Bond Outlook October 21 2009

Our recommendation this week is merely a reiteration of last week’s: there is still mileage in lower credits, but some form of insurance is required to hedge against the risk of inflation, together with a certain readiness to change tack if and when curve steepening begins in earnest and spreads start widening. The risk of inflation is now broadly recognised, both in terms of comments published by fund managers and also by the behaviour of financial markets (demand for “out of the money” interest rate options and the price of TIPS). “Linkers” in EUR however do not yet seem to reflect changes in other markets.

The growing public indignation at (some) banks’ profits and bonuses is spawning a growing political determination for more stringent regulation. The Brussels proposals on derivatives are one important dimension, whilst increased capital requirements are another. There is however a rising tide of opinion on both sides of the Atlantic which views as unacceptable the moral hazard created by the assumption that the major banks are too big to fail. The argument is “if they are too big to fail, let them not be too big, i.e. break them up”.

The self-appointed leader of what may be the beginning of a major campaign to break up banks in the form of “Glass-Steagal Mark II” is Mervyn King of the BoE. The central banker is behaving more like a politician, travelling the UK and making major speeches denouncing the delusion that tougher regulation could prevent future banking crises.

On the inflation front, Bernanke’s determination to keep inflation under control once quantitative easing is reversed may be called into question. He is, after all, a specialist on the Great Depression, and is quoted as observing that the removal of the USD from the gold standard, and the subsequent return to pre-depression prices, was key in returning the USA to sustainable growth. The temptation to “inflate away” federal debt must be very great indeed! Hence the markets’ (and our own) view that the risk of inflation should be a major consideration in all portfolio strategies.

Any investor’s view on whether, or more correctly when, inflation will return must hinge on their expectation of economic developments in the USA. Great optimism currently reigns in stock and credit markets, and is based on increasing corporate profitability. That profitability is based on three things: cheap money, lower wages and higher productivity. With the possible exception of Apple, it is not however based on increased sales revenue. Increased profits for corporations are, much like those for some banks, a further manifestation of the shareholder capitalism excoriated by retiring professor Bruce Scott of HBS (as reported in our Weekly of 7th October). The continued decline in household earning power can scarcely help GDP growth through increased spending, although it may be very helpful in the rebalancing process brought about by market forces, despite government attempts to counter them.

The major criticism of current US Administration policy, and of general US business practice, is precisely that the hope, and objective, is a return to the pre-crisis status quo, with negligible changes in either regulation or business behaviour. It is surely a legitimate question to ask whether “more of the same” (flooding the market with liquidity at low interest rates) can lead to renewed and sustainable growth when it was these very same policies that caused the problem in the first place. As regular readers will recall, our expectation is that the USA will traverse a multi-year period of negligible GDP growth, accompanied by a continual weakening in the dollar and renewed inflation during 2010.

Not an easy climate for investors!

Focus

( ?) USA: in September: retail prices + 0.2%, retail sales – 1,5% (after rising 2.2% in August). Industrial production + 0,7%. Weekly new jobless claims still over 500,000

(!) UK: a distinct drop in inflation: 1.1 % over the year to September, after 1.6 % in August. Unemployment is 5.0%, an increase of 0.1 % over the previous month. House prices have stabilised. Public financing requirement over last twelve months: GBP 110 billion

( ?) Japan: BOJ maintains its target rate at 0.1%

(+) France: the massive public debt offering proposed by Sarkozy has dropped from EUR 100 billion to EUR 30 billion and will now be via capital markets. The cost will be 2.5% instead of 4%

( ?) Markets: some shift to raising capital from stock rather than debt, with a re-emergence of mandatory convertibles

( !) Argentina: with a view to returning to international financial markets, government may make a new exchange proposal for outstanding defaulted bonds

 (+) positive for bonds (-) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds.

Stay relatively short across the board.