Bond Outlook by bridport & cie, November 14 2012

While we enjoyed a bout of optimism and good news last week, the time has come to be a little more circumspect. We identified quantitative easing as good news, but just how good has to be put into context. Without QE, many economies would today be in an even worse state than they actually are. So cheap and plenteous money supply has been an essential element of recovery, or at least of avoiding recession.

The really good news will be when QE can be discontinued. We would suggest that if the cost is somewhat higher inflation, it is a price worth paying, as the only reason why inflation is so low is because of the weakness of the economy. The UK has taken the lead in announcing the end of its QE measures. Its circumstances are special, notably for not being in the euro zone, and therefore being able to follow its own monetary policy. In addition, or, rather as an indirect consequence, UK top-end housing has become a major investment target for foreign buyers, pushing up Sterling rather more than the Government might wish.

Will the USA finally stop QE? The Fed has already tried, and had to backtrack. The economy really is too weak to be weaned off cheap money. Nevertheless, the USA, first to pull the world economy into slow down, looks like being the first to lead the way out. We have two reasons for this optimism:

• the first is that housing prices have bottomed out, thus the immediate cause of the 2007/2008 financial crisis is gently disappearing

• the second, and this is even more important, is that the fundamental issue of spending beyond one’s means is also gradually looking better. This is particularly true of the deleveraging of households, where debt as a proportion of disposable income has dropped from about 135% at its peak to some 115% today, and it is still declining

As it happens, the latest US trade data are also positive (see Focus), so the country as a whole may be reducing its reliance of foreign purchases of Treasuries. Of course, both household, and foreign debt reduction, are long, slow processes, while the third component of over-indebtedness, the internal deficit, is far from solved. The looming fiscal cliff should sharpen minds: it will be intriguing to see if Congress can now do a deal with a re-elected President. If they can get their act together, the news that the Fed is discontinuing QE may be announced as early as in the New Year.

For the moment, we can find nothing positive to say about Europe’s chances of ceasing its version of QE. While politicians appear to be asleep at the wheel, bond markets are shaking them awake with renewed pressure, especially on Spain. The banking union, one of the essential steps of the fiscal union, is struggling. Spain is reluctant to declare itself a candidate for bail-out, and there are fundamental questions about the governance of the new supervising organisation. Will it have its own board, with more influence from its biggest contributors, notably Germany, than the one vote per member, as is the case with the ECB itself? What will be the position of the non-euro members, especially the UK, and how much delegation will there be to the central banks of each country?

Overall, the current fixed-interest market requires a defensive position for investors. As we stated last month, and which our latest internal analyses of spreads confirms, we believe a corporate bond bubble is building. That does not mean dropping all corporate bonds! Far from it, but it does mean that portfolios need detailed review for value at all levels of ratings.

Finally, we can report increased interest in commodity currencies, and in the rouble, as rumours abound that the long-running negotiations to allow settlement of Russian domestic bonds via Euroclear may be approaching a positive conclusion.

Macro Focus

United States

Exports from the US climbed to a record in September. The trade deficit shrank by 5.1% to $41.5 billion, the smallest since December 2010. The improvement was broad-based: from soybeans to fuel and civilian aircraft!

Confidence among consumers reached a five-year high. The preliminary consumer sentiment index climbed to 84.9.

The cost of imports climbed 0.5% in October, led by increases in energy costs.

Europe

Euro-area retail sales decreased as a decline in Spain offset gains in Germany and France. Retail sales fell 0.2% from August and 0.8 % from a year earlier.

French industrial production declined 2.7% in September from August and confidence among industrial executives was near the lowest in almost three years. The Bank of France fears the country may be tipping into recession.

German investor confidence declined in November. The ZEW index of investor and analyst expectations fell to minus 15.7 from minus 11.5 in October.

United Kingdom

The Bank of England halted expansion of its bond-buying programme as officials shifted focus to stimulating bank lending to support a recovery that remains lacklustre. The Monetary Policy Committee said that it does not plan to buy any more bonds beyond the £375 billion already purchased, concluding a third round of quantitative easing.

Inflation accelerated in October to a CPI of 2.7% from a year earlier. This compares with a near three-year low of 2.2% in September. Retail-price inflation (RPI), a measure used in wage negotiations, quickened to 3.2% from 2.6%.

Switzerland

Unemployment increased for the first time in six months in October, from 2.9% in the previous month to 3%.

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

The SNB’s foreign-currency reserves fell last month for the first time since February to CHF 424.4 billion.