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The damage done to liquidity in the financial services industry by the credit crisis is slowly on the mend (see “Focus” below), but within an environment of inflation and a US recession. If that description of the financial world is accepted, what does it mean for fixed-income investments? We see three dimensions to a likely answer: |
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- Continue the shortening process we began three weeks ago
- Venture very cautiously and selectively into the area where mending is taking place, i.e., into the finance sector
- Enhance the role of inflation-linked bonds
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The BoE has belatedly joined the Fed and ECB in setting up facilities to exchange mortgage-backed securities for government bonds, but nevertheless at a price to pay for past errors. All the central banks are following the example of the ECB in recognising that, with the liquidity crisis partly out of the way, attention needs to be directed towards bringing inflation back down, even if they are still running scared of a slow down. Their focus must be on real inflation, not the meaningless “core” rate that excludes energy and food. |
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The one problem with this is that slowing the US economy by means of higher interest rates no longer “works” in terms of bringing down inflation. Adding a slow-down in Europe to a US recession will still not be enough. If Asia stopped growing, the Chinese went back to meatless diets and the crude oil supply expanded, inflation would decline, but none of these three is likely to happen. So, frustratingly, the central banks will fight inflation with the only tool at their disposal, higher interest rates, and will not succeed in the short term. Yet they have to try, lest inflation be even worse. |
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Given sufficient time, however, they might even succeed in bringing inflation back to target (2% for the euro zone), but at a high cost to the world’s economy. Basically the Western economies will not just have to slow, but actually decline to reduce the export-based growth of the emerging economies. That is if the Asian economies remain dependent on exports to the West. If ever they turned to domestic consumption to maintain growth, inflation would be even higher. The central banks and governments do indeed have most difficult waters to navigate. |
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All US data point to a recession. The debate is mainly about “V” vs “U”, with no one willing to accept “L”. (These letters refer to the shape of the GDP curve, whether it goes down sharply and swiftly bounces back, goes down and stays down for a long period before again climbing, or goes down and stays down.) Our own view? “U”, with a base as long as three years. We make this assessment on the time needed for the US housing bubble to stop deflating. US (and UK) property prices (both residential and commercial) look set to continue declining for a period of at least two years. During this time US households will no longer be able withdraw equity from their homes. True, they have turned to credit card debt to maintain their reckless spending, but even that source of borrowing is approaching an end (credit card debt has already caused HSBC losses, and they are usually the first to “confess”). All in all, the liquidity crisis may well be mended in a matter of months, but the credit squeeze and the economy as a whole will require much longer. |
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One curiosity of this whole crisis, or at least of the part that says the eventual outcome will be a better balance of the world economy, is that US policy makers and commentators alike are horrified at the idea of consumer spending being cut back. Yet the most elementary understanding of macroeconomics stresses the importance of saving as a key component of sustainable growth. An increase in household saving from net negative to modest positive should normally be heralded as a good thing. Not in the USA, however, as that would imply lower household spending and a reduction in GDP. It is too much to hope for in an election year that any party or presidential candidate actually admit that that is precisely what the USA needs. Never mind, it will happen anyway. Market forces will eventually overcome denial and wishful thinking. |
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Focus |
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(–) Yields in EUR: the 10-year Bund lost 2% in value this week. The ECB will “do what is needed” to bring inflation back to target |
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(+) BoE: GBP 50 billion of Gilts are available for banks to exchange against mortgage-backed securities but with a “haircut” of 10% to 30% |
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(?) Banks: Citigroup and RBS are next to issue new shares to strengthen their balance sheets. While we have said financial markets are mending, expect more losses, not least from supposed contributions to profit from the mysteriously-valued “level three assets” (for which no market prices are available) |
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(+) New issues: renewed activity |
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(!) Commodities: the forthcoming wheat harvest looks abundant and may help lower prices |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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