Bond Outlook by bridport & cie, October 31 2012

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A “phoney war” is underway on both sides of the Atlantic. Like its predecessor in 39/40 all hell will break out quite soon. With the Fiscal Cliff?

The term “phoney war” has surfaced to describe the current state of the economy. For readers for whom this expression may not mean a lot, it refers to the first eight months of the WW2, when Great Britain and Germany were at war, but nothing much was happening. Then all hell began!

 

In Europe, Outright Monetary Transactions have been declared by Draghi, but all is quiet, mainly because Spain is still not officially asking for a bail-out (with all the inherent strings attached). In the USA, the economy is showing positive signs, notably in housing, but the Battle of the Fiscal Cliff will begin next year, just as (to continue our parallel) the Battle of France broke out in May ’40.

 

The demand for government bonds has resulted from the search for safety in uncertain times. Yet government debt in the USA and Europe (with the exception of the peripherals) is not keeping up with inflation. In turn this has resulted in a search for yield which has greatly narrowed corporate spreads. Is this a bubble? “Yes” is the short answer, but, as with all bubbles, just when it will burst, and corporate yields surge despite low government interest rates, is presently unknown.

 

That so much is unknown about the politico-economic situations partly explains why US corporations are sitting on USD 1.7 trillion in cash and failing to invest it. Indeed, the cash pile continues to grow as all sorts of increasingly unfamiliar corporations continue siphoning money from willing investors, desperate to earn something (anything!) above inflation. An optimistic interpretation is that once the two most important unknowns (who will be President and how the fiscal cliff can be avoided) are resolved, corporate America will be all ready to expand. A pessimistic one is that the fundamental problems of many years of over-consumption, under investment, and loss of manufacturing competitiveness to China, mean that there will be few attractive opportunities to deploy these funds in the USA. They might rather be directed to plants in Latin America or Asia!

 

The data on inflation suggest that wages are now growing ahead of inflation. This may explain the expansion of household consumption and improved consumer confidence (see “Focus”). Yet the dominant feature of the US economy is that wages have been flat for years while the cost of food, tuition, municipal services and healthcare have risen sharply. Manufactured goods, most of which are imported, have fallen in price to such an extent that inflation has been constrained down to current levels. So, where does the improved consumer confidence come from? We do not have a definite answer. Could it be the impact of the political campaigns? Relief that home prices have turned round? The lessening of the burden of household debt owing to lower interest costs and reimbursement of principal?

 

The corporate debt bubble will eventually burst. It may burst at the same time as the seeds of inflation sown by quantitative easing finally sprout. This is therefore a time for short maturities and maximum care over credit risk.

 

For our next Weekly, at least one unknown will have disappeared!


Macro Focus

 

United States

 

GDP rose at a 2% annual rate after climbing 1.3% in the prior quarter. Consumer spending rose 0.8%, the most since February, after a 0.5% gain last month.

 

Confidence among consumers (the Thomson Reuters/University of Michigan index) climbed to 82.6 in October, the highest level since before the last recession began five years ago.

 

Purchases of new homes climbed 5.7% in September to a 389,000 annual pace (the most since April 2010) while the index of pending home resales climbed 0.3% after a 2.6% drop in August.

 

Euro Zone

 

Euro-area services and manufacturing output fell to 45.8 in October, the lowest in more than three years, and the IFO German business confidence dropped to 100.0 from 101.4 in September, the lowest in more than 2 1/2 years as Europe’s recession deepened.

 

French consumer confidence fell for a fourth month from 85 in September to 84.

 

Spanish unemployment, the second highest in the EU after Greece, rose to 25.02% from 24.6% in the previous quarter and September retail sales fell 11% from a year ago.

 

United Kingdom

 

Britain exited a double-dip recession in the third quarter with 1% GDP growth from the three months through June, the strongest in five years. However, the manufacturing industry declined to minus 23 from minus 8 in September.

 

Switzerland

 

This month the KOF economic indicator decreased for the first time since January. The monthly gauge, which aims to predict the economy’s direction about six months ahead, dropped to 1.67 from a revised 1.68 in September.

 

Swiss consumer demand rose in September to 1.07 points from a revised 1.02 points in August, led by retail sales and overnight stays in hotels.