Bond Outlook [by bridport & cie, January 21st 2009]
A new era has indeed begun with President Obama, but old problems have not gone away, as the fall in bank share prices on Inauguration Day forcibly reminded everyone that after the hope must come the reality of a seriously wounded economic giant.
Our concerns about the bail-out plans being a further dose of Greenscamism remain. So long as their objective is to encourage the return of credit availability for households so that they may return to their spendthrift ways, a fundamental error is being made. Credit to companies, yes, credit to prolong consumers spending beyond their means, no. There are signs on both sides of the Atlantic that the authorities are beginning to see this important distinction, but it needs to be made much more explicit. This recession is and has to be L-shaped, i.e., when the economic decline has stopped, a long, probably years-long, period of mediocre growth will follow. This is because consumers will be repairing their own balance sheets by saving, rather than spending excessively. Even when house prices stabilise, they are unlikely to return to their old habits once bitten twice shy (at least for some years!).
To a large extent then, Greenscamism, with its ill-conceived purpose of never allowing living standards to adapt downwards, will not work any more; the process of adjusting the standards of living in the USA and other countries will proceed anyway. The L will come to pass. We had hoped that the downward leg would terminate, along with the financial market crisis, in about mid-2009. It requires much optimism to stick by that timetable, and we are wavering!
In the meantime, two phenomena are clearly underway:
The key question is how long these trends will last. At the back of our minds all the time is the inevitability that a country which prints money and has a massive current account deficit faces both inflation and currency depreciation. The UK, without the protection of a reserve currency, has shown the way. The euro zone, despite the weakness of its southern and western members, still benefits from an overall current account balance and is proving more disciplined and less tempted by the print money approach. We cannot say when the trends will reverse, but we can point to the USD yield curve as a source of warning. When long-term yields move up seriously, it will imply that inflation is near. Currently there has been a modest increase of 10-year T-Bond yields, and the USD yield curve is steepening, a small sign of optimism that the financial markets are improving, but there is a long way to go.
Our recommendation for new investments in favour of quality corporate bonds over governments reflects our continued sense that the latter are over priced, although inflation-linked government bonds are returning to the radar screens of several of our institutional clients. Care must be taken over the choice of corporates, as they are also looking expensive. The yields being offered on new corporate issues are higher than those offered on issues for the same borrowers in the secondary market which obviously has the effect of depressing secondary market prices.
The idea of a bad bank based on the Swedish policy of the early 90s to buy toxic assets at their low market value is gathering weight. It promises a clean sweep to a leaner banking industry. `
(?) Bank of America: USD 20 billion Federal support. 4th quarter losses amount to de USD 1.8 billion, plus a loss of USD 15.3 billion for Merrill Lynch
(?) Citigroup: after already absorbing USD 45 billion of Federal aid, is creating a structure for their toxic assets
(!) Deflation: US CPI fell 0.7% in December as a result of the sharp drop in energy costs and the economic slowdown. Novembers data were revised downwards from -0.6% to 1.3%
() US Economy: industrial production fell a further 2% in December
() Ireland: nationalisation of AIB and Bank of Ireland is underway
(!) Canada: Bank of Canada cuts benchmark rate to record low of 1% as expected
(+) positive for bonds () negative for bonds (!) watch out (?) begs the question
Recommended average maturity for bonds.
Shorten for new investment, but no need to liquidate long-held long maturities.
As of 21.01.09
As of 8.10.08
Dr. Roy Damary