Bond Outlook [by bridport & cie, June 4th 2008]
Despite the view of a certain former central banker to the contrary, we think that it is fairly easy to recognise a bubble when it is building. Dot.com was obvious, so was housing; the bubble in low-credit perhaps less so. A much more difficult challenge is to detect the beginning of the deflation of a bubble, for example, the current commodities bubble. We suspect that this has now begun. Many soft and hard commodities are already well down from their peaks, although this has been little noticed because of the focus on crude oil. Yet this has also pulled back from its USD 135 peak, which it reached not only as a result of supply/demand imbalances, but also because of much speculative investment.
Our suspicion that the commodities bubble is deflating does not mean that we expect cheap commodities again, nor that politicians can legitimately blame speculators without considering their own responsibility (ethanol subsidies, anti-gm, general interference in agricultural markets and little encouragement of alternative sources of energy). Nevertheless, if the speculative component of the oil price is shaken off, a fall of some tens of dollars per barrel is on the cards.
Even with a modestly lower price, the cost of oil will still be onerous for importers, and incredible wealth will still be accumulating in the exporting countries, and so it will continue for many years. Nevertheless the quadrupling of oil prices is, just as in the 1970s, producing a major change in the demand structure. The GM announcement illustrates this with the closure of SUV and pick up truck factories as car demand shifts away from gas guzzlers. Electric and hybrid cars are now back on the agenda with specialists speaking of a six-year time horizon for electric cars to dominate (sounds too optimistic to us).
To these two turning points the commodities bubble and new vehicle technology must be added a third, the public recognition by Bernanke that inflation is a problem, and that a weak dollar feeds it. This implies the end of interest rate cuts in the USA and suggests that rate rises are likely later in the year. It also, in our view, signals a pause in the long-term decline of the dollar. In the meantime, other central banks are all in the hold/raise mode for interest rates.
Alas for the credit crisis, there is no turning point, unless the move from phase 1 of the crisis (insufficient liquidity) to phase 2 (the real credit squeeze) counts as one. Everywhere you look there is now a shortage of borrowing capacity: the commercial paper market has virtually disappeared, the auction rate security market is malfunctioning, collateralised debt obligations are treated with great distrust, refinancing mortgages is practically impossible, and banks have very little lending capacity. Rather than seeking opportunities to lend, banks are more interested in raising capital both to compensate their recent losses and to balance assets previously parked off balance sheet in SIVs.
The original trigger of the current crisis, the fall in US house prices, is still being pressed. It looks like the fall in house prices there has so far reached only half way. We expect the final overall decline to be about 30%, at which point even Fannie Mae and Freddy Mac will probably need bailing out from the Federal coffers. Linked to the government-sponsored mortgage agencies, but little noticed, are the losses incurred by mortgage insurers with names which few of us find familiar, like MGIC, PMI, Radian and Triad. They reported a combined 2007 loss of USD 4 billion and are presumably having great difficulty in meeting claims against delinquent mortgages.
Generally corporate bond spreads are again widening, especially in the financial sector, and there are few new issues. Emerging market bonds are however doing well, a reflection of the long term shift in economic power which provides the backdrop to the current situation.
() US banks: commercial banks are criticising the relative ease with which investment banks can borrow from the Fed. Eight major banks are on negative watch list
(!) US retail sales: Sears report a loss due to a decline of clothing purchases
() UK: the annual rate of decline in house prices is some 10%, while 75% of all mortgages are variable rate. Construction companies are suffering
() Spain: the housing situation in Spain is even worse, with annual declines of 15% to 20% and even more in coastal areas
() EU: inflation in May at 3.6% per annum the highest since the euros creation. Households are serious curtailing spending (-2.9% in April annualised)
(+) positive for bonds () negative for bonds (!) watch out (?) begs the question
Recommended average maturity for bonds.
Our recommendation to maintain short maturities remains firmly in place.
As of 23.04.08
As of 02.04.08
Dr. Roy Damary