Bond Outlook [by bridport & cie, January 23rd 2008]
The Greenspan put continues under new management. The 75 bps cut in the Fed rate on Tuesday slowed the fall of US stocks and gave rise to what seems a temporary rebound in other markets. Whether this will avoid a recession in the USA is a quite different issue. Whenever we address questions about the real economy, we remind themselves of the underlying causes: excessive US spending and the fall in house prices. Can lower interest rates reverse the fall in house prices? We think not because of the excess of supply over demand and tightening credit conditions. Availability of new mortgages is much lower, irrespective of interest rates. Can lower interest costs impact excessive spending? Yes; even if new credit remains hard to come by, a lower cost of existing debt allows households to spend a bit more. The inevitability of an eventual matching of spending to income remains, but the rebalancing process has been slowed by Fed rate cuts. We remain therefore extremely sceptical that the Greenspan put Mark II can do much good for the economy, even if it does bail out the stock market in the short term (which is far from obvious).
The UK has followed the same route as the USA with its credit-fed economy and housing bubble. Yet there are subtle differences. Perhaps the most important of these is the attitude to the standard of living and inflation. It is an anathema to the US authorities to accept a lowering of standards of living, and if that standard can be maintained only be cheap credit, so be it. In contrast Mervyn King, whose role in the British economy must be at least as important as Chancellor Darlings, admitted in his Tuesday speech that inflation will be above target this year, but the UK will cope well provided wage inflation does not also take off. That is another way of saying that households must tighten belts. Whether this is acceptable to trade unions is another question.
King is to be admired for admitting inflation. Bernanke is more coy. Our interpretation that Fed policy is to give up fighting inflation is proving correct. Bernanke knows full well that inflation has taken off, but he uses expressions like inflation concerns have faded enough for us to focus on the economy. Concerns have faded only in the sense that the Fed is ignoring them. Inflation will grow, fed more by cost-push than demand-pull. (The distinction is a little artificial: globally the commodity, oil and food inflation is all demand-pull.)
The BoE will soon follow the Feds example in also lowering the bank rate. The ECB will be slower, both because the need for economic stimulus is less and also because the remit of the ECB is in principle and practice more focused on containing inflation. Nevertheless, we expect the resistance to rate lowering will give way by mid-year.
We stand by our recommendation on long maturities in USD and EUR quality bonds. However, most of our clients are concentrating on short maturities.
The credit crisis is far from over. The volatility of stock markets has taken eyes off the continuing menace of monoline downgrades. Indeed, the first has already happened: Ambac, the second biggest monoline insurer (after MBIA), has been downgraded by Fitch to AA, and this has already led to falls in the price of bonds insured by them. The falls will be greater if and when Moodys follows Fitchs example. The Ambac news led to share price losses of both Société Générale and Dexia as analysts starting looking at their exposure to Ambac-insured bonds. This supports our view that bank losses due to the sub-prime crisis are still not fully revealed. Even China has set up a task force to monitor the CDO exposure of Chinese commercial banks. It is unlikely that the monoline problem will be allowed to get out of hand, as so much is at stake. Help may be forthcoming coming from the NY State Insurance Commissioner, who has already encouraged Warren Buffet to set up a new monoline insurer.
Every emergency cut by the Fed in recent years has led to the creation of a new asset bubble. Some suggest that the next one will be emerging market stocks. Quite likely, although we are still positive for sovereign bonds in local currencies. Besides, bubbles are attractive on the way up; the issue is to exit before they burst!
(+) Switzerland: pension funds said to have lost CHF 30 billion from sub-prime (Sonntag Zeitung). UBS shareholders want the issuance of convertibles to be open to the public, with compensation for those who reject the plan. Pictet also said to be exposed to the current crisis via its short-term funds
(+) USA: taking advantage of a weak dollar, foreign investors, especially from the Gulf and China, almost doubled their rate of acquisition of US companies in 2007
(!) Euro zone: in 2007 half of all real estate agents in Spain closed down
(?) UK: panic over property funds has forced Scottish Equitable to forbid withdrawal from its fund for one year. The BoE loan to Northern Rock will be converted into government guaranteed bonds. The share price climbed 50% on this announcement
(!) Venezuela: Chavez is menacing nationalisation of banks unwilling to lend to the agricultural sector
(+) positive for bonds () negative for bonds (!) watch out (?) begs a question
Recommended average maturity for bonds.
Long maturities in USD and EUR, but ready to shorten. Quite short in CHF and GBP.
As of 09.01.08
As of 22.08.07
Dr. Roy Damary