| Last Week, the Greek Government voted to approve a further austerity bill, opening the way for Greece to receive a second IMF/EU aid tranche. This was essential, but is not enough. Now begins the long road to deleveraging. In order to reduce the level of indebtedness of distressed countries, authorities will do everything in their power to gain time. Whilst immediate actions are necessary, current structural problems are too big to be solved within the next 3 to 5 years. Deleveraging will be protracted, with a time frame of decades, rather than years. |
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| It would therefore appear to be an opportune time to consider the changes which have occurred over previous decades, and how these might influence the outlook for bond investors for the next 20 years: |
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Developed countries experienced rising inflation. In the United States for example, inflation rose from 2% to 14.7%. Economic growth remained robust, despite short term recessionary periods, such as that which followed the oil crisis of the early 70’s. High inflation with moderate growth resulted in a decline in purchasing power for consumers. This long term cycle finished with a major inflation crisis and a rethinking of central banks’ policies.
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Central banks targeted inflation, and globalisation helped to reduce production costs. Consequently, inflation declined rapidly and remained at low levels. Growth remained strong, assisted by easy access to credit which supported consumer demand. Low inflation with moderate growth resulted in an increase in purchasing power.
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After 30 years of easy access to credit, the debt hangover has finally set in, requiring both complex, and sizeable solutions. High levels of indebtedness at consumer, corporate and government levels are compounded by longer term structural problems such as pension and healthcare funding, which look certain to escalate as western demographics shift over the next 20 years.
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We expect these structural problems to weigh on western economies for the next 10 to 20 years, and, as a consequence, for growth to be below average for a generation. Growth in exports to emerging economies will help, as the purchasing power of these nations increases, both in absolute, as well as relative terms with growing access to credit. (Echoing the 1980/2010 period in the West)
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There is a danger however that this growth in exports will lead to an element of imported inflation, and a continued depreciation in the Dollar, Euro and British Pound against emerging market currencies.
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As a consequence, we expect moderate inflation (around 2.5% - 3.5%) with low growth (approximately 1.0% – 1.5%) resulting in a reduction in purchasing power.
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| For fixed income investors, the primary concern is the protection of investor’s purchasing power, and we therefore suggest that our clients give strong consideration to adding Index Linked Bonds to portfolios to take advantage of the next long term trend. |
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| In terms of timing, the coming quarter should be a good entry point, as |
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- Breakevens tend to weaken in Q3 on a seasonal basis,
- Breakevens have already declined significantly due to the correction in commodity prices, and a reduction in expectations of QE3.
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Macro Focus |
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- US: Manufacturing unexpectedly expanded at a faster pace in June, the ISMs factory index rose to 55.3 last month from 53.5 in May. Construction spending dropped in May for the sixth straight month falling 0.60%. Consumer confidence rose to the highest level in 10 weeks according to the Bloomberg Consumer Comfort Index.
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- Europe: Investor confidence rose for the first time in four months in July. An index measuring sentiment in the euro region rose to 5.3 from 3.5 in June. Europe’s insurance regulator estimated that around 10% of European insurers wouldn’t be able to meet new capital requirements under more severe market conditions, a decline in equity prices, and a higher-than-expected number of natural catastrophes.
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- Germany: Chancellor Angela Merkel’s government raised borrowing targets by more than 10% for the three years through 2015 after pledging contributions to a future European bailout fund. Borrowing will amount to €24.9 bln in 2013, more than the €22.3 bln the Cabinet endorsed on March 16. Retail sales unexpectedly fell in May. Sales, adjusted for inflation and seasonal swings, fell 2.80% from April. Moody’s initiated, or continued, reviews for downgrade on 12 German banks.
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- Greece: George Papandreou’s efforts to stave off the euro area’s first sovereign default stayed on track after lawmakers backed a bill to authorize an austerity plan required to keep rescue aid flowing. French banks tabled a proposal for rolling over short dated Greek debt and Germany’s biggest banks and insurers also signaled a willingness to roll over maturing debt. Standard & Poor’s and Fitch Ratings may enable European Central Bank President Jean-Claude Trichet to support a private investor rollover of Greek debt by saying a default rating would be partial and temporary.
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- ECB: European Central Bank President Jean-Claude Trichet signalled officials remain determined to raise borrowing costs next week even as Greece struggles to stave off a default amid violent street protests. Trichet stated that “The monetary policy stance is still accommodative and risks to price stability are on the upside”.
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- UK: A CBI survey showed Banks and other lenders are the least optimistic about employment prospects for the next three months as they seek to control costs. However an employment creation index accelerated in June as insurance and engineering companies increased hiring
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- BoE: The credit conditions survey showed that banks expect demand for mortgages will fall in the third quarter after increasing “a little” in the three months through June. “The reported increase in demand was driven by a marked pick-up in buy-to-let lending, which was expected to continue in the coming quarter,” the Bank of England said.
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- Switzerland: Retail sales fell 4.10% in May from a year earlier when adjusted for inflation after increasing a revised 7.80% in the previous month
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