Bond Outlook November 7th

The oil price is at an all-time high and rising, the USD is dropping by the day, food is more and more expensive, foreclosures are climbing, house prices are dropping, and yet the US stock markets stage a recovery. Do we explain this as wishful thinking on the part of equity investors, or are there genuine reasons why the stock market should apparently deny the risks facing the US economy? We lean toward the former, but must admit that a lower dollar and the prospect of lower interest rates can explain optimism about company earnings.

Several pessimistic analyses have been published in the last few days about banks, starting perhaps with the Merrill Lynch analysis of UBS having more losses to declare, but now going beyond one bank criticizing another. Some of the issues have already been addressed on this page, but are worth repeating anyway:

1. off-balance sheet investment vehicles cannot simply be lopped off like a dead branch – they are returning to banks' assets and liabilities
   
   
2. asset-backed commercial paper is being renewed as on-balance-sheet commercial loans
   
   
3. level 3 assets – the ones that (apparently) cannot be sold or priced but which are valued by unproven models – are in excess of major banks' own equity (exception ML), suggesting, but not proving, that the banks' equity bases are threatened
4. sub-prime losses (which are proving to be more than sub-prime assets themselves) are reckoned to be anywhere between USD 100 and 300 billions, but only USD 20 billion have been declared. Obviously the losses reduce banks' owners' equity, and specifically their "Tier 1" equity, which, in the USA, should be more than 6% of the weighted assets (more severe than the Basel Accord's 4% Tier 1 and 8% for Tiers 1 +2)
   
   
5. Even though people like the CEO of a major monoline insurer claim that losses due to marking to market are not real, there is an underlying disappearance of real cash flow as mortgage borrowers fail to pay interest and principal
   
   
6. The underlying cause of the entire credit squeeze, the decline in US housing prices, is, like the revelation of bank losses, far from over
   
   
7. Debt created by derivatives and securitisation is significantly greater than debt created by bank lending and cash lenders (93% vs. 7% according to "Independent Strategy"). This is inherently beyond the control of central banks and very much subject to the market's risk sentiment
   
   
8. The problems of the credit squeeze are not limited to the USA, although the hope that the rest of the world will cope "quite well" still reigns.
   
   

If that were not enough, the Chinese are confirming their wish to diversify their currency holdings and seek improved returns from their Sovereign Wealth Fund.

Where does all this lead? Not, we believe (and hope) to a breakdown of the banking system, but rather a continuation of the credit squeeze. The tighter standards of mortgage lending can only prolong the decline in house prices, which is likely to spread to Europe (the UK, Spain and Ireland appearing to be most susceptible). This will reduce consumer spending. In addition corporations will be able to borrow less easily– or at least it will cost them more – but this may not be so important since balance sheets are quite healthy (outside the financial industry!). The problem clearly lies with US consumer spending, the decline of which has scarcely begun, but which appears almost inevitable.

The Fed may not want to reduce its target rate but the pressures to do so will be irresistible. The long end of the yield curve cannot but rise as inflation builds. Inflation is of course already there; to focus only on "core inflation" cannot change the fact that consumers are paying a lot more for food and energy and the money spent on those items cannot be spent elsewhere.

For USD investors, a falling Fed rate and gently increasing long-end yield suggests that our current recommendation of a 7 year average USD maturity is reasonable. We must however admit that most of our USD clients prefer very short maturities, reflecting a "cash is king" philosophy. We cannot simply recommend a "flight to quality" in bonds, as the very shift in economic power to which we referred last week speaks of so many opportunities in emerging markets. Perhaps they are the "new quality"!

Focus

(!) Sub prime : - the crisis, far from being over, is worsening:

-new fears about Merrill Lynch

-Fortis refusing to publish its exposure to sub-prime

-Citigroup, still the world's largest bank, sacking its CEO and is alleged to have lost USD 8-10 billion in the credit crisis

-Trichet believing the risks to the financial economy are being underestimated

-Northern Rock said to have borrowed GBP 23 billion from the BoE since September 14

(+) Brazil : 17% of Brazilians have escaped from poverty. The political and social economic policy is still being questioned.

(–) Switzerland : inflation at its highest for 15 months (October : 1.3 % ( Sept: 0.07 % )

(–) Peru : third largest producer of copper and zinc, .... a country-wide strike has been announced leading to fears of a copper shortage

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

Recommended average maturity for bonds.

Generally long, as long-end yields seem unlikely to rise immeadiatly, and short-term rates will be lowered.