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Capital Markets

Bond Outlook by bridport & cie, April 4 2012

We try to define the real problems on both sides of the Atlantic to see if political leaders are actually addressing them. It is not encouraging.

The USA is getting it right and the economy is improving, whilst Europe is getting it wrong, and the economy is in decline. That is the widespread view, but one which has to be seriously questioned. Let us step back and consider the causes of the economic problems on both sides of the Atlantic:

 

USA: overspending at national, government and household level, with the decline in house prices being the trigger of the crisis in 2007.

 

Europe: divergence in competitiveness between “north” and “south”, intra-euro-zone trade imbalance and unsupportable levels of government debt in the south.

 

Just to complicate matters, the UK has some of the USA’s problems, and, along with Spain, a major housing problem.

 

The next question, assuming the diagnosis is correct, is what treatments are being applied. “Cheap money” is a major component on both sides of the Atlantic. The other is deleveraging, a fancy word for paying down debt.

 

In the USA, the private sector has deleveraged quite well. Households have cut debt, or at least ceased increasing it, since they can no longer use their property as an ATM, while the corporate sector has not, in general, taken on too much debt. (There are exceptions in old “legacy” companies in telecommunications, transport and retailing.) However, government deficits remain unaddressed, and the current account remains in large deficit. House prices are continuing to decline.

 

In Europe, the “south” is addressing its non-competitiveness by austerity programmes. The cuts are so severe that many countries have re-entered recession. In principle, structural reforms, mainly concerning employment, are under way in the south, but even as the ECB’s cheap money has kept things ticking over, reforms are painfully slow. The biggest and most important reform for the euro zone – the creation of a fiscal union with its own “Treasury” and system of monetary transfer – is just not happening.

 

It would be hard to judge which of the two major economies is being the more badly run. In neither are the underlying causes being addressed – over-indebtedness in the USA, and incomplete fiscal union in the euro zone. In the USA the “let’s pretend all is well” approach has led to an appearance of growth this year, but lays up problems which will eventually demand to be solved. In the euro zone, the cost of austerity is economic stagnation in the zone as a whole; this may indeed clear the decks for a better future, but not without the fiscal union which politicians love to speak about, but seem unable to act on.

 

That is, in fact, another common factor on both sides of the Atlantic: a surfeit of political talk about the problems, accompanied by very little action. Elections of course have to be over for any politically unpalatable steps towards a resolution to finally take place.

 

Our own analysis of the “Taylor Rule” for appropriate short-term bond yields suggests that the current Fed rate is correct, but that continuation, as promised, of low interest rates for another two years runs the risk of exasperating the imbalances, much as in the first half of the last decade.

 

In the meantime the shift in economic power to Asia is continuing. Little notice seems to have been taken of the massive reduction in China’s current account surplus. There again, the long awaited government action of allowing domestic demand to grow, and internationalisation of the currency, is so very slow in coming about.

 

Our own clients are continuing the search for yield ahead of protection.

 


Macro Focus

USA: strong data this week: the ISM index climbed from 52.4 in February to 53.4; new applications for unemployment benefits dropped to a four-year low; consumer confidence rose for a seventh straight month. Orders for durable goods rose in February for the fourth monthly gain in the last five. This followed economic growth at a 3% annual rate in Q4 2011. Shadows came from lower construction spending and a surge in delinquent student loans

 

Euro-region: unemployment rose to 10.8%, the highest in more than 14 years and manufacturing contracted for the eighth month. Economic confidence in the euro region declined in March. German unemployment fell to 6.7% in March. European governments capped fresh rescue lending at € 500 billion after a German-led coalition opposed further expansion of the region’s anti-crisis firewall. The overall ceiling for the rescue of the region’s indebted nations is now € 1.1 trillion. The ECB settled no government bond purchases last week, the third week in a row

 

UK: GDP fell 0.3 % from the third quarter. This decline was mainly due to services as manufacturing growth unexpectedly accelerated in March to the fastest in 10 months. Job vacancies at London’s financial- services companies fell 11 %. Consumer confidence dropped to minus 31 as they suffered a 1.2 %. drop in disposable income, the biggest in more than three decades

 

Switzerland: the KOF economic indicator improved in March, adding to signs the economy is regaining some strength. Manufacturing output expanded for the first time in seven months and retail sales rose 0.8% in February from a year earlier, after gaining a revised 4.7 % in the previous month

 

Denmark: the economy entered a recession in the third quarter of last year as investments and government spending shrank. Gross domestic product contracted 0.1 % in both the third and fourth quarters

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