Bond Outlook by bridport & cie, October 17 2012

The end of every year tends to see quiet descend on financial markets. This year the effect is exaggerated by the US presidential election and uncertainty as to the economic consequences of its outcome. As it happens, there have been some positive news items this week, like improved housing data in the USA, and less reticence from Germany about bailing out weak European economies, but these are hardly sufficient to mark a significant change in direction. We therefore allow ourselves to indulge in a little economic supposition, and present a politico-economic view of our own.

Let us begin with the obvious. If a company, a city, a household, whatever, spends more than it earns, it will eventually pay a heavy price, usually involving belt tightening. The same applies to countries, except that the process is much slower, especially when other countries are willing to hold deficit countries’ currencies as reserves. That was once the case for the UK and is now the case for the USA. Having a reserve currency slows a country’s need to go through belt tightening, but does not obviate it.

For a country with the “exorbitant privilege” of having a reserve currency, weaning itself from that privilege is painful (witness the UK). In the USA, only a few recognise that the current practice of allowing deficits to grow without limit is not sustainable. It is political suicide however to address the subject, because rebalancing external and internal deficits implies a drop in the standard of living – not exactly a vote winner. Will a new or re-elected President have the courage to deal honestly with the deficits, or will the current denial continue until economic reality forces changes on the USA?

We have championed belt-tightening for many years, but faced with the impact of austerity on the weaker economies of the euro zone, have gradually modified our views. Far from enabling an economy to rebalance its budgets, too much austerity induces a decline in GDP, actually making rebalancing impossible. The implication is that austerity remains necessary, but to a more moderate extent and spread over a greater period of time.

There is another dimension associated with deficit reduction however, and that is inflation. Because the value of most debt is fixed at issue in absolute terms, but profit, incomes and taxes are in current, inflation-impacted terms, (and should therefore grow ahead of debt), the effects of inflation alone should reduce the ratio of debt to GDP, and debt to current revenue. Of course too much inflation risks hyperinflation and economic collapse, but a rate of around 4% (double the target rate of most central banks) could be a positive contribution to rebalancing. Those of us who lived as adults through the 1970s will remember how 4% was then a distant dream!

Many see the seeds of inflation as already having been sown. The reason the seeds are not sprouting is that the economy, and thus demand, are so weak. Perhaps the question should be reversed: if we accepted some inflation, might the economy not be so constrained? In using the verb “accept”, we are obviously being optimistic as inflation will at some stage ultimately impose itself anyway.

In the last two weeks, we have mentioned the better economic news concerning the British economy. Many commentators are now recognising it, but without providing an adequate explanation. Our explanation is micro-economic: the UK is remarkably entrepreneurial and has a plethora of innovation centres and support centres for new enterprise, along with universities unashamedly collaborating with industry and facilitating start-ups. In addition, the country’s openness to foreign investment and takeovers has turned around major sectors, of which the obvious example is the automotive industry. Even the strength of the “City” can be put down to the entrepreneurial spirit.

Whilst the British experience shows that economic success does not depend on macro-economics alone, but also requires sound micro-economics. It is interesting to note that, amongst the major Western economies, the UK has also ‘endured’ one of the highest rates of inflation for the past 2 years. Perhaps there is a lesson here for the rest of Europe?

Macro Focus

United States

Manufacturing in the New York region contracted for a third straight month in October. However, the Federal Reserve Bank of New York’s general economic index rose to minus 6.2 from minus 10.4 in September.

Retail sales rose in September by 1.1%, following the 1.2% increase in August, partly explaining the widening of the trade in August from $ 42.5 billion in July to $44.2 billion in August. Furthermore, slower global growth reduced demand for American exports.

Mortgage applications decreased last week from a three-year high as fewer Americans refinanced their homes. Refinancing decreased 2%, while purchase applications climbed 2.4%.The average rate for a 30-year mortgage climbed to 3.39%.

Euro Zone

Industrial output may be bottoming out. It actually rose 0.6% from July, but was still down 2.9% YoY after a 2.8% decline in July.

The inflation rate remained at 2.6 % from a year ago.

Confidence among European chief executive officers is at the lowest level since the financial crisis, based on share repurchases falling to a three year low and the near disappearance of mergers and acquisitions.

Greece’s unemployment rate climbed to 25.1% from a revised 24.8% in June.

Portugal’s trade deficit narrowed to €2.18 billion from €3.46 billion as exports rose 10.4% and imports fell 1.5%.

United Kingdom

Asking prices for homes in the London Borough of Kensington and Chelsea surged to a record this month as values rose to an average £ 2.2 million, according to Rightmove Plc.

The Financial Services Authority relaxed the amount of funds U.K. banks must keep in reserve, in an effort to spur lending and stimulate credit growth.

Switzerland

Producer and import prices had the first annual gain in more than a year in September as energy costs increased. Prices for products rose 0.3% from a year ago after declining 0.1% in August.