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Capital Markets

Bond Outlook by bridport & cie, July 25 2012

You have to look very hard to find any positive developments on either side of the Atlantic. How strange that the USA’s currency and sovereign bonds have become havens for investors despite the chronic problems of the world’s largest economy in terms of internal and external deficits, political stagnation as well as chronically underfunded future pension and health care costs. The reason, of course, is that confidence in the euro and in the survival of the euro zone is so low that even the dismal outlook of the US economy looks good by comparison.

To some extent, bad news for the euro (notably its falling exchange rate) is good news for the euro zone economy. Member countries are becoming more competitive internationally as a result. At the risk of being over-optimistic, euro devaluation could return the euro zone to growth – a far better environment for the move to a federal structure.

This move remains essential if the euro is to survive and flourish. At the risk of repetition it is “federal structure or bust”, and the cost of “bust” is so high than even the recalcitrant Frau Merkel is likely to yield, not least because she says she wants a “fiscal union” – different from a federal structure only in name – but then opposes every move towards it. Moreover, the urgency of moving to a new structure is continually increasing because of Spain.

Most of us are assuming that Germany is the sole keeper of the key to the federal structure, and that the key is in Merkel’s pocket. However, the German Constitutional Court has to lot to say on this matter. The judges meet on September 12 to decide whether such issues as debt mutualisation are constitutionally acceptable. If the judges vote that they are not, a national referendum to modify the Constitution would be needed for “fiscal union”. Germany may already be at the legal limit of yielding sovereignty to Brussels.

Yet other quiet dangers lurk. Spain might simply say “enough is enough”, and Dutch opinion polls suggest the negative outlook on Holland’s AAA rating has further encouraged both extremes of the political spectrum in their opposition to the euro. We therefore continue to lean towards the euro surviving while recognising that the risk of break up has increased.

In that regard, a banking union cannot bail out every bank. It is an abuse of financial markets to suppose that bank creditors should be protected as if they were depositors. In fact, that whole issue needs revamping in the context of banking union rules. Whether banks can default, and not just banks, but also lower-credit corporations, will be the subject of our next Weekly.

In the meantime are there high quality government bonds available in euros which still give a positive yield short-term? Our research shows that the place to look is inflation-linked bonds, currently not so sought after as the market rather expects deflation.

In our opening paragraph we alluded to the poor state of the US economy. Once the Presidential election is over, whoever is in charge will have to address another time bomb: student loans. They explain how households have been able to continue spending more than their earnings: some 4% more each year in nominal terms versus 3% in earnings growth. Instead of re-mortgaging their homes, they are taking loans for student fees (instead of paying the fees direct). The interest rates are low, the students are given credit cards but delinquency on these loans is growing (we have seen data of USD 270 billion at least 30 days delinquent).

Nothing will be done this year, but we expect the student loan bubble to burst in 2013.

WEEKLY COMMENT

Macro Focus

2 / 2 Roy Damary July 25, 2012

United States

The index of leading economic indicators decreased 0.3% in June and manufacturing in the Philadelphia

region shrank for the third consecutive month. In addition, the slowdown in hiring is dimming moods as the

third quarter begins. Companies last month added the fewest workers in almost a year. All signs are that the

economic expansion is slowing.

Bernanke has outlined options to ease policy further in case the flagging economic recovery fails to lower

unemployment. Easing tools include further purchases of Treasuries and mortgage-backed securities, and

altering the Fed’s language on the outlook for interest rates.

Euro Zone

Euro-area construction output rose in May, as gains in Germany and Portugal offset declines in Italy, Spain

and the Netherlands. Construction in the 17-nation euro area advanced 0.1% from April.

Spain’s recession has deepened. The gross domestic product fell 0.4% from the first quarter resulting in a

third consecutive quarter of contraction.

Portugal is sounding out the market as it prepares to resume sales of medium-term notes.

The government debt of the euro area increased in the first quarter to the highest since the single currency

was launched. The debt of the 17 nations that use the euro climbed to 88.2% of gross domestic product from

87.3% in the fourth quarter.

United Kingdom

Retail sales rose only modestly last month, reducing expectations that Britain was able to exit a recession in

the second quarter. Sales including auto fuel gained 0.1% from May. Unemployment fell to a nine-month low

(8.1%) in the quarter through May as the London Olympics helped to create jobs.

Britain had a bigger budget deficit than forecast in June. The budget shortfall, which excludes government

support for banks, was GBP 14.4 billion compared with GBP 13.9 billion a year earlier.

Switzerland

Exports held steady in the second quarter, suggesting the economy may struggle to gather strength as cooling

global growth weighs on demand. Investor confidence increased to minus 42.5 from minus 43.4 in June.

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