Bond Outlook by bridport & cie, December 12 2012

There are appearing to be two contrasting views on the USA:

• housing prices and building activity have stabilised, banks are healthy, much manufacturing is being repatriated, shale oil and gas are changing the reliance on petroleum imports – the future looks rosy

• the only way the economy is kept going is by printing money. Budget deficits and federal indebtedness are still growing, state budgets and pension schemes are in deficit – the future looks bleak

Given our historical view of the way the US economy is run, particularly with regard to spending beyond the means of households and government alike, we are rather in the second camp, while acknowledging that “fracking”, if it does not wreck landscapes and water tables, would be a boon to the economy. That boon may, however, be several years in the future. In the meantime, the country faces the fiscal cliff. We expect a solution to be found in the nick of time with the Republicans yielding to the President, but any deal will still increase taxation and reduce government spending.

To see fracking as the great answer reminds us of the old dictum about proposing to drain the swamp to the person in a leaky boat surrounded by alligators!

In recent Weeklies, we have stressed that good microeconomic policies, particularly with regard to the creation of new business, are needed alongside macroeconomic principles. Generally we admire the USA for its entrepreneurial atmosphere, and tolerance of failure; Schumpeter’s “creative destruction” is given free rein. There is however an interesting link between macro and microeconomics (and for this we are grateful to economist Andrew Hunt). Cheap money enables companies to keep going when they would otherwise die. It also encourages “Zaitech”, a neologism to describe borrowing at low cost to seek financial gain dissociated from the basic activity of companies.

If weak companies are kept alive artificially, the whole process of creative destruction is interfered with. This was the case in Japan in the 90s and 00s. Yet creative destruction, as in Thatcher’s Britain, is painful and takes time to bear fruit. As for whether it was worth the cost to US tax payers of bailing out the likes of GM and AIG, the jury is still out. GM has cost multiple billions, whereas AIG has proven a profitable investment.

In Europe the divide between the euro zone and the non-euro members of the EU is growing. Sweden has now joined the UK in opposing a shift in authority for bank supervision to the ECB. What might be sensible for countries in, or planning to join, the euro zone seems inappropriate for non-members. A two-level EU seems inevitable, but is probably a better option than a complete divorce.

If we are critical of US economic policies we can scarcely be optimistic for Europe. Basel III (bank capital adequacy) implies a doubling over some six years from 8% to roughly 16% of the ratio of capital to weighted assets. Faced with such a massive adjustment to their balance sheets, it is scarcely surprising that banks are lending almost nothing to small and medium enterprises (which have no access to bond markets). Again we see this as a highly negative consequence of a macroeconomic policy (reinforcing banks’ financial bases) upon microeconomics (encouraging entrepreneurship).

Our own clients are following our advice to lighten the credit risk of their bond portfolios, but only for EUR and CHF; clearly many of them choose the first, positive view of the US economic outlook above, despite our reservations!

Macro Focus

United States

Employment climbed by 146,000 in November, taking the jobless rate to an almost four-year low (7.7%). Service industries expanded in November with the ISM non-manufacturing index rising to 54.7 from 54.2 in October.

Orders for manufactured goods climbed in October by the most in eight months. Bookings for non-defence capital goods, excluding aircraft, a proxy for future spending, rose a revised 2.9%.

October saw a sharp increase in consumer borrowing with a jump to $14.2 billion in October, marking the third consecutive monthly expansion.

Eurozone

In Q3 the euro-zone economy was in recession for the second time in four years; GDP slipped 0.1%.

German exports rose 0.3% in October as shipments to countries outside Europe offset weaker demand in the euro area. German factory orders jumped 3.9% from September driven by foreign demand.

French business confidence and industrial production declined.

United Kingdom

Manufacturing and industrial production fell respectively -1.3% and -0.8% in October.

The trade deficit widened in October to £9.54 billion from £8.44 billion in September as exports dropped, led by a decline in capital goods.

The Halifax house price index rose 1% from the previous month to an average £160,879.

Services growth slowed in November as demand fell for the first time in two years. PMI Services fell to 50.2, the lowest in 23 months, from 50.6 in October.

Switzerland

Unemployment rate was unchanged in November at 3.0%.

Consumer prices extended their longest decline in at least four decades in November as the franc’s strength continued to erode the cost of imports. Prices declined 0.4% from a year ago after falling 0.2% in October.

The central bank’s foreign currency reserves fell for a second month in November after pressure on the franc eased. Reserves declined to CHF 424.8 billion from a revised CHF 426.8 billion in October.

Switzerland’s 10-year bond yield fell to a record-low 0.36%.