Bond Outlook [by bridport & cie, November 14th 2001]

The relief and subsequent optimism generated by the fall of Kabul and the accidental cause of Monday's plane crash has triggered a return of many investors to the stock markets and to marked recovery. This has been reinforced today by strong retail figures, and profit warnings (such as Oracle's) and firings (such as Merrill Lynch's) are not denting the present enthusiasm. In reality, the fundamentals for the US and European economies are as poor as ever. Reasoned doubts about overcapacity needing a further year to work its way through industry to allow further investment carry no weight in the current climate. On top of that, positive data on Europe (such as not actually moving into negative growth as in the USA and Japan) have not prevented the euro from falling against the dollar. These are difficult days for believers in economic fundamentals, just as they were when the stock market was reaching ever newer heights two years ago.


The impact on the bond market of the present optimism is a slightly higher yield curve at maturities beyond two years (i.e. a slight steepening), while spreads on corporates and emerging markets have narrowed. Hence there increasing willingness to take on risk in fixed-income markets, too. Our advice to stay long in bonds has proven correct, with the range 5-10 years being the most expensive and in demand. Several commentators and even some of our clients believe that the bond rally is over or nearly, but our view is the opposite, despite this week's increase in yields. Moreover, to remain long is appropriate in this period of great uncertainty and continued interest rate cuts.


The US interest rate cuts plus fiscal rebates have not so far given "traction" (the word that has recently become à la mode to describe getting the economy moving forward again). The Fed will therefore cut again, but is now near to the lowest it dare go, reckoned to be 1.5%. Back in the mid 1950's however the Fed rate dropped below 1%. The danger facing US (and therefore world) economic policy is that prices will fall enough to turn low nominal interest rates into higher real rates. Indeed, in October, producer prices fell by 1.6%, but it would be wrong to take just one month's figure as a trend. Producer prices have been oscillating ±1% around the same level since December 2000.


A continual fall in prices is the Japanese syndrome, dreaded by political leaders everywhere. How serious is the risk for the USA? Enough apparently for a number of economists to fret about it, although so far we rather lean to the opposite danger of inflation returning rapidly when "traction" finally takes (an outcome we are expecting for the end of 2002).


So long as the world economy is undergoing mere disinflation we cannot change our recommendation to remain long on the yield curve. Actually, we had rather expected to change our recommendation by now, but have had to stick to it just because traction looks like being well off into the future. Ironically, success in US economic policy will lead to inflation, while failure will lead to deflation. Deflation is entirely positive for quality bonds, while inflation means rapid shortening or buying indexed bonds. All the more reason, then, to stay long in bonds and not to confuse this stock market rally with a turnaround in the underlying economy.


Prices of emerging markets bonds are increasing everywhere except Argentina, a phenomenon we would expect as part of the "ring fence" scenario. Russian bonds are leading the rally in emerging markets, and we note with interest a Russian oil company going to the Eurobond market with a rating of B1, one notch above its Government's (B2).!


Japan's Government has released data confirming the obvious, that the country is in recession. A headline this morning was "Japan on the Brink", but that has been the case for many years. One day the country will fall over the edge, but just what does that mean? Probably a continued recession with deflation and a growing Government deficit until the latter finally has to be monetised and massive inflation sets in. All the recommendations for Japan are that the country needs inflation to return to economic growth, but inflation goes hand in hand with higher interest rates, and they would make the Government debt totally unsupportable. Not a pretty choice, and a serious warning for the rest of the world.


Recommended average maturity for bonds in each currency.
Stay long.

Virtually unchanged since 15.08.01

Dr. Roy Damary
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