Bond Outlook by bridport & cie, January 25 2012

The hesitant mood of optimism in financial markets is continuing on both sides of the Atlantic. It is however legitimate to ask whether the benign atmosphere is a result of a real turn around in the economy. In terms of the economic cycle, the recovery in the USA seems well-based. Europe is surely behind the USA, but the economy has stabilised somewhat, which may be another way of saying “has hit bottom”. Nevertheless, yesterday’s IMF’s global growth forecasts still point to a period of ‘mild recession’ for 2012, before growth of 0.8% resumes in 2013.

The problem is, of course, that the long-term issues have not been resolved:

• in the USA, the need for better balance in the budget is recognised, but the gulf between the two parties’ approach to achieving this is so great that progress is frozen. Obama’s State of the Union address focused on wide-spread wealth generation, whereas the Republican candidates favour a reduction of public services. Inasmuch as Obama is appealing to the 99%, his chances of re-election have just gone up, and the Democrat approach to budget balancing (greater taxation of high earners) may prevail. That, however, cannot be implemented before 2013
• in Europe, the solution to the euro crisis is only to be found in federalisation. Germany’s Merkel is sitting ever more firmly in the driver’s seat (Sarkozy seems to have fallen off) and is stubbornly refusing to go further than a rule to keep national budgets under control. This has put Germany in the strange position of holding the cards to solve the euro crisis, but refusing to play them. Some think she is playing a waiting game: get budgets under control, and then perhaps move towards the “fiscal union” of which she speaks while preventing its very creation

An analysis published by McKinsey (thank you, John Mauldin) suggests that deleveraging of household debt (i.e. bringing the ratio of household debt to earnings to its long-term trend) is most advanced in the USA, with the likes of the UK and Spain well behind. With a starting point of summer 2008, the USA is reckoned to be about half-way through the process. That would imply an end to US deleveraging in mid 2015. However, even then, the lack of capacity and appetite for remortgaging to finance spending implies no great economic take-off.

Europe can scarcely do any better, despite the competitiveness of German industry (courtesy of a weaker euro). There are other bright spots like UK entrepreneurship and its (now foreign owned) auto industry, but that has to be offset by such things as the innate sense of social entitlement which continues to prevail throughout the continent (witness: a candidate for the French Presidency promising to reduce the retirement age !).

Lest we think the world economy is based solely on North America and Europe, it is worth recalling the huge shift in manufacturing power to Asia. China’s growth is still high, but slowing, partly because of the weakness of export markets, but also because of rising labour costs, and the tight control over domestic demand. Japan shows how a declining population affects economic growth.

Some years ago in this Weekly, we suggested that the world needed a third international currency to reflect the growing influence of China. That is gradually happening, albeit as slowly as only an authoritarian government can control. How interesting to see the moves by the City of London to become a, if not the, major centre for RMB trading.

Overall, our judgement is that the current “risk on” atmosphere has a lifetime of months, not years. Inflation is being kept at bay only by the weakness of the economy. That weakness has years to run, during which period yields will remain low. A solution to the US and European issues described above should prevent the economy sliding into recession. However longer-term sustainable growth is reliant on the emerging world, where China appears to hold most of the cards.

Macro Focus

USA: the housing market improved in December for a third month to the highest level since January 2011: purchases of previously owned homes increased 5% to a 4.61 million annual rate. Unemployment levels suggest a broad based improvement in the job market. Industrial production rebounded in December, showing gains in demand for business equipment, automobiles and construction materials. Relative yields on U.S. corporates have fallen below those of the rest of the world for the first time on record,: the spread over Treasuries is now averaging 335 bps

Germany: the government cut its forecast for economic growth this year from 1% to 0.70%, just above the projected average of the euro zone. The Government has suggested it may be open to boosting the combined aid limit from €500 bln when a permanent fund runs alongside the temporary fund starting in July

Spain: the economy contracted 0.30% in Q4 and will shrink 1.50% this year, according to estimates from the Bank of Spain. The central government will provide a credit line and other liquidity measures to ease pressure on cash-strapped regions while demanding tighter deficits in return. Deeper budget cuts may be postponed until after a regional election in March, adding to the risk the nation misses its deficit goal for the second year running

Greece: while holders of Greek bonds are hoping for a haircut of 50%, Greece is now arguing for a greater level: up to 70% and debt would be swapped for 30 year bonds with a coupon below 4%.The agreement is key to a second financing package for the country, which faces a €14.5 bln bond repayment on March 20

UK: the IMF cut its forecasts for economic growth this year to 0.60% (from a 1.60% in September), and to 2.0% for 2013 (from 2.4%), Unemployment rose to 8.40%, the highest rate in 16 years. Consumer confidence fell in December, although retail sales rose by 0.60% from November, when they fell a revised 0.50%. Britain’s budget deficit narrowed more than forecast, net borrowing excluding support for banks was £13.7 bln compared with £15.9 bln a year earlier

Switzerland: investor confidence had the largest gain in nine months in January. The ZEW index of investor and analyst expectations rose to -50.1 from -72 in December. Moody’s “Aaa” rating on Swiss government debt is underpinned by the country’s very high levels of economic, institutional and financial strength

Global: the World Bank cut global growth forecasts: the economy will grow 2.50% this year, with euro zone area contracting 0.30%, vs. a previous estimate of a 1.80% gain. The IMF forecasts for the world are more optimistic: 3.30% this year and 3.90% in 2013. The IMF is proposing to raise its lending capacity by as much as $500 billion to help insulate the global economy against any worsening of Europe’s debt crisis