Bond Outlook March 22nd

Can anything new be drawn out of Bernanke’s recent comments? About the only thing we can see is that he recognises the importance of long-term yields and is shifting attention to 10-years, stating that the Fed will lift the short-end enough to drag the long-end up with it. He is totally anodyne about the forthcoming end of the housing bubble, seeing price declines as inevitable but moderate. We disagree, of course, as the end of mortgage equity withdrawal, now firmly underway, implies anything between a 1% reduction of GDP growth (Freddie Mac estimates) to 3% (a Greenspan estimate at the end of last year). Of all the data now available, the most striking for us is the new record high of the inventory of unsold houses. The bubble is indeed deflating. That cannot yet be said for the current high valuations of the US stock markets, but if both stock and house prices deflate together, problems will indeed be severe.

The USA is now playing out a change in its fortunes linked to past excesses. Euroland, in contrast, may now be benefiting from its past sluggishness. A recovery is underway, but a slow one. Trichet continues to threaten higher interest rates, but at nothing like the pace the USA has been through. There is no tightness in labour supply in the euro zone, so there is plenty of capacity for continued growth on the supply side, just as there is for domestic demand.

Just as the UK can give pointers to the outlook for the USA economy, so Switzerland can for Euroland. The country has a healthy balance of trade, low unemployment, and enough growth to justify its central bank in raising interest rates modestly. It is curious that the CHF is relatively weak against the EUR. Could the currency be losing its appeal as a safe haven? If so, Swiss industry is likely to rejoice!

While we are so chronically pessimistic about the US economy, we remain sanguine about the world as a whole, as rebalancing – the move from a uni-polar to a tri-polar economic world (North America, Europe, Asia) — is steadily happening: Japan, like Euroland, is expanding once again and is moving to a more normal interest rate structure, China is recognising the need to satisfy the aspirations of all its population (the shift from quantity to quality in growth), and India is taking steps to make the rupee convertible. Freeing the rupee would release captive Indian savings for worldwide investment, open India to foreign investment and force major changes in the direction of the Government letting go of its control of the economy. For the moment India has had to be left off the list of countries where access to domestic bond markets could be attractive and practical to fixed-income investors, but we expect a change, analogous to that in Russia, as it, too, opens its economy.

Within emerging bond markets, a class of investment which we almost always favour, there are, of course, problem countries. Peru is the current example, as its political outlook is becoming nationalist, creating doubts about its respect of international commitments. If Humala wins the Presidency, bond prices are likely to fall further. However, many would say that a buying opportunity will arise as bond prices overshoot and economic reality constrains the President, much as it did Lula in Brazil.

The student resistance to the new French law for first jobs for young people is rising as we write. Clearly they will not accept the paradox that easier firing makes for more hiring. Yet if the Government holds it course, which seems likely enough, then actual results should speak louder than words (always supposing, of course, that youth unemployment really does decline as a result of the new law). What then? Could this be a first step to overall reform of labour reform and unleashing the entrepreneurial spirit of the French? Our hope springs eternal, but it will be fulfilled only very slowly. Is there not a clear message in the movement of French entrepreneurs to England and of British retirees to France?

Recommended average maturity for bonds in each currency

No change to recommendation to stay with bar-belling for CHF and EUR.