Bond Outlook [by bridport & cie, January 20th 2010]
Consider this dream: moderate but steady growth has returned to the US economy, as a lower exchange rate allows exports to increase and the trade gap to decline. Households are continuing to deleverage, and are increasing their savings. The volume of funds they, together with institutional investors, are looking to place, are quite able to meet the needs of Federal borrowing. Thus government debt requirements will be met without raising the long end of the yield curve. |
Such is the view held by a large part, possibly the majority, of financial markets, and propagated by influential commentators like Gary Shilling and a more anonymous group of economists interviewed by Bloomberg. |
We see it as but a pipe dream. Unemployment in the USA is increasing steadily (and is grossly underreported because of the strange system that those who have ceased looking for a job no longer “count”). Household deleveraging – which we have long recommended and are now seeing – must mean lower consumption. Government borrowing can only maintain upward pressure on long-term yields. Inflation, currently absent, may be round the corner, imported from Asia (where it is already at 7 to 8% — see below), and that is before taking into account a likely revaluation of the RMB. |
Last week we observed how some quality corporate bonds were offering lower yields than equivalent governments. We described that as anomalous. Maybe it is not so anomalous, only unusual, but with good reason. There is now a strong case to distinguish between swap and government yield curves. We see the latter steepening, but the former either not following, or following only partially. |
Another way of seeing this is to deduce that the potential for duration-based gains is limited, with better opportunities available in “playing” credit risk. That is obviously what many investors are doing in “snapping up” new issues almost regardless of quality. We reiterate our view that the current enthusiasm for “junk bonds” is risky. Yet quality corporate bonds remain reasonable in terms of risk/reward – better in fact that government bonds. In a recommendation we could not have envisaged in recent times, we believe fixed-income investors should increase their quality corporate holdings at the expense of governments. We cannot go so far as to recommend long maturities, but, selectively, corporate bond maturities could be a little longer than those recommended in our table (which focuses on government bonds). |
For investors taking the route of credit risk, we believe our old favourite of emerging markets continues to offer attractive opportunities. |
Asian regional growth, and a somewhat reduced dependence on Western markets, has a down side, viz. inflation. In India, inflation is running at over 7%, whilst in China, it is closer to 8%. Food prices are rising even faster in these countries, where poverty is still rife. Asia was first to come out of recession (the “slowdown” would be a better term for the region), and is the first to suffer from inflation. To reduce inflation, the governments have the difficult task of tightening money supply, but this will also slow growth. We suspect that such tightening will have only a minor impact on both, as the middle classes are emerging very fast, leaving behind the poor, who remain in poverty. The impact on the West can only be inflationary as Asian goods and services will cost more. In the meantime, the un-pegging of the RMB from the USD will prove a double-edged sword, certainly helping trade rebalancing, but at the cost of more expensive imports for the West. |
The sudden increase in UK inflation may be a foretaste of this effect. |
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Focus |
(–) USA: retail sales declined 0.3% in December after growing 1.8% in November. Weekly unemployment registration rose to 444,000 vs. 433,000 the previous week. The CPI increased 0.1% in December. In contrast, the Fed’s manufacturing index for New York reached 15.92 in January, vs. an expectation of 12.00 |
(–) Germany: the ZEW index of business confidence fell to 47.2 in January, vs. 50.4 in December |
(+) UK: house prices rose by 0.4% in January after a drop of 2.2% a month earlier. Core consumer inflation reached 2.8% over the whole of 2009 |
(+) Europe: 2009 Euro zone inflation was 0.9% |
(!) Greece: no exceptions for a particular country according to Trichet |
(+) Russia: the budget deficit came in at 5.9% of GDP in 2009, much lower than earlier forecasts (9.4% in May) |
(?) “Junk bonds”: the default rate on low-credit corporate bonds was 12.5 % in Q4 2009. The default rate should fall substantially in 2010 as a function of the strength of the recovery |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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Recommended average maturity for bonds. |
Stay short across the board. |
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Currency: |
USD |
GBP |
EUR |
CHF |
|
As of 17.06.09 |
2012 |
2012 |
2012 |
2012 |
|
As of 21.01.09 |
Max. 2013 |
Max. 2013 |
Max. 2013 |
Max. 2013 |
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Dr. Roy Damary |
