Bond Outlook May 5 2010

Despite highlighting the importance of Bernanke’s comments last week concerning his fears about the efficacy of US Government debt management, this week our focus inevitably returns to the Euro zone. Whilst notable (and perhaps mistrusted) in its own right, the most significant element of the Greek bailout is its implications for the treatment of other Southern European nations, most of whom have debt levels of a much greater magnitude than the Hellenic Republic. (In the case of Spain and Italy, up to 10 times the size.)

The argument that we have echoed here over and over again about the USA – that living beyond one’s means is unsustainable – certainly applies to the deficit euro zone countries, although not necessarily to the euro zone as a whole, an important point as we draw parallels with the USA. It is ironic that the EMU is having to face up to, and is acting upon, an unsustainable situation before the USA, which ‘benefits”, if that is the right word, from a provisional sustainability courtesy of China and Japan’s US bond holdings.

If markets were left to their own devices, Greece would default. Of course this is not the case, any more than US markets were left unfettered in the subprime crisis. There is simply too much at stake:

• the danger to the entire single currency project
• the magnitude of debt cross-holdings among the EU countries (e.g. 20% each for France and Germany of Spain’s debt, 36% for France of Italian debt, etc)
• the exposure to “southern” debt by both banks and insurance companies
• the consequences of a failure of the euro for the entire world’s financial system

Thus the EU countries and the IMF will do everything they can to avoid a Greek default and its exclusion from the euro zone. Rescheduling of Greek debt owned by other countries, as we suggested two weeks ago, remains a likely ingredient of any rescue, but we see outright default or dismissal as unlikely. If Greece does leave the EMU, it will be through its own volition, predicated, we would suggest, upon the level of civil unrest proving too great. .

So what price will be extracted for the rescue of the euro project? In simple terms, austerity for years to come in the deficit countries. In addition, much stricter control over irresponsible Finance Ministries will come as a means of mitigating the problem of a single central bank but 16 individual “Treasuries”. There will also no doubt be meetings in Brussels resulting in a treaty for euro zone countries to yield more sovereignty, accompanied by sighs of relief in the UK and other non-euro countries that they are not subject to such a move. Overall, economic growth will suffer, and a mere “L” shape to the recession in Europe will seem benign!

For a greater appreciation of the high degree of integration in European debt markets, we recommend that readers consult the New York Times “Europe’s Web of Debt”. As for the UK election, we refrain from comment until the result is known, but trust that any change will help the country face economic reality, including the need for drastic deficit reduction.

That hope is vainer for the USA, where deficits at all levels of government grow ever larger, and that is without taking into account the huge underfunding of social security and health care. It may take some time for markets to return once again to worrying about the USA and the dollar whilst Europe is providing such an entertaining distraction!

Our basic recommendations remain the same, to which we might add that some shift from southern to northern Europe, for both sovereign and corporate risk, might be appropriate.

Focus

(!) USA: a modest lowering of new unemployment claims to 448,000 per week. Household expenditure increased in March by 0.6%, while revenues expanded only 0.3%

(!) UK: the rebound of house prices is continuing (+1% on one month, 10.5% yoy)

(+) Euro Zone: business confidence improved to 101.6 in April vs. 97.9 in March. Producer prices were up 0.9% yoy

(+) Germany: unemployment declined in April to 7.8% from 8% in March

(–) Japan: unemployment has reached 5%, while deflation has accelerated to -1.2% per year

(+) Australia: The RBA raised it target rate by 25 bps to 4.5%

(–) Hungary: unemployment has reached 11.8%, an increase from 11.4% over the past three months

(–) Spain: unemployment has reached a new record of just over 20%

(+) Brazil: industrial production expanded 2.8% in March and by 18.1% yoy in Q1

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

Recommended average maturity for bonds (corporate/government)

Current market conditions suggest a different maturity for corporates and government bonds.