Bond Outlook [by bridport & cie, June 25th 2008]
The US authorities continue in their state of denial about the economy, and Bernanke is suggesting that it has been saved from collapse by the Feds rate cuts, freeing the central bank to tackle inflation. The US people think otherwise, reporting their lowest level of confidence in 16 years and turning away from McCain as the Presidential candidate who is likely to carry on the Bush economic policies (or should we use the less dignified word practices). The spiralling costs of food and fuel, removed from the official consumer price data, are diverting household revenues to the shopping basket and fuel tank, making it increasingly difficult keep up with their mortgage and other credit repayments. That goes for relatively well-heeled Americans, never mind those who are the direct victims of the sub-prime crisis. How symbolic that the FBI is now investigating mortgage fraud remember all those liars mortgages; we wonder if they will be interviewing Greenscam, whose policies really started it all.
Du Pont and other major industrial companies are now announcing that they must pass on their higher input costs. So we stand by our view expressed last week that rate rises are very likely on both sides of the Atlantic from late summer onwards. We take off our hats to Pimco for stating so clearly that a supply shock can be absorbed only by a mixture of inflation and increased unemployment, but not by one of these alone.
Stagflation is now frequently mentioned as a strong possibility even by such authorities as the Bank for International Settlements. Others (we mention Dexia, but there are many) see stagflation as impossible given that wages are no longer indexed as in the 1970s, and unions are much weaker. We lean towards assuming a recession in the USA, stagnation in Europe and inflation gradually brought under control by higher interest rates. Do not lose sight of the great shift in relative economic power now underway, and that energy, food, water and land are the subjects of huge shifts with geopolitical and economic implications (see our previous Weekly on Lester Browns outlook).
When most of what we have been warning of these last months comes about ever increasing financial sector losses, recapitalisation of banks by sovereign funds, downgrading of monolines (linked directly to CDS), continued decline of house prices, a credit squeeze, a non-performing stock market, a weak dollar and inflation it is frankly hard to make further recommendations, although it is worth repeating that if ever there were a capital protection period, this is it. Last week we made the tongue-in-cheek comment that banks are now competing with emerging markets for risk-seeking funds. We can add to them US auto firms, whose bonds are now offering yields of over 10%! Just how dire the outlook is for auto makers, and not just American ones, is clear from Volkswagens warnings that hedges taken on raw material costs a year ago are now ending, just when demand for cars looks set to fall.
One country which has quietly ducked most of the sub-prime fiasco is Japan. It has plenty of problems of its own, but at least its banks have strong balance sheets. Examples: Sumitomo Mitsui Banking Corporation joining the Qatar Investment Authority in buying into Barclays; and Daiwa SMBC (itself part owned by Sumitomo Mitsui) setting up a new derivatives business in London and in Asia.
Zürcher Finanzbrief has published the estimated losses of 48 banks from the sub-prime crisis. They amount to USD 372 billlion, while USD 280 billion has been raised by these same banks to recapitalise. (There are three Japanese banks on the list, with combined losses of USD 10 billion). Even if there were no more losses, the search for new capital would have to continue, but there will be more losses!
() Monolines: MBIA has been downgraded five notches from AAA to A2, which will have knock-on effects for banks. MBIA and AMBAC are seeking to commute insurance cover of $ 125 billion
(?) Auto firms: spreads for the US car makers are now over 1000 bps in EUR/USD
() Switzerland: a slow down is expected: GDP growth should be between 1.9% and 2% in 2008 but no higher than 1.3% in 2009
() Spain: the government expects unemployment to rise to nearly 11% in 2009
() Germany: the IFO index has come out lower than expected at 101.3 points, reflecting high fuel prices and an expected rise in interest rates
() Europe: the PMI index of manufacturing and services is showing a decline in activity for the first time in five years (49.5 in June versus 51.1 points in May)
() Ireland: the reputed ESRI (Economic and Social Research Institute) is forecasting a decline of 0.4% of the GDP for 2008, the first recession since 1983
(+) 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