Bond Outlook by bridport & cie, February 27 2013

Can bad news be good? Italian voters have soundly rejected austerity, and made formation of a stable government unlikely (what’s new? Snafu* has always been the perfect description of Italian politics.). This has led to an increase in Italian yields, a decline in the euro, a drop in stock markets, and EU politicians almost shouting at Italy, “You have no choice but austerity!”

Yet the Italians do have a choice and so does the whole of Europe. There is a growing chorus in Europe, and not just from the man in the street, that austerity is being overdone. We would be among the first to say that belt tightening is unavoidable after such profligacy (in fact, we were), but now we must admit that austerity can be too severe. A slower move to balancing budgets might be more effective in maintaining GDP growth.

So to come back to our opening question: our answer is a cautious “yes”:

• a change from extreme to moderate austerity may now be more appropriate in Europe

• in the euro zone, a greater sense of solidarity through fiscal union is needed more than ever, and the Italian result puts the pressure back on the politicians to deliver on their promises

• a week ago there were complaints that the euro was too strong. How can its weakness now be considered bad?

Italy may have pushed consideration of US politics and economics off the front pages, but on the 1st March, federal budget cuts across the board are inevitable. Trepidation over the size of the cuts seems to have moderated with 2% of the Federal budget and 0.3% of GDP seen as less drastic than feared There is also hope that the impact will be slow, and that Congress will probably just cancel the sequester after a few weeks anyway! Still, it seems a strange way to run a country, lurching from one political deadlock to the next.

While we can be sanguine about both the effect of the Italian vote and the US sequestration, the relative optimism we were hinting at in recent weeks is now fading. Signs that the reining in of quantitative easing were predictive of growing fundamental strength in certain economies, appear to have been overly optimistic. Alas, on neither side of the Atlantic, nor in Japan, are the central bankers near to announcing that the recovery no longer needs “intensive care”. Our initial reaction to Japan’s change in rhetoric was quite hopeful, but our suspicions are growing that, like many of its bridges, the new programme to induce inflation is a road to nowhere! Given the economic mess after 2007, QE was essential, but the current addiction of the USA, UK, euro zone and Japan to cheap government money will have to be broken.

Perhaps the most encouraging aspect of Bernanke’s recent testimony is that he believes the cost of QE is acceptable. At least he recognises that it has a cost!

It appears that fixed-income investors are resigned to low returns. Our own clients are expanding their bond holdings with the emphasis on seeking yield through lower-credit corporate bonds. The risk of a surge in yields and inflation has declined this week (for negative reasons), but still merits some protection via corporate floaters.

*WWII US Marine slang: “Situation Normal, All Fxxked Up”

Macro Focus

United States

Consumer confidence is quite high: 69.6 on the Confidence Board vs. 58.4 in January. New house sales rose to 437,000 in January vs 378,000 in December. Only two orders for aircraft were received by Boeing as the Dreamliner fiasco continues. US banks are making good profits: the $141bn they earned in 2012 was more than in any other year on record except 2006. Nevertheless, J.P Morgan is cutting 4,000 jobs.

Eurozone

The Italian election is having a knock-on effect on other peripherals. In addition, Rajoy is having to deal with scandals of kick-back schemes. Spain is the only peripheral not to meet plans to narrow the deficit. It has been reduced (from 9.4% in 2011 to 6.7% of GDP in 2012, as announced by Rajoy), who stresses the enormous effort by his countrymen to clean up public finance. However the objective negotiated with Brussels was 6.7%.

The negative impact of the “Italian effect” is being felt acutely by European banks. The Cyprus bail-out negotiations should be completed by the end of March.

United Kingdom

4th Quarter GDP fell 0.3% from the previous quarter, with exports declining by 1.5%. The BoE is open to still more QE. The downgrading of Gilts seems merely to have confirmed the obvious and had little impact. The Government is pressing both Lloyds and RBS to downsize prior to denationalisation.

Switzerland

Upward pressure has returned to the CHF after the Italian election.

Argentina

The “hold-outs” from the ten-year old restructuring are being supported by US courts, if not by the US Administration. A possible outcome is that USD-denominated emerging market bonds may never again be “restructurable”.