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Banking

Bond Outlook June 30 2010

Politicians might say recovery and retranchment can go together, but that is clearly not the case. Recovery might now be four years off.

Bond Outlook [by bridport & cie, June 30th 2010]

The present environment is causing us to question whether the normal rules of economics are still applicable. Perhaps it is just some rules which are temporarily suspended, like one that states that increasing money supply (By such methods as quantitative easing) will fight off deflation and induce inflation. However, the inescapable reality, whether economic or otherwise, is that retrenchment and expansion cannot occur in parallel, despite the pretense at the Toronto meetings.

Europe is retrenching “voluntarily”, the USA as a result of market forces. Of particular issue in the USA are the fiscal imbalances of States and municipalities and the pressure on the Federal Government to bail them out. Maybe it will, but in the meantime summer jobs programmes for teenagers have been axed and bus services eliminated. These are just tiny, anecdotal drops in the ocean compared to the total cutbacks. Of far greater importance is the growing tension between the irresistible force of required budgetary cutbacks, and the immoveable object of Public Sector Union intransigence. Whether this results in similar scenes to those we have witnessed in Athens and Madrid only time will tell, however as we have hinted above, opposing forces cannot both prevail at the same time.

Despite (mainly) American propaganda that the economy is expanding slowly but steadily, there are authoritative voices spelling out the truth. The BIS in Basel is an example; of course its language is necessarily diplomatic, but is still rather blunt. Banks will have to cut their leverage drastically, and governments reduce their debts. Then, with the decks so cleared, there is the possibility of renewed economic expansion. Likewise, a spokesman for the ECB stresses the powerful political forces in favour of holding the euro zone together, while emphasising the necessity of greater political union. Again, the whole emphasis is to retrench first and expand later.

Which of course begs the question of how much later? When we initially wrote of an L-shaped recession, we alluded to years of little growth. Given the schedules of the retrenchment plans, we are now able to estimate a time horizon; we would not expect renewed expansion until 2015. This date assumes that the “L” holds, and we do not begin to see the much feared second leg of the “W”. There are views out there of course, such as Krugman’s, that the West is entering its “Third Depression” (the first was in the 1870s, in case you were wondering).

A good friend and client has pointed out that the recent flight from the EUR to the USD may be hiding the disenchantment of investors with both currencies. It is as if any currency other than this pair is attractive, such as the JPY, the CHF, emerging countries’ currencies in general, and even the GBP. The moderate strengthening of Sterling has the merit of suggesting that the market approves of the “retrench first” approach. The Swiss National Bank is still seeking to wean the market off 3- and 6- month zero-interest bills.

Issuance of both new equity and bonds has come to a grinding halt, and it is difficult to imagine either picking up again until the summer is over.

Our conclusions for fixed-income investors: our recommended lengthening was appropriate, if a little late, and we continue to advocate widening the choice of currency, despite fears of USD strength.

Focus

(?) Etats-Unis : Q1 growth has again be revised downwards. Consumer confidence fell to 52.9 in June from 62.7 in May

(–) Europe : PMI index a dropped to 56 points, its lowest in three months

( ?) France : consumption of manufactured goods increased in May by 0.7% over April, when it dropped 1.3%, but this may be due to a World Cup effect

(+) Argentina : economic growth of 9.7% in April compared with a year earlier

(+) Japan : retail sales grew for the fifth month running in may to reach 2.8% more than a yearago, suggesting a modest increase in consumption. Unemployment stands at 5.2%

(?) Germany: consumer prices are 0.9% higher than a year ago

(!) Belgium: inflation has been speeding up for nine months running to reach 2.46% yoy

(!) BP : the situation on its indebtedness is very complex

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

Recommended average maturity for bonds (corporate/government)

Market conditions suggest aligning government maturities with corporates, but longer, keeping a shorter maturity in USD.

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Dr. Roy Damary

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