Bond Outlook by bridport & cie, December 5 2012

With yields on government bonds and high quality corporate bonds falling below inflation, with low-end investment grade bonds generally matching inflation, and only low-grade corporate bonds actually yielding above inflation, fundamental arguments for further bond investment are difficult. Yet returns on bond portfolios in 2012 have been rather good. If, by way of example, a typical portfolio has returned 9% in 2012, approximately 7% of this can be put down to the narrowing of spreads. The question facing portfolio managers is whether such performance can be maintained in 2013.

We think not, which is why we have been making two basic recommendations to our clients:

• to begin steadily lightening the credit risk of bond portfolios

• to conduct their credit research particularly thoroughly on purchases of both primary and secondary issues, rather than blindly following a trend

The world economy is not improving, and in certain areas, accidents are still waiting to happen. When they do, defaults on lower-grade bonds will surge. We may have been early in already sounding this note of caution a month ago, but better to be too early than too late!

By contrast, there is a potential “positive accident” waiting to happen in the USA: the fiscal cliff may yet be avoided! That will give a boost to financial markets. In the meantime, the Administration/Congress stand-off is firmly entrenched. Obama insists that an increase in taxation on the rich (and he always adds “like myself”) is essential, while Boehner says that he is totally opposed. The two men are also at loggerheads over the level of capital gains tax.

There is a view that the Republicans will finally give way, because the general public is behind the President, and Republican Congressmen are liable to suffer in elections. In Obama’s video broadcast, there is the quiet confidence of a man who knows he will win. We have some sympathy for Boehner, who must be equally conscious of public opinion, but has a recalcitrant Congress on his back. Until the deal is finally struck however, concerns over the fiscal cliff are negatively affecting both the economy and financial markets.

There is also mixed news in Europe. Spanish yields may have declined after the latest bank rescues, but Schäuble is now slowing down the move to a banking union by opposing a single monetary and supervisory body at the ECB. He favours a Chinese wall between the two activities. He may be right, but it does not help speed things up.

We remain intrigued by the issue of when quantitative easing will be discontinued, as this will be the single strongest evidence of economies moving off life-support. Clearly there is no sign of an end in the USA. The only change there is that “operation twist” is being replaced with traditional T-Bond and agency bond purchases by the Fed. This makes yield curve steepening likely, adding maturity risk to the credit risk we have already identified.

The UK remains a candidate for being first to stop QE. The business lobbies are urging that BoE bond buying could usefully be switched to the private sector. We wonder what Governor-in-waiting Carney thinks of that?

Macro Focus

United States

The economy expanded in Q3 at a 2.7% annual rate, up from a 2% prior estimate, as both a narrower trade deficit and gains in inventory offset a decline in consumer spending of 0.2% as incomes stagnated in October.

The ISM factory index decreased from 51.7 in October to 49.5 last month, the lowest since July 2009,

While Americans signed more contracts to purchase previously owned homes, purchases of new homes declined in October.

Europe

Manufacturing output in the 17-nation euro area shrank for a 16th month.

The jobless rate rose to a record in October (11.7%). German unemployment climbed for an eighth straight month and the Italian rate rose to 11.1%, the highest level in 13 years.

Economic confidence in the euro area nevertheless rose in November. An index of executive and consumer sentiment in the 17- nation euro area increased to 85.7 from a revised 84.3 in October.

United Kingdom

PMI Manufacturing in November climbed to 49.1 from a three-month low of 47.3 the previous month.

GfK Consumer confidence rose from lows to an 18-month high of minus 22 in November, from minus 30 in October.

Overall London house prices fell in November, while luxury-home prices in central London rose at their slowest rate in more than two years.

Switzerland

The economy returned to growth in Q3, expanding to the fastest pace since 2010 as exports soared. GDP rose 0.6% from Q2, when it fell 0.1%. PMI Manufacturing advanced to 48.5 from 46.1 in October.

The KOF economic indicator decreased for a second month in November, dropping to 1.50.

The franc depreciated to the weakest level in almost three months against the euro as Credit Suisse Group AG set a negative rate of as much as minus 1% on foreign balances held in the Swiss currency.