Bond Outlook by bridport & cie, April 10 2013

Back in 2008, we forecast that the world’s economy would take at least 5 years to recover from its overspent status. It turns out that our time horizon was too optimistic. The hope that we then entertained, and which financial markets still seem to believe, was that after a degree of deleveraging, budget rebalancing, and exchange rate adjustment, the global economy would return to expansion, “normal” levels of inflation, and positive real interest rates.

Over the last several months, the stabilisation of the US housing market, stock market performance, and modest decline in unemployment, allowed a degree of optimism that the USA was leading the way to renewed growth. Yet even while sharing this optimism, the nagging doubt at the back of our minds was that little had really changed in the USA as regards government internal and national external deficits, and that only the private sector had seriously deleveraged. As we have written here several times, until the US economy no longer relies upon ultra-cheap money, its recovery has no sustainable basis.

The time has come to recognise that the old “normal” has disappeared into history, and that a new “normal” is here to stay (for many years, rather than months):

• Economies are sustained by indefinite quantitative easing

• Yields and interest rates will continue to be low, and, in many Western countries, will remain negative in real terms

• Inflation will threaten, but not strike, any time soon

• No government or central bank will dare seek an exit from reliance on the provision of cheap money, lest recession return

This new normal has led to a number of distorting market behaviours:

• Growth in equity values, and lowering of corporate bond yields, almost irrespective of rating

• Massive issuance of corporate bonds, accompanied by a surge in the size of corporate treasuries, and deployment of many of the funds so harvested to fund share buy-backs and mergers

• Low levels of investment in wealth creating projects for lack of attractive opportunities, despite the cost of capital being so low

• Lack of funds for entrepreneurial investments as small businesses and start-ups cannot tap the bond markets like large corporations

• The survival of companies which, under normal interest conditions, would be closed down and the capital and skills redeployed according to Schumpeter’s principle of Creative Destruction

• Much higher corporate profitability than historical averages (now at around 10% of GDP vs. an average of 6%)

Where does this leave fixed –interest investors? On the positive front, we consider convertibles to be a sound way to participate, in a hedged manner, in any potential upside in equities. On the negative side, extreme prudence is needed in all types of bond, even government issues, which one wit has described as “return-free risks”. Bridport has the analytical tools to seek the few good opportunities in a very difficult environment for all investors. In particular, we are expanding our data base on convertible bonds.

A last thought: Japan’s experiment is still underway and its results, other than further weakening of the Yen, and the creation of volatility in the JGB market, are as yet unknown. Whilst, over the longer term, we worry that Japan’s experiences may serve as a template for Western economic performance, in the short term, we are beginning to wonder, slightly mischievously perhaps, whether the enormous amounts of money being printed are the source of capital to maintain the euro, much as Chinese money has maintained the dollar over the years. More on this next week.

Macro Focus

United States

The ISM manufacturing index fell to 51.3 in March as orders and production cooled. Nevertheless, housing and auto-related industries outpaced other areas last month; as spending has bolstered the expansion, while exports grew at the fastest pace in almost a year.

The ISM non-manufacturing gauge declined to 54.4 in March from a one-year high of 56 (and which reflected the 39th consecutive month of expansion).

Employers hired fewer workers (88,000) than forecast but a shrinking labour force helped push the unemployment rate down to the lowest in four years (7.6%).

Eurozone

A gauge of manufacturing in the euro zone declined from 47.9 in February to 46.8 last month. The euro-zone economy has now contracted for five consecutive quarters. The jobless rate has risen to a record 12 %.

Retail sales fell in February as a drop in France offset gains in Germany and Spain. Sales decreased 0.3 % from January.

Producer-price inflation slowed to the lowest annual rate in almost three years, led by easing energy price growth. PPI rose 1.3 % from a year earlier.

United Kingdom

While services unexpectedly strengthened to 52.4, manufacturing shrank for a second month in March from 48.3 to 47.9. Manufacturing exports have been hit directly not only by the problems in the euro zone, but also by strong competition overseas.

House prices rose in March, according to Halifax. Home values increased 0.2 % from the previous month to an average of £163,943. From a year earlier, values were up 0.3 %.

Switzerland

The chaos surrounding the bailout package for Cyprus, and stalemate in the Italian elections, also impacted the Swiss economy: manufacturing output contracted in March as the PMI index declined to 48.3 and the unemployment rate held at the highest level in two years (3.1% adjusted for seasonal swings).

Consumer prices decreased 0.6 % from a year earlier. That is the 18th straight month of annual declines, the longest stretch since at least 1971.