Bond Outlook by bridport & cie, June 6 2012

Although we asserted last week that Spain’s problems would only be solved if and when those of the euro zone as a whole were dealt with, they may have unwittingly pushed themselves to the fore and to the point where the country’s banks may force a first step towards the very federal system which might be the saviour of the single currency. Spain is calling for a rescue of its banks accompanied by the issue of euro zone bonds. Schäuble, respecting the German tradition of opposing everyone else, basically says that this is a good idea but after the fiscal union is in place. After? -- when euro zone bonds are an integral part of fiscal union!

In parallel, Draghi, playing a more political role than his predecessor (who did however propose a euro zone ministry of finance), has stated that the ECB cannot fill the vacuum caused by the lack of action by national governments on fiscal growth and structural problems.

Remembering Merkel’s seven “neins” (to euro zone bonds, an expanded ESM, common bank backing, austerity-light, direct government financing, looser money supply and a greater level of German consumption) we are beginning to see the order in which she and her colleagues may give ground:

1. Banking union, the new expression for what only last week was called a “bank backing system”. If the banking system in Europe collapses, so will the entire economy. The Americans showed the way in 2008, when all stops were pulled out to keep the banks operating, including having the Fed act as lender of last resort. The Spanish and other banks must be saved in terms of their operations, although probably at the expense of their shareholders’ funds

2. The body to come to the rescue may not be the ECB, but the European Stability Mechanism. This appears to be the German preference

3. The ESM will need more funds, and these are likely to be raised via euro zone bonds. It appears that the barrier of the German constitution forbidding taking on other states’ liabilities may be circumvented by creating a “Redemption fund” financed by euro countries transferring reserves to the fund, which could then issue bonds against a 20% collateral pledge

The rest may have to wait, although:

4. a lightening of austerity is an objective of most euro zone leaders,

5. direct government financing is part of the debt mutualisation (also called “collectivisation”) process which many see as an integral part of European federalism

6. and the ECB appears ready to lower the repo rate

As for 7, encouraging consumption in Germany, that may have to await a change of government.

What does all this say for fixed-income investors? First, that despite all the public inaction of European political leaders, they may be doing more behind the screens to save the euro from break-up than the markets currently perceive. We admit that our scenario above is not assured, and that all the issues of the democratic deficit have yet to be resolved. Yet we remain optimistic that a major move to federalisation of the euro zone is on the drawing boards and will soon be revealed.

The market, however, is assuming the worst. This is epitomised by the historically low yields on safe-haven government bonds. Investors are buying Bunds and Swiss sovereign bonds at zero, or even negative rates as a hedge against the failure of the euro. What, however, if the scenario above is realised? Investors are wise to hedge against failure, but should they not also hedge against success?

We have specific ideas on this based on identifying corporate bonds which are cheap today because of the sovereign risk of their country, rather than the fundamentals of the companies themselves.

USA: owing to weakness in the global economy, business activity is slowing: factory orders dropped 0.6% in April and the Institute for Supply Management’s factory index fell to 53.5 in May after reaching a 10-month high of 54.8 in April. The labour-market recovery is also stalling. The unemployment rate increased to 8.2% as job-seekers re-entered the workforce. Job cuts, led by computer companies, jumped in May by the most in eight months. Consumer spending nevertheless rose 0.3% in April

Euro Zone: euro-area unemployment reached 11.0% the highest on record. In contrast to Germany’s unemployment rate which slid to a new two-decade low in May (6.7%), Spain registered a record rate of 24.4% and Italian unemployment rate increased to 10.2%. Euro-area manufacturing contracted in May and economic confidence declined. The inflation rate fell from 2.6% in April to 2.4%. Cyprus may need rescuing because of its high exposure to Greek debt

UK: while manufacturing shrank last month at the fastest pace since the depths of the financial crisis in 2009, services showed some signs of stabilization. Job vacancies in the City and Canary Wharf financial districts rose from 3,455 in April to 4,320 in May. The number of jobs created in May is the highest since August 2011. As a consequence, consumer optimism about the economic outlook rose and slowing inflation eased pressure on shoppers. The housing sector continues to improve: house prices rose 0.3% from April, and mortgage approvals rose, as record-low interest rates helped sustain demand

Switzerland: growth unexpectedly accelerated in the first quarter to the fastest pace in 1 1/2 years, led by consumer demand. GDP climbed 0.7% from the fourth quarter. This positive momentum is confirmed by the KOF leading economic indicator which unexpectedly increased for a fourth month in May. However, manufacturing output contracted as Europe’s economic slump crimped export demand

Canada: the Bank of Canada kept its main interest rate unchanged for the 14th time and may soon raise interest rates with the domestic economic recovery proceeding as forecast, even as global risks have increased

Australia: the Reserve Bank cut its benchmark interest rate by a quarter percentage point to 3.5 %, and is expected to drop to the historical low of 3 % (2009) as Europe’s debt crisis and slower Chinese growth overshadowed a stronger domestic labour market