Bond Outlook October 15th

Our cautious optimism last week that the UK Government plan would eventually lead to market normality appears so far to be justified. The UK approach to taking equity positions in banks to increase their capital adequacy has indeed been adopted just about everywhere, including in the USA. Stock markets may be closer to finding a level above the floor they hit last week but well below previous highs. Whilst it is a concern that the TED spread (spread of 3 month USD Libor over government bills) has not declined at a faster pace (it is still nearly 10 times pre-crisis levels), CDS spreads on banks are coming in. That is not surprising, really, given the central bank guaranties on commercial bank loans and bonds. If that does not work, nothing will!

Our own clients have certainly found confidence in banks again, and are putting cash into financials just as we indeed recommended last week. They have not yet taken the next step of moving out of Treasury Bills into better yielding bonds, but we see that coming.

At the AsiaHedge conference in Hong Kong we happen to have met one of the architects of the Swedish bank bailout of the early nineties. He stressed how important it was, that the legal entity that buys into the banks and takes on board the troubled assets, be established as an independent entity, free of political interference and run transparently, so that both the public and also the potential buyers of the shares and assets perceive integrity. The Swedish state did, by the way, recuperate over several years all its investments plus a profit.

Just how close the world came to seizing up completely last week was illustrated by the refusal of banks to accept letters of credit from other banks to support international trade; the catastrophic effect of international trade ceasing for lack of finance scarcely bears thinking about!

We suppose that a return to normality of financial markets is underway. That is far from saying, however, that the world economies are “back to normal”, not, at least, if normal is defined by the standards of recent years. A recession is inevitable as Western consumers save more and spend less. It is entirely possible that the stock market will reach new lows, as sustained negative news on the world economy can be expected over the coming months. It would be helpful if China could expand its domestic consumption faster, and there are claims at the Hong Kong conference that it will (although the Economist this week warns of a significant slowdown). We hope the Hong Kong view prevails, but cannot imagine that such a turnaround can happen as fast as Western consumption declines.

The economic fundamentals remain little changed: excess production, diminished consumption, housing prices still declining (including in Hong Kong), falling commodity prices, limited credit availability even if no longer a “crunch” – they all point to a deflationary environment. Yet all the time the shadow of inflation hangs over our heads as governments are basically printing money for their bailout schemes.

We remain puzzled by the strength of the USD; some of the participants in the conference see it as a long-term trend reversal. We rather see it as a reflection of asset repatriation and of the difficulty of obtaining USD loans from any bank (and non-US banks needing to borrow dollars). This second issue should be put to rest as the bailout steps take effect.

Focus

(?) China: foreign currency reserves have now exceeded USD 1.9 trillion, an expansion of 32.9% over one year

(+) Spain: Inflation slowed in September to 4.6% per annum versus 4.9% in August

(+) Hungary: Inflation slowed in September to 5.7% per annum versus 6.5% in August

(+) UK: Northern Rock, nationalised in February, has announced that it has already repaid half of its debts to the Treasury since the beginning of this year

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds.

Following recent gains on short-term Sterling, we recommend profit taking and lengthening, only in government and supra bonds.

Currency:

USD

GBP

EUR

CHF

As of 8.10.08

2015

2015

2015

2015

As of 16.07.08

2015

2010

2015

2015

Dr. Roy Damary