Bond Outlook by bridport & cie, September 26 2012

In three months, everything has changed. Whilst in June we saw only headwinds, now everything seems resolved, and the sky is blue once again. This is the story being told by the market, but we do not share this view. We recommend a cautious stance.

It is true that we received positive news in September. First, Germany's constitutional court rejected a call to block a permanent Eurozone rescue fund, clearing a key hurdle towards resolving the debt crisis. Then, the Dutch Prime Minister, Mark Rutte, won in a close race after voters backed pro-European parties, dispelling fears that more extreme groups and Eurosceptics were gaining ground in the Netherlands, and the wider Eurozone. Finally, the ECB announced the “Outright Monetary Transactions” (OMT) policy.

Of course, it is important to have a plan, but now execution will be critical. Europe has articulated a set of policy responses to the debt crisis, but will now have to follow through on three key issues: 1) the EFSF/ESM-ECB bond buying plan, 2) bank union, and 3) Greece. Another key milestone will be whether Spain will ask for support under the programme. In addition, investors may be placing too much faith in the ECB, and in the ability of governments to cope with their fiscal problems in a 17-nation bloc still lacking economic union.

While important as a signal of intent, the economic impact of these moves is questionable. While authorities’ intervention has once again supported risk assets, the underlying issues that Europe faces are unchanged. The Euro crisis has pushed the world’s second largest economic region into recession and the recent ECB announcement will not reverse this trend in the short or medium-term, especially when elsewhere in the world, other concerns are rising.

• The Chinese economy is weakening. Cement prices, which are a good indicator of the pace of growth in the Chinese economy, were down 4% in August and 26% year to date. China’s slowdown has had repercussions elsewhere around the region.
• Brazilian exporters reported some improvement, benefitting from a weaker Real, but their performance is still down vs. 2011, mainly due to lower commodity prices. Brazilian financials also showed weak performance reflecting a slowing economy and rising non-performing loans.
• A firming in global consumer spending can be attributed partly to the recent sharp fall in global inflation. In the three months ending in July, global consumer prices are estimated to have risen at an annualised 1% - the lowest rate in over three years. However, the recent jump in food and oil prices is likely to dampen purchasing power, and push down global consumer spending growth.

In the best case scenario, growth will stabilize at a below trend rate, neutralizing some of the negative economic momentum which had boosted bonds earlier in the summer.

Our analysis suggests that economic momentum is still somewhat to the downside. As a consequence, for investors having a time horizon of 12 to 18 months, we would recommend using any rebound in top quality 10 year government bonds to lengthen the duration of their portfolios.

You will find full details in our 2012 Q4 Strategy published tomorrow.

Macro Focus

United States

Manufacturing in the Philadelphia region shrank for the fifth consecutive month in September. The Philly Fed index was published at minus 1.9.

This week we had two additional signs that the housing market has gained traction in the second half of the year. First, the purchases of previously owned houses increased 7.8% to a 4.82 million annual rate, a two-year high; second, new housing construction rose 2.3% in August to a 750,000 annual rate.

Euro Zone

Euro-area services and manufacturing output fell to a 39-month low in September. A composite index based on a survey of purchasing managers in both industries in the 17-nation euro area dropped to 45.9 from 46.3 in August.

The German business confidence fell to the lowest in more than two and a half years in September. The IFO index dropped for a fifth straight month to 101.4 from 102.3 in August. This is the lowest reading since February 2010.

Greece's budget deficit is €20 billion, much more than previously estimated.

United Kingdom

Retail sales fell in August as the Olympics distracted shoppers and internet shopping plunged the most in almost five years. Sales including auto fuel declined 0.2% from July.

The manufacturing index increased more than forecasted in September. The gauge of factory orders rose to minus 8 from minus 21 in August.

Britain posted its biggest August budget deficit on record as the recession hit tax revenues and pushed up spending on welfare. The shortfall excluding government support for banks was 14.4 billion pounds.

Bank of England policy makers voted unanimously to maintain their bond-purchase target as officials differed on the need for more stimulus in light of growing inflation risks.

Switzerland

Investor confidence dropped to minus 34.9 from minus 33.3 in August.

The trade surplus narrowed to CHF 1.73 billion in August. Exports advanced helped by chemicals and watches.