Bond Outlook March 1st

A fortnight ago we were writing defensively about our bearish scenario for the US economy. This week we are seeing a return to the steady process we have been expecting for many months: a slowing in the housing market, a decline in consumer confidence and a drop in manufacturing indices, coupled with doubts about the valuation of Google and other internet stocks. However, we shall not fall into the trap of announcing that the tide has now turned, as there will be surely be many reversals in the declining outlook we have been painting. Remember the two major fault lines:

• the housing bubble and the end of “mewing” (mortgage equity withdrawal)
• the withdrawal of Asian support for the dollar (mainly China, but not only)

While we see the housing fault line as the first to crack, two elements are a reminder of the second:

• American resentment of foreign acquisition of US companies (“buy our T-bonds to let us spend more than we earn, but hands off our companies”). Congress seems bent on removing a major outlet for foreigners to put their dollar holdings to work.

• The imminent end of the zero interest rate policy in Japan and subsequent shift from T-bonds to JGBs by Japanese private investors (whose role in the sustaining the USD is not far behind that of central banks).

In that same Weekly of 15^th February, we raised the subject of emerging market economies buying back foreign-currency bonds in favour of local currency bonds (and less overall government indebtedness). This trend is accelerating and is even leading to a shortage of EM euro and dollar debt. It partly explains the very narrow spreads on USD EM sovereign debt which now are very close to 50 bps over Treasuries. We think chasing such modest spreads is scarcely worth the risk, although many of the emerging economies are indeed much healthier thanks both the commodity boom and better economic management. Andy Xie of MSI links EM success firmly to India and China “joining the world”.

We think that local currency EM bonds, which (taking the case of Russia) offer about 100 bp greater spread than eurobonds, is the better way to participate in emerging markets. Of course there is a currency risk, but many of the currencies are likely to strengthen.

That is the case for the rouble, where there is now a long list of government, quasi-government and corporate bonds available. For the rest of this year, access to the domestic Russian bond market (which is exchange–driven, by the way) requires arrangements with a Russian entity, but the restrictions on foreign participation in Russian financial markets are scheduled to end on 1.1.07. There is a case for investors to position themselves in advance of that date. Another factor relevant to Russia (and brought out in a recent Troika Dialog conference) is that the government pension fund has a huge and growing appetite for all sorts of securities.

In Europe, the measures of confidence are still positive, although there is still a very high level of unemployment to be absorbed in the euro zone. The UK is, as much as ever, taking a route between the USA and the euro zone, but rather closer to the USA than may be comfortable. The UK’s housing boom is over, and retail spending accordingly lower. This has rekindled expectations of a cut in the bank rate, a move we would find bizarre in a world of rising bank rates. Gordon Brown has announced his intention of meeting the pension-fund demand for long Gilts. This should help to normalise the inverted GBP yield curve, and suggests that the seven-year maturity recommendation we have been advocating now needs shortening somewhat, to five years.

Germany is joining other European countries in issuing inflation-linked bonds. We maintain our view that bond portfolios have a place for them, but a modest one.

Recommended average maturity for bonds in each currency

Stay with bar-belling for CHF and EUR; shorten in GBP.