Bond Outlook January 28th

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Rebuilding the balance sheets of banks, households and governments, with all that implies for higher savings rates and taxation, means the leg of the L-shaped recession will be years long.

As often mentioned in this Weekly, we see this recession as “L” shaped, by which we mean that GDP, still falling, will eventually reach a bottom and then stay there for years, not just months. The reason for this gloomy, but realistic expectation is that households in the USA and elsewhere will take many years to repair their “balance sheets”; they will not be ready to spend beyond their means for all this time. David Rosenberg of Merrill Lynch supports this scenario, but lays down three benchmarks for recovery. The following is our summary of the views he presented in Geneva recently:

  • This recession is not cyclical but secular, i.e. a major shift has taken place in economic growth, expansion cannot return by the traditional process of inventory adjustment
  • The loss of household wealth is about USD 3 trillion, and this means that households will have to save for years to achieve acceptable levels of indebtedness
  • Even then, the US consumer may not pull the economy out of the recession; maybe his Chinese counterpart will!
  • No recovery can happen until house prices stop declining
  • The three benchmarks for recovery in the USA are:

1. The inventory of unsold houses falls to 8% -- currently 11.5%

2. The household debt-service ratio falls to 10.5% from the current 14%

3. Savings rates return to 10% from current 2% and zero a couple of years ago

Now Jeffrey Sachs, writing in the FT, argues for a long horizontal leg to the “L”, based on taxation. Massive government deficits are building a “fiscal straight jacket; to close the government budget gap, taxes must return to higher levels. This reflects that today’s bail-outs will have to be paid for by future generations.

Our own hope remains that the turn from the downward leg to the horizontal leg of the “L” will happen in mid-2009. Thereafter, or whenever the turning point does arrive, the new danger will be higher interest rates. They will not reflect an expanding economy, but only the result of fiscal deficits and “printing money”, and they will reinforce the length of the “L”’s horizontal leg. Inflation should go together with higher interest rates, but may be a few months behind. Readers old enough to remember the 1970s hardly need reminding of the phenomenon of “stagflation”.

Our clients are almost all positioned for an increase in bond yields. Currently they rarely invest beyond three years, and many prefer bills, even if the return is close to zero. In the search for an acceptable return, the enthusiasm for new issues of quality corporate bonds remains. Despite the borrowers offering new issues at substantially higher spreads over the yields of their existing bonds, we hear of over-subscription up to seven-fold (the case of Toyota’s new issue in EUR). At first glance it looks like underwriters are stacking the odds in their favour, but, actually, there is no longer underwriting as such; issues are sold on best efforts. Nevertheless, some of the top quality borrowers must be feeling hard done by as they see significant premiums on their issues a few days after launch. Holders of older issues from the same borrower also resent seeing the prices fall as yields adjust upwards to those of the new issues.

There are little bits of good news. The “bad bank” in the USA will be run by FDIC; Barclays and BNP-Paribas are claiming the worst is over. Spreads on emerging-markets are now narrowing. They reinforce our hope that the recession will not become a depression.

For the moment governments are still in “bail-out” mode; they will eventually pass to “system redesign”: new regulations, modified roles for institutions created after WW2 and possibly new financial structures. China, at least, will have to become a major player. But all that is for after the bend from vertical to horizontal in our “L”.

Focus

(–) USA: the index of consumer confidence reached a new low in January of 37.7 versus 38.6 in December. House prices fell further in November, 18.2% over the year (index S&P/Case-Shiller)

(+) France: record for creating new companies in 2008: 327,396, 1.8% more than in 2007

(–) Japan: Nomura incurred a net loss of EUR 2.9 billion in Q3 of their financial year 2008-2009. The cost of buying back certain assets of Lehman Brothers is weighing heavily on their profitability

(?) Netherlands: the Dutch Government is guaranteeing ING’s Alt-A mortgage portfolio against participating in any eventual gains

(+) 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.

Currency:

USD

GBP

EUR

CHF

As of 21.01.09

Max. 2013

Max. 2013

Max. 2013

Max 2013

As of 8.10.08

2015

2015

2015

2015

Dr. Roy Damary