Bond Outlook [by bridport & cie, November 13th 2002]

Why were we, along with so many others, so wrong about the expected stock market rally last week and expected drop in bond prices? Part of the answer lies in our not listening to our deep-felt doubts about the state of the economy and letting "technical" considerations and short-term thinking override our better judgement. (In our defence, that much was at least obvious from our text.) Part also lies in slowness to appreciate the implications of a 50 bps cut, when only a cut of 25 was priced in. On the one hand, the 50 points implied that the Fed knew the economy to be in a worse state than the Administration has been letting on. On the other, it meant that bond yields at the long end had to drop further to match the short-end cut, so causing bond prices to rise sharply.


So much for last week, but what should bondholders do now going forward? We would answer at two levels. One is built on strict consideration of the interest rate outlook; the other reflects the time of the year and the past several months of good performance in high quality bonds.


The former level tells us that the expected cut in euro and possibly sterling interest rates, be it before or after Christmas, will flatten the yield curves and therefore lower long-term rates just as is happening in the USA. Implication: stay long. The latter, or "trading view", is that the profit-taking we recommended last week should stand. The USA cannot be cutting again this year, and the effect of European cuts has already been priced in. Book profits on bonds, rather than seek the last bit of capital gain.


If forced to make a judgement between these two, we come down in favour of the argument of taking profits, implying that we leave our recommended average maturity at five years. We cannot pretend to readers, however, that this is a clear-cut decision. Actually, it is reasonably clear-cut in dollars, but less clear-cut in Swiss Francs (rates are low but the economy is stalling), and even quite murky in euros, where a cut is inevitable, perhaps greater than that alleged to be priced in (25bps). Overall, then, our formal recommendation is to retain the across-the-board average maturity at five years, but with the euro singled out as having the weakest case for not still being at ten years.


Recently we have heard arguments from clients that returns on bonds are now so poor that it is not worth investing in them; better to stay cash in case the stock market turns up. This argument also lacks conviction. It leads us to the question of asset protection through bonds. That is again the mood of our customers as they fear the risks in both stocks and corporate bonds. A new round of corporate bond defaults may well be starting, with Cirio, an Italian conglomerate in the food business, causing much concern in Italy to the point of liquidity in corporates drying up in that country.


On the question of share prices, we appreciate further input by "Greed and Fear" into an analysis we first brought to this weekly a few weeks back, taking data from The SP500 chart shows a marginal increase in average earnings per share over the last month from $25 to nearly $26 (this reflects cost cutting, not revenue growth). The average PE has dropped from 43 in May this year to 30 in September, but is now at 33 as a result of the recent bear market rally. This compares with an historical average of 16. "G & F" have investigated the impact of the USA adopting proper accounting rules as GAAP is aligned with IAS. Two serious issues are the recognition of pension fund shortfalls and the expensing of employee stock options. These two issues, plus other lessor issues, some positive some negative, bring the average EPS of S&P500 stocks down to $18, and lifts the PE's to over 50. No such adjustment can be made to historical PE's, so it makes the long-term average of 16 look still further away.


What we did right last week was to express a view that any stock market recovery would be short term, because the PE's are just too high and the fundamentals too weak for a sustained rally: profit improvement is by cost cutting without revenue growth; consumers seriously look like their "heroic" spending through additional indebtedness is ending; capacity remains woefully underused.


US economic management appears mistaken to us, but has the major advantage of at least being dynamic. The Americans make the Europeans look hopelessly stuck in the mud. The ECB should have cut long ago, never mind this week in response to the American move. They will have to give way in the end, just as the "Instability Pact" will have to be outmanoeuvred. While the ECB and the UK will both have to bring rates down, the UK has the excuse for delaying because of the housing bubble. It is a truly amazing phenomenon but which carries with it seeds of an inevitable post-bubble adjustment.


There is sense of mutual criticism growing between the USA and Europe, not always expressed in terms of the relative merits of economic policies. However, in the field of socio-economics the argument that demographic trends are towards a growing US population and a declining European population is powerful. An ageing and declining population is notably the root cause of Japan's problems. Japan's incapacity to reform, regarding banks and bankruptcy, is a policy mistake, but it is as much a symptom as a cause. The same issues are now affecting Germany, and are expected to spread throughout Europe.


In response, some, notably The Economist, advocate massive immigration to solve Europe's birth-rate problem. Yet expansion of the EU is already akin to immigration, provided there is freedom of movement and a genuine single market. Moreover, there are solutions to ageing like recognising the absurdity of putting healthy and experienced 65 year-olds out to pasture. Then, the Turks, with masses of young and educated people, are just longing to fill the gaps. One day, European politicians will wake up to the need to face a declining birth rate in many dimensions of life, from education, through retirement age and pensions, to immigration policy. Companies, too, will have to create and meet demand from older people, because if the older folk do not spend, domestic demand cannot grow. Japan's domestic demand just edged upwards. "One swallow does not a summer make" but can this be the impact of private sector supply at last adjusting to "grey" demand?


The dollar weakness we identified many moons ago is set to continue, because nothing has been done to change it. The Bush Administration is encouraging bigger internal and external deficits, which are unsustainable. The former means very limited room for growth, as if growth started, there would be competition for funds. The latter means a weaker dollar. However, a weaker dollar is one of the ingredients for rebalancing the US economy. Even if Europe hurts because of it, basically a weaker dollar is good for the world economy.


In emerging sovereign markets, unlike corporates, spreads have come in, and there is a feeling that neither in Brazil nor in Turkey are the changes of political power so bad as feared, not as yet anyway. Nevertheless, the only emerging market we still feel quite sanguine about is Russia, where we now have clients investing not only in sovereigns but also in corporates.



Recommended average maturity for bonds in each currency.
Shorten as a trading opportunity.

As of 10.07.02
As of 06.11.02

Dr. Roy Damary

Currencies (by GNI)


Finally, at the end of last week, the euro managed to close above parity. This week has had a quiet start with the USA closed on Monday. The market is now focused on Greenspan's speech at the Joint Economic Committee of Congress this afternoon and is looking for direction.


The rapid move of the yen displeased the Japanese Government. The market is being watched carefully and intervention will take place if necessary.


EUR/USD: As expected last week, the euro touched parity and the weekly close (1.0120) was strong. In the short term, the euro is still on the rise with a final objective at 1.0275, but it needs to break 1.0175 rapidly to confirm this. In the other direction, a daily close below 1.0050 could announce a consolidation period.


USD/CHF: The same kind of scenario applies. A break of the dollar at 1.4350 would be needed to confirm that the bearish trend is still valid, with 1.4150 on the low side. A daily close above 1.4555 could cancel this outlook for the week ahead.


USD/JPY: We do not think that the BoJ is ready to act at these levels. A break of 120.10 should announce a small recovery (around 120.80), but we prefer a break of 119.00 with an objective at 117.40.


EUR/JPY: The exchange rate is right in the middle of the range between 122.35 and 120.00. Resistance is at 121.25, support at 120.65. We expect a return to the lower figure.


USD/CAD: A nice rally for the USD here. The next resistance is at 1.5810 and a break of it should provoke a move of at least 100 bps more. Support is at 1.5700.


AUD/USD: The Aussie is supported at 0.5575 and that level should hold. The next objective is 0.5710.



Current spot level
Current spot level

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