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Capital Markets

Bond Outlook by bridport & cie, May 16 2012

The threat of Greece “walking away” from the euro should add some realism to Hollande/Merkel talks and give a push towards Germany taking its responsibility.

The Greek issue has come back with a vengeance. The immediate impact on financial markets has been to put them into a state of near suspension, as the question of whether the country will stay in the euro, or exit with inherent defaults, will be decided after the new elections on either the 10th or 17th of June. A large majority of the Greek voters claim that they want to stay within the euro. Yet opinion polls point to a left-wing victory in what will de facto be a vote on whether to stay or leave. It is a grim choice: pain for years to come if they stay, or agony at first if they leave, but with a possibility of a better future in a few (2 or 3?) years.


The debate is now raging as to whether other countries would rush to the exit if the door is opened by Greece. We are inclined to think not, mainly because every other peripheral country is at least trying to rein in their deficits. Even France, in its push for growth programmes, may yet have enough sense to restrain itself on spending. The big test will be whether Hollande really does push the retirement age back down (more on this below).


A Greek euro exit and default go hand in hand as Greece, with a severely weakened drachma, would be even less able to pay its euro-denominated bondholders than it is today. Note that we are still writing in the conditional as the leaders of all other euro countries claim that they will do everything they can to keep Greece in. Fine, but the possibility is not that Greece will be pushed out, but will walk out by its own volition. Let us therefore consider the outlook for that choice.


Who will take the default losses? Private sector creditors (mainly banks) along with the ECB and IMF. All banks have been working to reinforce their reserves, and to write down their holdings of Greek debt. Whether that would be enough to absorb the level of potential losses is unclear. A possible scenario is that Merkel will finally be forced to act by digging into the deep German pockets, and using this as leverage towards an accelerated fiscal union. We continue to be amazed at the words she uses being so much at odds with the action she takes. She now says “the EMU is not just a monetary project but a political one”. Quite! While neither Merkel nor her advisers would admit it, they must be thinking in terms setting up a firewall around the remaining 16 countries if the Greece “walks”.


In the meantime, other events are moving forward, even if the euro zone’s problems are in the spotlight. For example, the RMB bond market is developing apace, and at least one major Western bank is putting great efforts into growing the use of the RMB for trade financing. In the latest of a series of US books on a doomsday scenario (The Clash of Generations by Larry Kotlikoff, summarised by John Mauldin), the opening chapter describes how a major oil contract is drawn up in RMB instead of USD, triggering the collapse of the latter. This would require acquiescence by the Chinese, which we do not see as forthcoming. However, the same book spells out in detail what we have often raised in past Weeklies, viz, that the US Federal budget deficit measures only cash flows for current years. If the Federal budget balance sheet included the net present value of future obligations (as any private sector balance sheet would), the impact of Social Security and Medicare commitments would mean that the USA would already be in virtual bankruptcy, in the solvency, if not the liquidity, sense.


Kotlikoff’s book is a protest about leaving so much debt to future generations, and focuses on the burden for those working to maintain a growing number of retirees living to ever greater old age. For us the solution is blatantly obvious: extend the retirement age as life expectancy increases. In the face of this basic logic, readers will understand our exasperation at Hollande wanting to move the other way!


Macro Focus

USA: the two consumer confidence indices were contradictory this week: the Bloomberg Consumer Comfort Index fell, whereas the University of Michigan index of consumer sentiment climbed to 77.8, the highest since January 2008. Positive news appeared on the housing market: prices for single-family homes rose in the first quarter and mortgage rates declined for a third week, reaching record lows, 3.83 % for a 30-year fixed loan. Nevertheless, retail sales are struggling to pick up significantly


EU: industrial production in the euro area slipped 0.3 % from February and German exports rose 0.9 % MoM for a third month in March as demand from outside the euro zone offset weaker sales in Europe. This trend is confirmed with the GDP data: growth in the zone’s largest economy offset contractions in the peripheral countries. Greece’s possible exit from the euro moved to the centre of Europe’s financial-crisis debate. Spain is struggling with its banking sector and asked lenders to increase provisions for bad debts by € 54 billion to € 166 billion


UK: manufacturing output rose more than economists forecast in March as producers of chemicals, transport equipment and electronics led a recovery, after disruptions caused by snowfalls the previous month. While factory output rose 0.9 % from February, consumer confidence dropped and retail sales declined 3.3 % from a year earlier, the most in more than a year as poor weather and consumer caution on spending curbed demand at stores


BOE: Bank of England officials halted stimulus expansion after seven months of bond purchases as the threat of inflation trumped concerns about an economy in a double-dip recession. The nine-member Monetary Policy Committee led by Governor Mervyn King held its quantitative-easing target at £ 325 billion ($ 525 billion)


Switzerland: producer and import prices (PPI) declined 2.3 % from a year earlier. The government said that it agreed with Italy to open talks on financial and tax issues

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