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Bond Outlook by bridport & cie, December 14 2011

Such was the attention paid to the UK veto at the Brussels summit, and the image of the UK being isolated 1 vs. 26, that it has taken a few days to realise that the proposed pact, or treaty, is but phantasmal. A system to impose fiscal responsibility by control through the courts! That is as unlikely to work as, for example, persuading France and Germany to mend their ways when they were the first to break through the 3% budget deficit limit imposed by the Maastricht Treaty.


Without being great fans of a federal structure, it is the only sustainable solution to the euro crisis. We had fully expected Brussels to make tentative steps to the three components of federalisation: a ministry of finance, Eurobonds, and an ECB with powers much like the Fed’s. Instead we were given “control through the courts”. The sheer nonsense of this approach is likely to dawn on the politicians in coming months – in fact it is already dawning on the would-be euro members. Will the sheer uselessness of the Merkozy proposal lead to renewed interest in federalisation in coming months? Or will it be market pressures that force some move towards a serious solution? We cling to the optimistic view that the alternative (dissolution of the EMS) is so devastating that even the most incompetent of leaders will be pushed along the federal route. We note that Merkel still uses the term “greater political union”, which of course is merely a euphemism for a federal structure.


Our first reaction to Cameron’s intransigence was that, if the euro zone members want to federalise, why should those who are not only outside the euro zone, but have no intention of joining it, have the right to influence the new structure ? The quid pro quo is of course why should a “federalised” euro zone be able to dictate how the City of London operates. It would appear to have been a diplomatic mistake for Cameron to have demanded protection for the City at a summit devoted to saving the euro. Those of a cynical bent might suspect a trap set by Merkozy, given that they began attacking banks in general, and the City in particular, long before the summit began. With each facing a fight for their own domestic political survival, being able to divert the blame from themselves to the banking sector, with the unwitting assistance of a demonised Cameron, must have been very gratifying, and all the more so, given that the UK’s reaction would ensure that they would not be around to hinder the progress towards “political union”.


Returning to our opening theme, it would seem that the Brussels summit has not solved the euro crisis. It will now drag on, with any resolution being many months, or even years, away. There can be only two outcomes: euro break up or the federal structure. The base line of the L-shaped recession mooted in 2008, and which we originally envisaged to be around 3 to 5 years, has now been extended to more like ten years. Normal levels of growth will only resume when the euro is put on a new, sound footing, however if this can only be achieved through enforcing greater fiscal rectitude on profligate Government spending (which in pre-crisis times, was such a large driver of growth), the outlook is far from encouraging


And what does this all mean for fixed-income investors? In the light of potential downgrades in the new year, we continue to see EU sovereign bonds as speculative, with the potential for further widening against Bunds. (Albeit with the attraction of higher yields) Investment grade corporate bonds still appear to offer a reasonable risk/return proposition, although we would recommend that investors focus upon non-financial names, despite the illusory ‘value’ in a financial sector which is so dependent upon a successful, and some might suggest, equally illusory, resolution to the Sovereign crisis.


Macro Focus

USA: retail sales rose in November at 0.20%, the slowest pace in 5 months. However, the UoM index of consumer confidence rose from 64.1 at the end of October to 67.7, beating the median estimate of 65.8. Weekly jobless claims fell by 23k to 381k, the lowest figure since February. The trade deficit narrowed in October by 10.20% YoY. Bank credit is growing at the fastest pace in three years, with commercial and industrial loans expanding at an average annual pace of almost 10% in Q3, the highest since Q3 2008


Fed: Bernanke acknowledged that the European crisis will impact the recovery in the US, stating that strains in global financial markets continue to pose significant downside risks to the economic outlook


UK: inflation slowed for a second month: consumer prices rose 4.80% from a year earlier versus a 5% rise in October. House prices were down 0.7% YoY in November, with no change MoM. The goods-trade deficit narrowed by a record seasonally adjusted 26% MoM


BoE: at its monthly meeting, the Bank kept interest rates on hold and the target for bond purchases constant. The Bank for International Settlements suggested the BoE’s first round of QE over 2009 to 2010 may have had limited impact on Gilt yields. The BIS estimates that the £200 bln programme lowered yields by 74 bps


Germany: investor confidence rose for the first time in 10 months in December, the ZEW index of investor and analyst expectations increased to -53.8 from a three-year low of -55.2 in November


Spain: the Government sold €4.94 bln of bills, more than the maximum target, and borrowing costs fell. The Treasury sold 12-month debt at an average yield of 4.05%, compared with 5.022% in mid November, 18-month paper sold at 4.226%, down from 5.159%


EU: leaders agreed on the Merkel-Sarkozy deal to limit future debt and to add €200 bln to the IMF’s war chest for spending on Europe. Currently the plan includes all 17 Euro zone countries; nine of the other ten (excluding Britain) may participate, but will first consult their national parliaments. March was set as the deadline for finalizing the plan’s details


ECB: the ECB cut interest rates by 25bps and offered banks unlimited cash loans for three years


Switzerland: the government lowered forecasts for growth this year and next: GDP is expected to rise 1.80% this year and 0.50% in 2012. Uunemployment remained at 3.0%, the lowest figure since January 2009

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