Bond Outlook by bridport & cie, August 4th 2010

In our recent Weeklies, we have highlighted the differences in economic strategies being adopted in Europe and the USA. We have come down firmly in favour of confidence-rebuilding à l’Européenne as not only being preferable to renewed stimulus spending, but as the only realistic course of action after the euro crisis and the loss of confidence in Sterling earlier this year. We now take a further step, admitting that we may be sticking our neck out, but would claim that the economic situation across Europe is sounder than the USA’s (or is at least less unsound).

Naturally we put more faith in the behaviour of bond and forex markets than that of stock markets, believing them to see beyond the vicissitudes associated with such short term factors as quarterly earnings announcements. We would therefore suggest that the behaviour of bond and forex markets (the fall in yields for bonds in EUR is much less than for USD) are supportive of our view. Moreover, the attention of commentators has moved back from fears about Europe to serious doubts about the US recovery. Bernanke offers words of reassurance which give rise more to sniggers than relief. Meanwhile, his elderly predecessor snipes from the sidelines with “Yes, a double dip is possible”.

While Europe is on a laborious path to confidence rebuilding, the USA is prone to ever-increasing self-doubt. The FT recently devoted two pages to the “End of the American Dream”, explaining how the top 10% of earners have become ever wealthier, whilst the remaining 90%, including the middle-classes, have got precisely nowhere, over recent decades. The article followed the fortunes of typical middle-class families, who have seen grown children return home, repossession as an ever-present threat, and both spouses having to work whilst fear of losing their jobs has grown. Savings are tiny, and pensions unsure.

The Fed dare not yet reduce its holdings of Agency and Treasury bonds acquired during the period of quantitative easing. It is even reinvesting the interest and principal of expired bonds, thereby not exactly expanding Q.E. but certainly not reducing it either.

Of course, much of this is present in Europe, and it is not difficult, even in supposedly wealthy Switzerland, to see the hardship some are going through. Yet our sentiment is that in the movement of economic might from West to East, Europe is a little less affected.

Lest readers think we believe all is well in Europe, we reiterate that the Euro Zone still needs reinforced centralised control, and must not let up in its moves in that direction. The problems of the euro have been addressed but not resolved. Nevertheless, Estonia (with a fixed exchange rate to the EUR) has given a perfect example of how to use “internal devaluation” (basically a drop in wages and salaries) to turn the economy round. The GDP decline of 14% in 2009 has become 1% growth in this year, and the current account has moved from a 17% deficit in 2007 to a 4.7% surplus in 2009. Ireland, Latvia and Lithuania are on the same track. The peripheral EUR countries are at least revising their labour and tax laws. The mix of more centralised control and increased national responsibility should bear much fruit in the longer term.

For some weeks, the ECB has almost stopped its purchases of bank debt, whilst in parallel, European banks have become major issuers of new debt. American banks have been far less active., although, interestingly, Morgan Stanley and BoA have recently issued bonds in EUR. This could represent more good news for Europe in that its banks are rebuilding their cash reserves at low cost and should soon be able to renew their lending to industry.

Our optimism about Europe is tentative. The real test will be whether central banks feel that the risk of deflation has dissipated, and that they can move to tightening. That is not yet the case, although inflation in Europe, still low, is gradually increasing (see Focus). Until the fear of deflation has really disappeared, our recommendation in favour of fairly long maturities remains.

Focus

USA: GDP growth amounted to 2.4% in Q2. The Q1 figure was revised from 2.7% to 3.7%. The index of new sales in June fell 2.6% to 75.7, after plunging about 30% the previous month as a result of the expiration of the tax credit for first-time buyers

Euro Area: the annual inflation rate was 1.7% in July 2010. In June, the rate was 1.4%. The unemployment rate remained relatively stable at 10% in June, versus 9.5% in June 2009

Spain: unemployment is at its highest for 13 years, at 20.09% of the workforce in the second quarter 2010, versus 20.05% in the first

Japan: the unemployment rate rose 0.1 percentage points in June to 5.3% of the workforce

UK: manufacturing industry continues to grow at more than 1% per quarter, although export prices fell

Recommended average maturity for bonds (corporate/government)

Fairly long across the board, so long as the deflationary atmosphere pertains.

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09.06.2010

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Dr. Roy Damary