Bond Outlook
[by bridport & cie, September 11th 2002]
Inflation, deflation or stagflation? In seeking an answer as to
where the economy is going, a distinction has to be made between specific
events like retailers profiting from the conversion of legacy currencies
to euros or the impact of the Iraq war threat on oil prices, and the
underlying economic fundamentals. The latter are resolutely pointing
towards deflation. In one sense it has already started in the USA. The
retail price index is negative 2%, despite a positive overall
CPI. |
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The immediate causes of the deflationary pressures are excess
manufacturing capacity and absence of pricing strength by suppliers of
almost all products. Demand is weaker than production capacity and bound
to remain that way because of the over-indebtedness of both corporations
and households. We have often written of the need for rebalancing. Clearly
households in the USA have still not seriously begun debt reduction;
rather, they are responding to the Administration's policy of putting off
the evil day. Corporations have. Data on non-financial corporate debt
(i.e. ex-banks and the like) show that a peak in the ratio to GDP was
reached in March this year of 48%. Since then the ratio has declined to
47%. |
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How much further has the ratio to fall before rebalancing may be
complete? The previous high was 43% in 1991. After each high, the ratio
has fallen by several percentage points, always trending higher but with
very large declines in between the peaks. The US GDP is about $ 10
trillion. Taking a likely decline between 5 and 8% suggests a debt
reduction in the order of $ 500-800 billion over the next five years or
so. |
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In the meantime, the US Government will be borrowing more to cover
its ballooning deficit. However, the level of increased Government
borrowing for a deficit increasing at $ 150 billion or so per year looks
like it can roughly be covered by the lower rate of corporate borrowing,
never mind any future preference investors have for Government bonds. The
implications of investments moving from the private to the public sector
will only slowly be seen, but the outlook does not look too positive to
us. |
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In Europe, the same trend exists of Government borrowing growing
and private debt declining. For example, many convertible bonds will not
now be converted and will eventually have to be redeemed at par like a
straight bond. A current estimate is for $ 41 billion of redemptions over
the next 18 months from the likes of France Telecom, Vivendi and Olivetti.
Echoes of the Japanese convertible bond story of the
1970s! |
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Stephen Roach of MSI, a voice in the wilderness for which we have
great respect, blames the Central Bankers for fighting the wrong war (that
against inflation) when the real threat is deflation. "Fixated on the
inflation targeting of yesteryear, the authorities are unwilling or unable
to give active consideration to the possibility of deflation -- a classic
by-product of a post-bubble world." An influential voice in the person
of Deutsche Bank's Chief Economist, Norbert Walter, is rallying to this
view. |
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Our views are in line with Roach and Walter. Since early 2000 our
dominant theme has been that inflation, profits and yields will all be low
for this decade. The danger to this scenario is not a return to growth
and inflation, but to no growth and inflation, also known as
"stagflation". |
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Obviously not everyone agrees with our scenario. Many want to
protect their investments against possible inflation. Accordingly,
index-linked bonds are proving attractive to investors as a means to
address this fear, and to borrowers because they pay lower rates. (It may
also apply that borrowers, both government and corporate, are secretly of
the view that the risk of inflation and higher future costs is
small!). |
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Given that all investments are about balancing risks, we agree that
there is room in fixed-interest portfolios for a proportion of
index-linked instruments. Nevertheless, we cannot yet change our
recommendations on average maturities. |
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Many quality bonds are now trading at significant premiums. Some
investors may see this as a good time to take profits and move to newer
issues nearer par with current coupons. Holders of Swissair dollar bonds
have seen big gains recently as hope rises that the sale of Gate Gourmet
will allow redemption at par with accrued interest. However, the
couponless wait may be long before cash is collected. |
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Recommended average maturity for bonds in each
currency. Remain long across the board, except in
Sterling. |
Currency: |
USD |
GBP |
EUR |
CHF |
As of
10.07.02 |
2012 |
2007 |
2012 |
2012 |
|
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There are still no signs of a sustained recovery on the horizon,
while a lot of uncertainty over Iraq can be expected over the next couple
of weeks. A further erosion of investors' confidence in banking assets
could choke off credit and give rise to a credit crunch. The US unit
recouped some of its losses recently, but the medium-term sentiment leans
clearly towards a still lower dollar. In the short term, we expect range
trading to continue. |
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EUR/USD: The range is from 0.9730 to
0.9980. A break on either side would mean a minimum move of 100
points. |
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USD/CHF: Here the range is 1.4700
to 1.5050. A break on either side would likewise imply a move of at least
100 points. |
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USD/JPY: Same comment: the bottom of
USD has gradually moved higher, and 118.80 has already become a solid
support level. Topside is at 120.10, 120.80 and 121.30, while
115.50/117.00 remains the major support area. |
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EUR/JPY: Same comment: here as well,
consolidation is to be expected in a 115.00 to 118.00 trading
range. |
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USD/CAD: The CAD continues to weaken and, if
1.5780 is broken, the door is open for 1.6000. As stated previously, we
would use that weakness again to establish a long CAD short USD position.
Main support remains 1.5480. |
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AUD/USD: It looks like that the Aussie
has a lot of difficulty in sustaining levels above 0.5500. Consolidation
in a 0.5350 to 0.5550 range may be expected until further
notice. |
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|
USD/CHF |
EUR/USD |
EUR/CHF |
USD/JPY |
EUR/JPY |
Resistance/Breakout |
1.5030 |
0.9780 |
1.4680 |
120.30 |
117.20 |
Current spot
level |
1.4980 |
0.9750 |
1.4620 |
119.85 |
116.85 |
Support/Breakout |
1.4910 |
0.9650 |
1.4580 |
118.80 |
116.20 |
|
AUD/USD |
NZD/USD |
USD/CAD |
GBP/USD |
XAU/USD |
Resistance/Breakout |
0.5480 |
0.4730 |
1.5850 |
1.5680 |
323.00 |
Current spot
level |
0.5475 |
0.4695 |
1.5765 |
1.5560 |
317.50 |
Support/Breakout |
0.5350 |
0.4610 |
1.5610 |
1.5480 |
313.50 |
|
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