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Last week the Tuesday upturn in stock markets continued into Wednesday before fading out. We see a parallel with US consumers also having a fling before the credit squeeze and economic slowdown eventually overcome their prodigality. Surveys showing consumer confidence at new lows appear at the same time as those which show spending reaching new highs! While all expectations on bank lending capacity are pointing down, consumer borrowing is still increasing! This situation cannot last, because: |
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- Losses by banks are far from all being declared or even identified
- Loan write-offs are increasing, be they mortgage loans, credit cards or “other consumer loans”
- The government-sponsored mortgage agencies are in trouble
- SIVs are being brought back on to bank balance sheets
- Commercial paper is being replaced by lines of credit
- House prices are relentlessly declining
- Food and energy prices are climbing and general inflation beckoning
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Maybe the sentiment is that next year will be so difficult for consumer financing, and prices so much higher, that it is better to borrow and buy now, while it is still possible. “Eat, drink and be merry, for tomorrow we die!” |
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The U.K. is seeing definite signs of a slowdown, with consumer confidence dropping. The FSA is concerned about the 1.4 million households whose short-term fixed rate mortgages end next year. Moreover, a write down in profits, together with capital adequacy constraints, may affect the financial services sector. This will have a significant impact on UK growth, as finance is more important to the economy in Britain than in other countries, owing to the City of London’s role as the global financial hub. The finance sector represented 5.5% of GDP in 2000, and 9.6% in 2006, accounting for 30% of GDP growth over the last three years. Government revenues could be hit still further as 22% of income tax revenue is paid by the top 1% of earners, many of whom are from the City. |
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Every year in December, bond markets become more difficult. This year is much worse than usual. There are very few offers of short maturities and very few bids of long. “Everyone” is holding on to whatever short-term quality bonds they have. This phenomenon, coupled with mutual mistrust in the banking industry, largely explains the big spreads between government bonds and Libor. |
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As the end of the year approaches, let us give some consideration for strategy in 2008: |
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- The battle against inflation will be fought more vigorously in Europe than in the USA
- The ECB is therefore less willing to lower interest rates than the Fed
- The USD will thus weaken still further even if it has occasional rallies
- More losses from sub-prime and its contagion imply that credit risk will remain high
- Economic rebalancing will continue in favour of emerging markets, with Europe remaining stable
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Fixed income investors should therefore see 2008 as a defensive year, in agreement with the UBS assessment reported below. Reduce USD and credit-risk exposure. Consider lengthening the very short maturities which many of our clients have adopted during this crisis. The only areas of “risk diversification” we would recommend (in modest doses) are selected sovereign emerging markets in local currencies. |
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The danger of inflation in the USA is high. Whilst the USA needs to increase its exports, the one thing that governments do not wish to import is inflation, which is something that those countries that have a dollar peg risk. Consequently, there is a strong possibility of the peg being pulled in the Middle East and loosened in Asia. Inflation-linked bonds may have a role in USD portfolios but not yet elsewhere. |
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Focus |
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(+) outlook 2008 : higher inflation, credit risk and a struggling US economy make UBS see 2008 as too early to diversify risk, and they recommend capital protection |
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(+) USA : Bernanke’s recent speech has removed any doubt about the coming Fed move being down, despite core inflation at 1.9% and rising (the Fed appears to ignore real inflation) |
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(–) Moody's placed six of Citigroup’s seven top rated SIVs on negative watch list, which may cause holders of SIV paper to exit to comply with investment guidelines |
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(–) UK : one-month Sterling has shot up from 6.09% to 6.72%, as banks renew their financing for 2008, but not, apparently their mutual confidence |
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(?) Canada: BoC cuts rate to 4¼% |
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( ! ) Gulf States: they are leaving the door open to scrap dollar pegs in order to reduce inflation and protect capital |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question |
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