Bond Outlook November 20th

Every government has espoused the Keynesian principle that, in a recession, they have to spend more and reduce taxes despite the resulting deficit financing. The only problem is that the same governments were already massively in deficit while all seemed well. There are therefore few reserves in the developed world to call upon in this latest round of government spending, which is really the same Greenscam approach writ large: throw money at the economy to keep consumption up at any cost. It is not that we see any alternative now that this mess has been created, but in the back of our minds all the time is the thought that, even if the government actions work, the adjustment to living within a country's and its households' means remains an essential and inevitable process.

Yet perhaps this adjustment will take place despite government attempts to apply the old remedies to problems bigger than they have had since the 1930s. Households are beginning to save. At a very micro level, household by household, decisions are being made to spend less, cut the standard of living and save. Like a cat scalded, households are most unlikely to play with the hot water of excessive borrowing for many, many years.

Professor Roubini, who has always made our most pessimistic prognoses look rosy, has published a list of 20 reasons as to "why the US consumer is capitulating, triggering the worst US recession in decades." Of the 20, one is predominant and often cited in this Weekly: a return from negative to positive savings at an historical trend level of a few percentage points (e.g. in the 3 to 7% range). What is saved is not spent, and what is not spent brings GDP down to the tune of 75% of the amount not spent. If the current adjustment in savings rate is fast, the recession will be deep but short, if slow, shallower but longer. Not a very pleasant choice, but a slower adjustment may be less damaging. Still, our hope that the decline in GDP will end by mid-2009 is looking a touch optimistic.

In the meantime what suggests that the US economy is worsening?

• the car industry is demanding its share of the bail-out programme and can easily blackmail the Administration with its threat of at least 2.5 million job losses
• insurers are buying banks in order to tap into the credit facilities at the Fed
• credit cards are proving very vulnerable. For example the spread to swaps on an Amex 2012 dollar issue has widened to 540 bps
• CDOs (which may not have been mentioned much lately) are plummeting to new depths wherever valuations can be found

The story goes on. The G20 meeting produced only platitudes, although it planted a seed of hope that the world's financial system can be revamped in order to cater to a world so different from that of the 1940s. Likely themes for next meeting in April include harmonisation of accounting standards, coordinated regulation of financial markets and the creation of a "college" of supervisors.

Independently of G20, the finance industry is changing fast with the end of off-balance sheet vehicles and uncontrolled leverage, and reduced opacity between lender and borrower through securitisation. We feel strongly that those who are rewriting the rules let no one lend without retaining a component, even if only a modest one, of the risk. (The idea is to avoid both irresponsible lending as in sub-prime and to re-establish a connection between lender/investor and borrower.)

Last week, by removing our table of recommended maturities we rather rammed home the point that, currently, credit and currency considerations are more important than maturities. With the point made, we reintroduce the table this week, but with it focused on government bonds. Our recent recommendation in favour of high quality corporate bonds stands. A word of caution: government bonds are historically expensive during this period of flight to quality.

Emerging markets, the spreads of which had come in, are again widening.

Focus

(–) Citigroup: set to dismiss a seventh of its staff, (this weekend the figure was 10,000, yesterday 50,000 and now 52,000 jobs)

(–) Autos: if GM alone goes bankrupt, 2.5 million jobs are at risk, directly and indirectly

(+) Bank of America: has announced its intention of increasing its stake in China Construction Bank by USD 7 billion

(+) UK: inflation in October slowed to 4.5% on a yearly basis, versus 5.2% in September

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

Recommended average maturity for bonds.

Until further notice this table only concerns government bonds. We have stayed with our recommendations in favour of long maturities.

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