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Bond Outlook by bridport & cie, February 06 2013

Is the US economy really in better shape than Europe’s?

Having confessed one “heresy” – that a little inflation would be a good idea – we wish to confess to another: despite the present consensus, it is our view that neither that the US economy in such good shape as markets believe, nor that Europe is in such bad shape. The fundamental reason for this “heresy” is that the underlying problem of the US economy –spending beyond its means— remains addressed in only the most marginal way. Europe by contrast is facing up to its needs to move to a federalised structure for the EMU. The USA has a huge internal and external deficit, while the euro zone as a whole is more or less in balance.


In the USA, the fiscal cliff, which was narrowly avoided on January 1st, is about to return, as the “sequestration” process is back on the agenda for 1st March. It is not as if the EU is making great strides in its federalisation process, but something is happening. While the US economy actually depends on QE, the BCE is withdrawing liquidity at this point, the only major central bank to be shrinking its balance sheet. This is strengthening the EUR to the point where President Hollande, if not the BCE, is worried!


Fundamentally, this leads us to believe that the European economy is in ‘less bad’ shape. What is a little more difficult to fathom is where respectable returns can be made. Whilst there is often no obvious link between favourable economics and stock market prices (witness the Chinese stock market), it is possible that enthusiasm about the US economy has led to over-pricing of equities. The FT reports research by the London Business School showing that low interest rates are followed by five years of low equity and bond returns. As the FT puts it, “plan for a low return world”. That is partly why we would favour some inflation in the search for a fairer balance between the cost of borrowing and the return for lending.


We feel almost personally involved in the court case the US Government has brought against S&P over the grading of CDOs. Long-term readers may remember that we warned of the forthcoming sub-prime crisis in January 2007 (when HSBC pulled out of the US sub-prime market). According to evidence already published, S&P staff were already well aware of the problems at that time, and were singing a song including such choice lyrics as “Subprime is boiling over!” In many ways the US securities market operates so much better than in Europe, e.g. trading screens are updated and prices and quantities announced are real (not always the case in Europe). Yet the rating agencies caused enormous damage in awarding high credit ratings for CDOs based on subprime mortgages. It has taken five years for this chicken to come home to roost. It may at least be hoped that the agencies learn a serious lesson (Even if that lesson is to avoid threatening to downgrade your own government’s debt!)


The Japanese experiment continues. The departure in a few weeks of the old guard at the BoJ is said to give Abe a free hand to pursue his inflation-seeking policy, and this has led to further weakening of the yen. It is quite a complex economic process: to stoke inflation, interest rates are lowered and the market flooded with liquidity. However, inflation itself leads to higher yields and lower exchange rates. This devalues bonds and reduces the demand for JGBs. Where this will lead the Japanese economy is anyone’s guess. In the light of our calls for higher Western inflation as a partial panacea for our economic woes, this experiment is well worth watching.


Macro Focus


United States


The economy paused from growing in Q4, GDP dropping at a 0.1% annual rate as the biggest defence spending declines in 40 years exceeded gains for consumers and businesses. Rising auto sales led the advance in consumer spending thanks to a drop in fuel prices and the largest income gain in four years.


Confidence among households rose. The Thomson Reuters/University of Michigan index climbed to 73.8 in January from 72.9 in December. Manufacturing also expanded in January, reaching a nine-month high. The Institute for Supply Management’s manufacturing index climbed to 53.1 last month from December’s 50.2.


Payrolls increased by 157,000 workers and the unemployment rate rose to 7.9%.




Manufacturing output contracted less than feared in January. A gauge of manufacturing in the euro zone rose to 47.9 from 46.1 in December. Economic confidence in January rose to the highest level since June, with sentiment among manufacturers also at a seven-month high. An index of executive and consumer sentiment rose to 89.2 from a revised 87.8 in December.


December unemployment rate held at 11.7%.


The ECB’s balance sheet shrank to the smallest in almost a year on early loan repayments by euro-area banks


United Kingdom


House prices rose in January as the Bank of England’s credit-easing programme helped loosen the mortgage market. Mortgage approvals rose to an 11-month high in December and the average cost of a home increased 0.5% from December to £ 162,245.


Manufacturing expanded for a second month in January as orders and output rose the most since September 2011.




The PMI advanced to 52.5 and the UBS consumption indicator rose to 1.34 points. Nevertheless, the KOF economic indicator decreased for a fourth month dropping to 1.05 in January.


The housing market moved further into the “risk zone” at the end of 2012. The UBS Swiss Real Estate Bubble Index rose to 1.11 points in the three months through December. Property values climbed 6.3% in the 12 months through September.


Exports declined 1.5% from November while imports climbed 5.5 %. This made the trade surplus shrink to CHF 1 billion from CHF 2.9 billion in November.


Dr. Roy Damary