Bond Outlook by bridport & cie, July 27 2011

A measure of the uncertainty inherent in present-day markets, and the impact this is likely to have on the profitability of major investment firms, has been revealed, anecdotally at least, by two recent decisions:

• George Soros is closing his Quantum fund to outside investors after many years of success. The reason quoted for the decision is the growing burden of SEC hedge fund regulations, but the decision also coincides with a 6% loss this year to date, in the light of market circumstances Soros describes as “baffling”
• UBS is greatly cutting back its investment banking activities

Uncertainty is heightened this week as Congress remains in gridlock over the debt ceiling. Our own clients are basically awaiting the outcome of the stand-off. Most commentators believe a last-minute compromise will be found, but the uncertainty is affecting all components of financial markets. Even if the ceiling is raised, (our guess would be by a small amount, in order to allow the debate over budget cuts and tax rises to continue for many months to come), the risk of a downgrade of the USA’s credit rating remains (by the Western agencies – the Chinese Rating Agency Dagong downgraded the USA long ago). S&P has explicitly threatened a downgrade if the budget cuts are not of a certain level. The Republican plan does not meet that level, and tax increases are still being rejected. Republican leader Boehner must be relishing the prospect of being the “man who brought about the USA’s only downgrade”, but he will, of course, blame Obama.

This period of history will be remembered as one of irresponsible and indecisive government, alongside a responsible and profitable private sector (with the possible exception of the banking industry). For many months we have been recommending quality corporate bonds over sovereigns. This has proven correct and remains so. We have also stressed – for years, not months – that the USD is fundamentally weak and destined to follow a secular decline. A weaker dollar is helping US corporations and their profitability in dollar terms. We also see it as a necessary component of adjusting the US standard of living to a sustainable level, i.e. not living beyond its means. There can, however, be too much of a good thing, especially if you are a Swiss company wrestling with an overvalued currency!

The spotlight has moved on from the euro zone crisis to the USA’s. The news in Europe is moderately encouraging. The sovereign debt panic has, at least temporarily, calmed down, with the Irish situation improving. The principle of a restricted default by Greece with repercussions for private investors is becoming acceptable. This will cause losses at many banks, but not enough, apparently, to cause a financial breakdown. The perspective has led, however, to bank debt in Europe being hard to sell.

In the meantime, the political mood in the euro zone is moving towards greater fiscal integration. We expect work on this to advance seriously after the vacation period. It will mean that the UK, which was talking only a year ago about being “at the heart of Europe”, will have to adjust to being less influential. Yet the UK no more wishes to see a failed euro than any member country within the zone.

Our expectation of growing inflation, and a steepening in the yield curve, continues to haunt us. Whilst both still appear to be a logical progression of present US economic policy, both could be indefinitely delayed by an economy that is even weaker we could have expected. The answer will have to wait at least until the fog of the debt ceiling debate clears.

Market Focus

• US: home sales fell for a second month. Major US banks are lowering their forecasts for Q3 GDP in the light of building inventory levels and (despite a modest rise this month) the overall downward trend in consumer confidence. Senate Leader Reid claimed that credit rating agencies had agreed that his proposal for raising the U.S. debt limit would not lead them to lower the government’s credit rating, but that the Republican plan offered by House Speaker John Boehner would

• Europe: of the new bail-out money for Greece, €109 bln will come from the euro region and €50 bln will come from financial institutions after agreeing to a series of bond exchanges and buybacks. Banks agree to write down the value of their Greek securities by 21% as part of the bond exchange and debt buyback program, standing to lose € 20.6 billion. Loan maturities have been extended from 7.5 years to minimum 15 years and rates have been reduced from 5% to 3.5%. Portugal and Ireland will also have the interest rate on emergency loans pared and maturities will be lengthened to as long as three decades with a 10-year grace period

• Greece: in Fitch’s opinion, the private sector involvement in a new Greek deal “constitutes an event of Restricted Default’” .However, the International Swaps & Derivatives Association said it “should not trigger credit-default swaps” on the nation because it is “expressly voluntary”

• Germany: banks are opposing a tax on the finance industry under consideration by European officials to help bail out Greece, saying it would harm the lenders and the German economy. The levy “would hit the banks in a phase when they face numerous regulatory measures and the resulting burdens,” according to the Association of German Public Sector Banks

• UK: the economy barely grew in Q2, with GDP rising just 0.20%. House prices fell for a third consecutive month, the average cost of a home has declined 3.90% from a year ago. Dividends in the U.K. grew 27% in Q2, as BP resumed its dividend payout policy and the mining industry increased their payout almost four fold. BoE officials kept the benchmark rate on hold in view of the current weakness in economic activity

Disclaimer
This document is based on sources believed to be reliable, accurate and complete. Any information in this document is purely indicative. This document is not a contractual document and/or any form of recommendation. Expressions of opinion herein are subject to change without notice. We strongly advise prospective investors to consider the suitability of the financial instruments, based on the risks inherent to the product and based on their own judgment. It is not intended for publication. This document may not be passed on or disclosed to any other third party without the prior consent of bridport & cie s.a. © bridport & cie s.a.