Bond Outlook by bridport & cie, January 16 2013

Let us begin with a confession: we like inflation! Not high inflation, but a rate in the order of 3 to 4%, and ideally accompanied by interest rates of at least 1% higher Readers might think that such an opinion can only be expected from a specialist in fixed interest instruments, but our reasoning is much more profound:

• when national economies have so much domestic indebtedness, inflation allows the gradual absorption of the debt as a proportion of GDP

• inflation gives that extra incentive to spend versus a tendency to put off spending in the hope of lower prices (admittedly this advantage applies mainly to countries that have room for greater household spending like Germany and Japan)

• interest rates above inflation, and at generally higher levels, restores a proper balance between the rewards for savers and the cost to borrowers (currently so much in favour of borrowers that pension funds, for example, are in serious trouble)

Apparently PM Abe of Japan has a similar view, but with a more modest target of 2% inflation. We can but applaud his efforts, and his firm instruction to the BoJ to print enough money to achieve 2%. Nevertheless, his policy has to be seen as an experiment. If results are favourable, there will be lessons for other developed economies. If it fails, the lessons will be about what not to do. Certainly criticism of his policy is widespread. It ranges from the assertion that Japan has tried numerous stimulus packages over the last 20 years, all to no avail, to the view that success means a much lower JPY exchange rate and a massive decline in Japanese living standards.

We hope it will work, both for the Japanese and world economies, and because it will support our own argument for higher inflation in the West. The experiment is well worth watching!

The EUR is on the mend, but whether that means the euro zone’s economy is also improving is more debateable. Financial markets clearly think so. It is however hard to see real improvement while unemployment is so high and industrial production stagnating. No sooner does Ireland get off the list of countries needing a bail-out, than Cyprus takes its place. Nevertheless, Spain seems to be improving, and attention may turn now to Italy and its forthcoming election. The euro zone economy may better be described as stabilising rather than recovering.

As for the USA, the political system has become dysfunctional. The country is lurching from one self-inflicted crisis to the next – from fiscal cliff to debt ceiling, and then on to controlling entitlement spending. The Europeans are pathetically slow in achieving a political consensus, notably in the context of the federalisation of the euro zone, but at least they are moving, which is more than can be said for the Americans.

Some of our clients have expanded their USD holdings regardless of exchange rate trends. Many are lengthening the duration of their corporate bonds. The attraction of new issues has largely disappeared, and we recommend considering the secondary market before jumping into the primary. Our warning last week of the dangers of “safe haven” government bonds was timely and still stands.

Macro Focus

United States

Import prices fell in 2012 for the first time since 2008, by 1.5% from December 2011.

The trade deficit widened by 15.8 % to $48.7 billion in November as imports jumped almost four times more than exports.

Retail sales rose more than projected in December. The 0.5 % gain followed a revised 0.4 % increase in November. Sales excluding automobiles and gasoline climbed 0.6 % for a second month.

Wholesale prices dropped for a third month in December as food costs retreated, capping the smallest annual gain in four years. The producer price index declined 0.2 %. For all of 2012, prices paid by companies climbed 1.3 %.

However, manufacturing in the New York region contracted in January for the sixth straight month as industry continued to face the effects of fiscal uncertainty in the U.S. and lacklustre demand overseas. The Federal Reserve Bank of New York’s general economic index fell to minus 7.8 from a revised minus 7.3 in December.

Eurozone

The ECB left the benchmark rate at a record low of 0.75 %. Euro-area industrial production dropped 0.3 % from October. Industrial output in Germany increased 0.1 % while French production rose 0.5 %, but Italy and Spain reported declines of 1 % and 2.5 %, respectively.

The November trade balance jumped to EUR 11 bln. Imports declined 1.5% while exports increased 0.8% MoM.

United Kingdom

The Bank of England left interest rates unchanged at the record low level of 0.5 % and refrained from fresh measures to stimulate the economy. Industrial activity was flat at the end of 2012.

Consumer prices rose 2.7 % from a year earlier and 0.5 %. from the previous month, the highest rate since May last year as gas and electricity costs rose.

Switzerland

Consumer prices extended their longest slump in at least four decades in December as the franc’s strength continued to erode the cost of imports. Prices declined 0.4 % from a year earlier after falling 0.4 % in November.