Bond Outlook by bridport & cie, October 24 2012

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Despite low coupon rates, bonds have provided respectable returns based on spreads narrowing. The same seems unlikely for next year and the danger of interest rate increases remains.

About the only firm statement to make about the economy is that the outlook is uncertain. Profits are down and lay-offs are up in many manufacturing companies, but service companies are doing well. US sales of existing homes are down but housing starts are up. China’s growth is slowing – or is it? Will the USA really march over the “fiscal cliff”? Above all, who will win the US Presidential election, with the two very different economic philosophies on offer?

 

This uncertainty has driven investors into bonds despite the low yields. The drive to perceived safety in turn reinforces the lowering of yields and narrowing of spreads (which we see as overdone). Data from the USA suggest a continued shift from equity into bond funds, although we hasten to add that this phenomenon is not currently being seen among our clients.

 

Fixed-income investors this year have done well. Their main source of gain has however been the narrowing of spreads (which we see as overdone) and the lowering of interest rates. Can that source of gains continue into next year? It seems very unlikely, as there is little room left for the trend to continue.

 

There is of course downside risk. Bernanke keeps assuring us that low interest rates will continue well into future. What will happen however the first time he fails to add that phrase to any of his public briefings? The answer is a rush for the exit, and to shortening durations, with holders of all types of bond being hard hit.

 

While that risk certainly exists, we do not see it as imminent. That is because the US economy is so sluggish that higher interest rates would kill the faint signs of recovery. Moreover, the day Bernanke does leave off the said phrase and yields do jump, recession will be inevitable. In the meantime, he has enough of a problem dealing with the approaching fiscal cliff as Congress so resolutely decides not to deal with the issue.

 

Irresolution remains the defining characteristic in Europe also. Spain cannot bring itself to ask for the bailout it so obviously needs. It appears loath to hand over sovereignty to Brussels, or (as the FT mischievously but correctly points out) to Berlin! Yet that is precisely what members of the very slowly emerging federal structure for the euro zone will have to accept. The UK never will. Others may be of the same view as the UK, both within and outside the euro zone. The visions of the EU proposed by the UK on the one hand, and of Germany on the other, are in such opposition that it is hard to see a compromise. Moreover, the FT calling Berlin the capital of Europe is not likely to endear the British public to the EU at all. A two-speed Europe is the least that can be expected; a break up, or departure from, the euro zone bloc the most.

 

We have long affirmed that somehow, and despite the European politicians lack of leadership, the euro will be saved. We are feeling less sure about the European Union itself.

 

In summary, fixed-interest investors can continue with reasonable safety to seek yield through selected corporates, but with the recognition that margins for error are gradually being eroded


Macro Focus

 

United States

 

Leading indicators increased 0.6% in September, the most in seven months, boosted in part by a jump in permits for home construction. Housing starts surged 15% last month, the highest level in four years.

 

The Federal Reserve Bank of Philadelphia’s general economic index rose to 5.7 from minus 1.9 in September.

 

Euro Zone

 

Construction output rose for a second month in August, advancing 0.7% from July, as gains in countries including Portugal, France and Italy compensated for a German decline.

 

The euro zone’s combined debt burden rose last year to the highest since the start of the single currency. The debt of the 17 nations climbed to 87.3% of GDP in 2011 from 85.4% the previous year.

 

Spain’s banks face more loan losses as the economic slump risks bringing about the worst-case scenario. Bad loans as a proportion of total loans reached a record 9.86%, or € 169.3 billion in July.

 

United Kingdom

 

Retail sales including fuel gained 0.6% from August on increased demand for winter clothing and school uniforms!

 

Jobless claims fell 4,000 to 1.57 million in September and payrolls rose to a record high. The unemployment rate dropped to 7.9%.

 

Britain posted its smallest September budget deficit since 2008. The shortfall, excluding government support for banks, narrowed to £12.8 billion from £13.5 billion pounds a year earlier.

 

Switzerland

 

The ZEW leading indicator increased to minus 28.9 from minus 34.9 in September.

 

Exports rose 2.6% in September helped by chemicals and watches. Imports gained 3%. The trade surplus expanded from CHF 1.61 billion in August to CHF 2.01 billion.