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. |
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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. |
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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. |
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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. |
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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. |
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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 www.bigcharts.com. The SP500 chart
shows a marginal increase in average earnings per share over the last
month from $25 to nearly $26¾ (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 $18½, 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. |
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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. |
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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. |
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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. |
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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? |
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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. |
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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. |
|
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Recommended average maturity for bonds in each
currency. Shorten as a trading
opportunity. |
Currency: |
USD |
GBP |
EUR |
CHF |
As of
10.07.02 |
2012
|
2007 |
2012 |
2012 |
As of
06.11.02 |
2007
|
2007 |
2007 |
2007 |
|
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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. |
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The rapid move of the yen displeased the Japanese Government. The
market is being watched carefully and intervention will take place if
necessary. |
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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. |
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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. |
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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. |
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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. |
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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. |
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AUD/USD: The Aussie is supported at
0.5575 and that level should hold. The next objective is
0.5710. |
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|
USD/CHF |
EUR/USD |
EUR/CHF |
USD/JPY |
EUR/JPY |
Resistance/Breakout |
1.4550 |
1.0175 |
1.4660 |
121.00 |
121.25 |
Current spot
level |
1.4490 |
1.0095 |
1.4627 |
119.90 |
121.00 |
Support/Breakout |
1.4350 |
1.0050 |
1.4600 |
119.00 |
120.00 |
|
AUD/USD |
NZD/USD |
USD/CAD |
GBP/USD |
XAU/USD |
Resistance/Breakout |
0.5650 |
0.4980 |
1.5810 |
1.5965 |
324.50 |
Current spot
level |
0.5600 |
0.4955 |
1.5765 |
1.5880 |
323.50 |
Support/Breakout |
0.5575 |
0.4930 |
1.5700 |
1.5815 |
321.50 |
|
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