Bond Outlook by bridport & cie, April 17 2013

Gold has fallen from its perch, China has been downgraded (a little), Japan’s QE programme is gathering speed and terrorism has returned to the USA. Banking secrecy in Switzerland is becoming a nostalgic memory. Does all this mean things are getting better or worse? Does it mean that the warnings we gave last week of the lack of a real base to the economy were justified, or is a true recovery underway?

Perhaps it just means that the “new normal” is now accepted by financial markets, and investors are learning to live with modest returns and uncertainty.

Consider the question we raised at the end of our last Weekly about capital flight from Japan supporting the EUR. We have sought an answer this week, and it is not the one we expected. Despite a generalised view that much of the liquidity that the BoJ is creating is flowing abroad, the data on currency flows suggest quite the opposite (for this insight we acknowledge MarketPulseFX). Japanese investors are net sellers of overseas bonds, net buyers (but of much smaller amounts) of overseas equities and short-term securities. The net repatriation flow last week came to JPY 1.06 trillion (roughly USD 10 billion). Moreover, foreigners have been buying into Japanese stocks, so that the net inward flow was JPY 3.76 trillion in just one week.

This is an example of unexpected consequences: a lower JPY leading to high stock values, and to a flow of money into Japan. Maybe the net sales of foreign bonds are a result of profit taking; after years of Japanese bonds yielding less than 1%, a windfall of around 25% from the rise of foreign currencies is very welcome. Whatever the end result of the massive QE in Japan, there will be many more “unexpected consequences”.

One dimension of the “new normal” is that search for yield has gradually over the last couple of years given way to cash income, i.e. to attractive coupon payments as distinct from returns on bond prices realisable on selling or maturity. At the same time, risk acceptance is quite high (whether justified or not). This may explain why many bank and insurance bonds are proving attractive as cash generators. Financial companies issue different classes of debt: subordinated debt classified as Tier 1, upper Tier 2 and lower Tier 2, which are issued to meet regulatory capital requirements, together with senior bonds and covered bonds to provide funding (bond types listed in decreasing order of risk). There is a European bond pool of over 50 financial issuers, all of whom issue various classes of debt, sufficient to provide appropriate diversification. This area has come under increased scrutiny from regulators in the past few years, and has seen significant innovation. CoCo bonds (Contingent Capital) where bonds convert to equity or suffer a write down when set capital levels are breached. Issuance patterns will see further changes due to the implementation of Basel III. In addition, a number of corporate Issuers are issuing subordinated debt (known as Corporate Hybrids), as it allows them to issue more debt whilst preserving credit ratings. Credit investors tend to find the 2-3% yield over senior bonds attractive for the increased level of risk. Despite our historical (justified) reservations on subordinated debt we are well placed to advise on these investment opportunities as the search for yield and income continues. Much attention is needed to the details of the covenants of each issue.

China is changing, with repercussions on the West. Its manufacturing costs have risen so much that repatriation of manufacturing to the USA, UK and elsewhere is actually happening. The Fitch downgrading points to a dangerous level of domestic indebtedness. Fitch refers to government indebtedness, but it is hard to say where the government stops. Much of the indebtedness is in banks (government owned) and in provincial and city governments. China is on a path to move from the world’s economic success story to the possible source of its next crisis.

Macro Focus

United States

Prices dropped in March, the producer price index by 0.6% MoM and imports by 0.5%, as fuel prices retreated.

Confidence among consumers fell to a nine-month low in April. The Thomson Reuters/University of Michigan preliminary index declined from 78.6 in March to 72.3 in April.

Retail sales dropped in March by 0.4%, the most in nine months.

Builders began work on more new homes in March, with housing starts rising to 930,000 annualised; mortgage rates are near a record low.

Eurozone

Industrial output expanded more than expected in February, with factory production rising 0.4% from January. Nevertheless, production was still 3.1 % lower than a year-earlier.

Euro-area export growth slowed in February as declines in Italy, Spain and the Netherlands offset gains in Germany and France. Exports rose a seasonally adjusted 0.1 % from January. Imports decreased 2.1 %. The trade surplus widened to EUR 12 billion.

The inflation rate fell for a third month in March, to 1.7 %, down from 1.8 % in February.

German investor confidence declined in April. The ZEW index fell to 36.3 from a three-year high of 48.5 in March. It was the first drop in five months.

United Kingdom

House prices rose 2.1 % from March to an average of £244,706. The scarcity of homes is supporting prices and masking the weakness of demand in many areas. In his budget last month, Chancellor Osborne pledged £3.5 billion of loans plus £130 billion of guarantees to spur house building and help people struggling to afford a first home.

Inflation in March extended its run above the Bank of England’s target. Consumer prices rose 2.8 % from a year earlier. Consumers are under pressure from rising prices and fiscal tightening. While the government has broadened the BoE’s scope to add to stimulus, even while inflation remains above its goal, a majority of the Monetary Policy Committee voted to maintain the size of the bond-purchase plan this month.

Switzerland

Producer and import prices fell 0.3 % from a year earlier. Producer prices were unchanged on the month and rose 0.3 % in the year, while consumer prices were flat on the year.