| The New Year is opening on a positive note. We take this opportunity to review major themes which are likely to reveal whether this optimism is well grounded. |
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| United States: falling off the fiscal cliff was avoided, but the fundamental problems of the internal budget are far from resolved. The economy is showing several positive developments, including recoveries in housing, manufacturing, domestic energy supply and bank lending. Nevertheless, the economy remains on the “intensive care” of quantitative easing. The true test of proper recovery will be that the economy can be weaned off QE, and withstand the higher cost of money. Curiously QE has not led to inflation, but may well have stored it up to be let out of the bottle once the recovery firms. Yet higher inflation and interest rates offer two major advantages: a reduction in the weight of government debt, and a return to a more equitable relationship between borrowers and lenders. |
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| Europe: the move towards a federal structure of the euro zone will continue, consolidating the stronger exchange rate already achieved at the end of 2012. This is bound to bring about a two-tier Europe, with the euro group at the centre, and the non-euro countries at the periphery, led by the UK. That is the only way to reconcile the vision of growing political union of Germany (and France?) and the free trade area preferred by the UK (always assuming that the UK does not leave altogether). Paradoxically (in the light of high unemployment and recessionary conditions), the ECB may be first to discontinue its version of QE. Further paradoxes are possible such as a strengthening EUR, despite the poor economic outlook. |
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| Ireland has dropped off the list of problem countries (to be replaced by Cyprus). The country is held as an example of how austerity can rebalance the economy, although it is very dependent on inward investment. Whether Spain and the other peripherals can follow Ireland’s example is very debateable. |
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| UK: to be out of the euro zone is universally recognised as an advantage to the UK economy; it gives the country freedom in its monetary policy. That freedom is nevertheless curtailed by weakness of both the USD and the EUR, which has led to a stronger GBP than the country really needed. Nevertheless, some of the positive signs about the US economy are present in the UK, including a stabilisation of housing activity, growth in manufacturing and services (despite a small decline recently of the latter) and even the potential for shale gas extraction. In addition, the UK has a flourishing entrepreneurial sector, working closely with its universities on innovation. Frankly the jury is still out on the UK economy, but optimism has a slight edge. |
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| Japan: most of the problems of Japan, its deflation and internal deficit, can be put down to its declining and ageing population. The moves announced by Prime Minister Abe to force the BoJ to create inflation will prove fascinating to follow. Will they achieve the result required? Will they result in a much weaker yen? |
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| In the light of this overview, the key issue at stake for fixed-income investors is where does the greatest risk lie? We believe it to be the former safe haven of government bonds. This is because the signs to date are that the optimism to which we refer in our opening paragraph are, on balance, justified. That means higher rates, and recycling of funds in government bonds, towards traditionally riskier assets. The safe haven has become a danger zone! |
Macro Focus
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| United States |
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| Manufacturing picked up in December, reflecting growth in orders, employment and exports. The ISM index climbed to 50.7 from a three-year low of 49.5 in November. Service industries expanded at the fastest pace in 10 months, the ISM manufacturing index climbing to 56.1 |
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| Payrolls rose by 155,000 last month following a 161,000 advance in November, leaving the unemployment rate at 7.8 %. Hourly earnings climbed 0.3 % on average in December for a second month, the biggest back-to-back increase since the economic recovery began in mid-2009. |
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| Eurozone |
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| Macro-economic data from the euro area contrast highly with US data: European services and factory output contracted in December, with the composite index based on a survey of purchasing managers at 47.2. The November jobless rate rose to a record 11.8%, and the Euro area November retail sales decreased 2.6% from last year. |
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| United Kingdom |
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| PMI Services shrank for the first time in two years in December in contrast to a surge in the PMI Manufacturing index. Indications from a Bank of England survey are that its credit-boosting program is beginning to have a positive impact on lending. |
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| House prices data were contradictory in December. The Nationwide Building Society average price indicator declined 0.1 % to £ 162,262 while the Halifax indicator rose for a second month. Prices advanced 1.3% from the previous month to an average £ 163,845. |
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| Switzerland |
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| The KOF economic indicator decreased for a third month in December, dropping to 1.28 from 1.50 in November. However, the PMI Manufacturing Index advanced to 49.5 from 48.5 in November. |
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| Unemployment was unchanged for a third month in December. The jobless rate held at 3%. |
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| Dr. Roy Damary |