Bond Outlook by bridport & cie, July 18 2012
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Bond Outlook by bridport & cie, July 18 2012

'Worry is the interest paid by those who borrow trouble’

Roy Damary, our economist, is away from the office this week, so we have asked our head of Investment Management, Jason Jones, to provide his perspective on current events:

‘Worry is the interest paid by those who borrow trouble’

The words of George Washington should be ringing loudly in the ears of certain nations, when investors shun 10 year Euro yields of over 6%, in favour of paying five governments (3 in that same Euro currency) for the privilege of holding their cash (France, Denmark, the Netherlands, Germany and Switzerland) and are willing to lend to an additional 8 Sovereign states at close to zero for up to 2 years.

Quite how Greece has only just got to the stage of cutting its loss making electricity company’s executives supplementary EUR 3,500 ‘family allowance’ each month, or how Spain’s banks will be saved by a bailout fund which a German court has decided cannot be constituted until 12th September at the earliest (and realistically not for many months after that), perhaps only European politicians know.

As we have alluded to previously, the chasm between self-serving political rhetoric, and the economic reality that the populations of many European states are enduring on a daily basis, continues to widen. This is typified by recent comments from Andrea Enria, the chairman of the European Banking Authority, who insisted that the temporary buffer of 9% Tier 1 Capital Ratios, which banks had to achieve by June, would now become permanent, stating that capital conservation would be ‘key’, and that ‘we don’t want the capital to be released’. Quite how this assists small and medium sized businesses, who are starved of capital, to spur an economic recovery in the region, perhaps again, only European politicians know.

If the EBA’s words are seen as a precursor to the actions inherent in a Europe-wide banking union, which will be required as part of a centralisation of fiscal control, then we now at least have an additional clue as to the identity of the buyers of high yielding government bonds, who seem to magically appear, irrespective of the dire economic outlook, at each auction. In order to calculate capital adequacy ratios, the divisor applied to Tier 1 and 2 capital is risk weighted assets. The asset which attracts zero risk weighting (and thus does not diminish levels of tier 1 and 2 capital when capital adequacy is calculated) is of course government bonds. It is no doubt a mere coincidence that the one asset (other than cash) which banks should favour as their capital requirements rise are the very assets which their respective government’s desperately need to sell !

On the economic front, the previous seven days have bought little to cheer, with the IMF once again cutting global growth forecasts for 2012 and 2013 and the ZEW Investor confidence index in Germany, and retail sales in the US, both falling for the falling for the third consecutive month as further evidence emerges of growth stagnating in the world’s largest economies. The IMF also warned of slower than expected growth in China, India and Brazil, and expressed concern over the potential effects on the US economy of mandatory budget cuts later this year.

Given this backdrop, bond investors (at least those who have managed to avoid the vagaries of Europe’s sovereign problems) have continued to enjoy positive returns, with UK and US corporates tightening further, whilst European corporate spreads have remained surprisingly resilient. Whilst there still remains a significant difference between financial and non-financial corporate yields, there is now a growing disparity in the performance of individual financial names themselves, and this is creating some interesting opportunities for discerning investors, as risk return considerations are reassessed in the light of European exposure, and other emerging factors such as the LIBOR, CDO pricing, and other regulatory cases. Equity investors meanwhile continue to deny to themselves that we are enduring a low return environment, and hope that economic data deteriorates sufficiently to spur QE3, or other ‘further action’ promised by Bernanke in his testimony to the Senate banking Committee yesterday.

Macro Focus

United States

The University of Michigan index of consumer sentiment declined in July to the lowest level this year, as the labour market showed few signs of improvement. As a consequence, retail sales also dropped 0.5% in June and outlook is not bright. Some 62% of businesses project no change in employment over the next six months

On the other side, we found two ‘positive’ figures for US consumers this week. First, inflationary pressure continued to fall (prices of imported goods plunged 2.7% in June). The 30-year mortgage rate also reached a record low at 3.56% for a fourth straight week

Euro Zone

Germany’s top court will take more than eight weeks to decide whether to suspend the euro-area’s permanent bailout fund, leaving Europe’s anti-crisis coffers less than half full to respond to the debt crisis

Spanish Prime Minister Mariano Rajoy rolled back social-welfare protections and raised taxes. Rajoy announced cuts in unemployment benefits and public sector wages, signalled reductions in pensions, and raised sales taxes as part of a 65 billion-euro package of deficit cuts

Germany’s three-year yields dropped below zero for the first time, and rates on Belgian, Dutch and French two-year also declined to all-time lows as the debt crisis bolstered demand for safer assets

European Central Bank

President Mario Draghi said inflation in the euro area is slowing faster than expected, justifying last week’s rate cuts to a record low

The ECB would no longer oppose the forcing of losses on senior bondholders of euro-area banks, said two officials with knowledge of the ECB’s thinking. A key condition to imposing losses is if the bank in question is being wound down

United Kingdom

Inflation fell in June as clothing prices plunged, helping to vindicate the central bank’s increase in emergency stimulus this month. Consumer prices rose 2.4% from a year earlier, the least since November 2009

Britain is to invest 9.4 billion pounds in the rail network between 2014 and 2019. The investment includes 4.2 billion pounds of newly announced money

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