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It is not the great greatest claim to success ever made, but over the last few months the bond market has outperformed equities by incurring smaller losses than they, and our recommendation in favour of short maturities has similarly outperformed long maturities. In addition the FT tells us that over the last ten years, bonds have given a modest positive real return and equities a small negative return. This week may be heralding an opportunity to move from the capital protection mode to careful risk taking, but first let us consider the outlook for the economy, and, in particular, inflation. |
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Our view on inflation is changing as the economic crisis unfolds. The current overall inflation is obvious for all to see. Until recently we imagined that it could be brought under control only by repeated hikes in interest rates. Last week we argued that only one or two modest rises should suffice while awaiting the full impact of the credit squeeze. This week reinforces that supposition and even suggests that the economic environment is turning deflationary. |
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The need for additional capital for a whole range of institutions is beyond the capacity or the willingness of western investors – hence the very visible turning to sovereign wealth funds by the impaired banks. Underwriting failures for mortgage issuers have occurred this week on both sides of the Atlantic: Indymac of California and Bradford & Bingley of the UK. In addition, the mere risk of the GSE mortgage agencies needing to bring back securitised mortgages onto their balance sheets, which would oblige them to raise USD 75 billion, has caused a drop both in their share prices and also in their perceived creditworthiness as measured by credit default swaps. The supervisory body for the agencies has had to state that they will be exempt from the new accounting rules concerned. |
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Thus the credit squeeze is still tightening. However, an even stronger argument in favour of deflation lies in the loss of wealth from the declines in the stock markets and in the value of housing. In the USA, since the peak on one or two years ago, these are estimated at approximately USD 3 trillion and USD 2 trillion respectively, in other words about half of the annual GDP! Of course, it can be debated just what “deflationary” means. During the stock market and housing bubble, the CPI rose only slowly, so inflation was declared moderate. Some of us suspected that something was wrong; inflation was actually very high overall if assets were also taken into account. Now the situation is reversed: consumer prices are rising and asset prices falling. Yet there is a third element in this dance of inflation versus deflation: commodity prices. They look very bubble-like. This week the bubble has deflated a little, but we are loath to fall again into the trap of declaring the bubble to have peaked. What we can affirm is that a western recession and a commodities bubble are incompatible in the long run, even if prices have to readjust permanently to reflect declining resources and expanding demand preventing prices falling back to where they were. |
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What then for the inflation outlook and positioning on the yield curve? We are tempted to lengthen but think it too early. However, we would like to re-echo our recommendation that corporate bonds from selected companies, perhaps lower down in the range of investment quality, can offer yields to maturity of 7% or better over several years. Bridport stands ready with specific suggestions for clients wishing to move carefully into higher-yield corporate bonds. |
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The Fed is taking a lead in revamping the regulations for US financial markets, almost usurping the role of the SEC (although Bernanke speaks of close cooperation). New rules on mortgage lending (“to protect the public”) are being drawn up, as are control mechanisms for Credit Default Swaps. Liffe is taking an initiative on CDS by creating a clearing market, and the New York Fed will be setting new regulations in the USA. |
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The ratings accorded by the rating agencies are often in disagreement with the quality of bonds implied by CDS. While CDS markets will be subject to greater regulation, so will the rating agencies. “Brussels” is going after them, and the issue seems to be, can the EC regulate along the same lines as those proposed by the SEC? |
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Focus |
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(+) Switzerland: unemployment in June fell to 2.4% from 2.3 % in May. UBS should report a net profit for Q2 thanks to a tax credit. In the meantime, its rating has been lowered by Moody’s from Aa1 to Aa2 |
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(-) Germany: industrial production fell by 2.4% over April, the largest monthly decline in nine years |
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(-) USA: According to Merrill Lynch, the danger of a GM bankruptcy is real |
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(-) ECB: Trichet, "The annual inflation rate is likely to remain well above the level consistent with price stability for some time, moderating only gradually in 2009." |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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