Bond Outlook by bridport & cie, August 22 2012

The August calm to which we referred last week has continued, and market sentiment, especially for equities, has become more optimistic:

• in the USA, improvements in the housing market, and corporate profitability, have led to a remarkable growth in stock market valuations
• in Europe, the promises of the ECB “to do whatever is required” are raising hopes, despite the lack of concrete action. The German hard-line position may be softening as Asmussen, a German member of the ECB, supports Draghi’s position
• bond yields in peripheral countries have fallen back from their highs
• there have been many new corporate issues in EUR and GBP
• the UK has an inexplicable mix of falling GDP and unemployment

The trepidation about a Greek exit from the Euro has also all but disappeared. That possibility is now being considered in terms of the cost of an exit versus the costs of staying, and of the respective advantages and disadvantages for the Greek economy (and people).

For those seeking good news, there is also the case of Ireland, whose debt may benefit from an upgrade as it gradually works itself out of the debt crisis.

It would be wrong, however, to be totally sanguine. Bad news also abounds. The Spanish debt situation is far from being solved; Asia in general is slowing, with South Korea’s household indebtedness reaching alarming levels; a sovereign default is also taking place in Belize.

The Belize credit event also raises the possibility of further defaults, not necessarily at country level, but for regions and corporates. Emerging market corporate bonds remain attractive but require greater care in their selection than ever.

Recent years have shown that our initial expectation when the recession first hit was all too correct: many years of slow growth in all developed countries (we called it an “L-shaped recovery”). The only mistake we made was that the length of the L would be even greater than we first surmised. This has led to central banks flooding the markets with funds to keep yields low, and the yield curve artificially flat at the long end. The assumption behind their moves is that inflation is being kept at bay because of excess capacity caused by the very weakness of economies. This leads to the strong likelihood that longer-term bonds will see their yields drop as their maturities shorten. Bridport will soon issue an “investment case” dealing with this phenomenon.

We have often referred to the ebb and flow of liquidity in bond markets as market makers devote varying levels of capital to support their positions. Their reluctance to carry an adequate inventory of bonds reflects both risk aversion, and pressure to increase their capital adequacy. Restrained market-making is but part of the general cut-back by European banks of their investment banking activities. It can only mean that the role of brokers in fixed-income markets will grow as banks choose to reduce their role as intermediaries, and the volume of inter client business, a growing source of liquidity conducted without the intervention, or spreads, of market makers, continues to rise.

Macro Focus

United States

Economic activity has improved with leading indicators increasing 0.4% in July. Manufacturing in the Philadelphia region improved to minus 7.1, and industrial production increased to 0.6%. These good data have led to an increase of the consumer sentiment index to 73.6, the highest level since May.

While housing starts declined 1.1% in July, applications for building permits increased 6.8%, reaching the highest level since August 2008. A builder-sentiment index found that homebuilders are more optimistic about the residential market than at any time in the past five years.

Euro Zone

Greece’s central government debt stood at € 303.5 billion. The country’s debt rose from € 280.3 billion at the end of the first quarter. Cash reserves stood at € 3.5 billion.

Italian debt reached almost € 2 trillion in June, an all-time high. That brings public debt to 123% of gross domestic product, a level in Europe second only to Greece.

Spain is seeking to protect small investors, and is talking with EU officials about a proposal that would protect these investors from losing all their investments in the nation's banks.

Sweden’s Finance Ministry projects a budget surplus in 2013. They expect debt to dwindle to 22.5% of GDP by 2016. Sweden has reduced its debt burden relative to gross domestic product every year since 2009.

United Kingdom

While home sellers cut asking prices by a record for the month of August (-2.4% to £ 236,260 from July), unemployment dropped to 8.0%, its lowest in a year, as the Olympic Games created jobs, and retail sales rose. Sales including auto fuel gained 0.3% from June. However, the ONS said the change would have a negligible impact on gross domestic product.

Bank of England policy makers dropped a reference to interest-rate cuts this month as they voted 9-0 to keep their bond-purchase target unchanged and said they will assess the need for other stimulus measures.

Switzerland

Swiss investor confidence rose, improving to minus 33.3 in August from minus 42.5 in July.

The Swiss government expects to post a surplus of about CHF 1.5 billion this year, but the budget surplus, based on income and spending in the year’s first six months, is still subject to “high uncertainty”.

Banks’ share of Swiss gross domestic product will probably continue declining until at least 2015, after falling to 6.1% in 2011 from 8% in 2007.