major banks will probably reduce the proprietary trading part of their investment banking activity by their own volition. The latest UBS scandal can only have hastened this process. The outlook on this matter in the euro zone is less clear. The concept of creating “bad banks” to park toxic assets is being considered. Overall, it seems that recognition is growing that conventional deposit taking and lending do not mix with proprietary trading.

Despite the recovery of bank share prices this last week, and the banks’ efforts to issue new-style collateralised bonds, the final outcome of the euro rescue, and of the vulnerable banks, needs resolution before we can recommend any bank paper.

Whatever happened to our fears of inflation and yield curve steepening following on from quantitative easing? The simple answer is that they have been swallowed up by stagnation. A more subtle analysis suggests that the risk of stagnation turning into stagflation is still present, and that the UK is most at risk of that development.

The recent fall in the price of gold is best explained by margin calls and the unwinding of carry trades. Both require cash and selling gold was a means to take profits.

Our basic recommendation remains to prefer high-quality corporate bonds over all others.

Market Focus

• USA: consumer confidence rose less than forecast in September, the Conference Board’s index increasing to 45.4, from a revised 45.2. Data showed new home purchases fell to a six month low. However, the Conference Board’s index of leading indicators increased more than expected, rising 0.30%

• EU: governments are looking into the possibility of starting the permanent rescue fund earlier than the currently planned date of July 2013, notably by setting up the European Stability Mechanism a year earlier. These moves, and plans for the European Union to begin recapitalising banks in the short term, were taken positively by the markets. Euro-area services and manufacturing output contracted for the first time in more than two years in September, a composite index based on a survey of purchasing managers in both industries fell below 50, indicating contraction

• Germany: the Finance Ministry forecast that the economy returned to a moderate growth path in the current quarter, having practically stalled in Q2. The Government cut its Q4 debt-sale plan, after tax receipts boosted government coffers and reduced the country’s net new borrowing needs. Germany will cut gross borrowing in Q4 by €16 bln. Business confidence continued to decline, the Ifo institute’s business climate index falling for a third straight month to 107.50

• UK: the retail sales index fell to its lowest level in 16 months in September, the CBI index dropping from -14 to -15. Consumer confidence, as measured by the Nationwide index, was also weaker, falling to a 4 month low. The Chancellor defended the government’s deficit reduction plan, suggesting it can survive the economic slowdown as ministers pressed for more stimulus and BoE officials suggested they may need to consider further QE to boost the economy

• Switzerland: the KOF Institute expects the economy to expand at a slower pace, with GDP to rising 2.3% for 2011 and 1.5% in 2012. Investor confidence sank to its lowest level in 3 years as weaker export demand led to concerns on the growth outlook. The Swiss regulator confirmed that the splitting of the investment banking businesses of the largest Swiss banks is not currently on the table

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.

September 28, 2011

Dr. Roy Damary