Bond Outlook [by bridport & cie, March 20 th 2002]

The debate has moved on from whether there will be a recovery to just how weak it will be. "Double dip" is scarcely mentioned now, although its echo may be observable as US companies catch up on inventories, but then find that demand has not moved forward to match increased production. The Fed's explanation for keeping its rate low, but moving to a neutral stance, reinforces our view that inflation will remain moderate and that economic weakness is very much present. Greenspan, in a speech to bankers before the Fed meeting, spoke of "encouraging signs of strength", coupled with a warning that "the dimensions of the pick-up remain uncertain". Interestingly enough he added that increased savings by American consumers could help the current account deficit and thus reduce the US reliance on foreign capital investment. He must have been reading our Weekly!


The IMF has revised upward its forecast for 2002 US GDP by a factor of 2, to the dizzy heights of 1.4%, almost as bad as Europe! Actually there is a modest world recovery underway, with all that it implies about asset reallocation and knock-on effects on the dollar. The over-valued dollar is vulnerable to world recovery, but two external factors continue to sustain it. The first is the risk of further military action in the Middle East leading to dearer oil and its dampening effect on growth. The second is a return to yen weakening once "Cherry Blossom Time" is over (March 31, financial year's end and time for a "reality check").


We have often commented that price earnings ratios are too high, both in terms of underlying profits growth and historical levels. The average PE of the S&P 500, for example, was around 16 over the first nine decades of the 20th century, but rose to 40 recently. It is still at 32 today. Such levels can only begin to be justified if earnings growth is at much higher levels that ever seen before. In fact, they are not, for the very good reason that profits cannot grow sustainably at a rate much different from that of GDP, since the slice of the GDP "cake" going to profits remains rather constant. In fact, growth rates of US earnings per share have been, and still are, close to 3% per annum. From this starting point, two possible routes open up: one is that share prices will correct sharply; the other is that the current paradigm on share price valuation will remain sine die, implying that real returns on stocks over the next ten years will be about 4.5%. Given the volatility associated with that outlook, the received wisdom that stocks "always" outperform bonds in the long run may be seriously questioned for the current decade. Besides, limited upside potential combined with large downside risk (like those "reverse-convertible" bonds we criticised last week) is inherently a bad idea.


Most equity investors have learned that stock markets go up about six months ahead of economic fundamentals. Over the last two years we have often been ironic about the "moving six months" of the recovery. However, let us accept that recovery has arrived, weak though it may be. Now we ask if the same investors have read the next chapter in the "How to Beat the Stock Market" books. There they will find that the most favourable time to sell stocks is six months after a recovery begins, as measured from the moment rates begin to rise. In the period either side of the interest rate turning point, the stock market moves sideways. It will be seen whether the self-fulfilling "six months" theory applies to both sides of the turn.


In earlier weeklies we have noted the trend, led by British companies, to change their pension funds from defined benefit to defined contribution, and to move from stocks to bonds. The argument is spreading across the Atlantic, actually in the form of another major criticism of GAAP, which put pension fund assets and liabilities on the company's balance sheet (that, by the way, is an astoundingly bad idea by the standards of Switzerland, the only country that has really come to grips with pensions). The American system allows shareholders to keep the profits when investment performance exceeds requirements, but shifts the downside risk of company insolvency and poor performance partly to the beneficiaries and partly to the Federal Government (Pensions Benefit Guarantee Corporation). The degree of shift is unclear - all part of the crying need to clean up the entire US practice of "accounting transparency" or, rather, the lack thereof.


When short-end rates begin to rise, the long end of the yield curve is unlikely to follow and flattening is probable, as witnessed in Sweden this week. Bond portfolios therefore still require short average maturities, including substantial cash.


Recommended average maturity for bonds in each currency
If anything we would shorten further, but yields are so low in money markets, that three years at least gives a measurable return.

As of 05.12.01
As of 30.01.02

Dr. Roy Damary

Currencies (by GNI)


The main focus of the currency markets till the end of March will clearly remain the yen. The sell off in USD/JPY down to the critical support levels of 126.50, and in EURO/JPY to nearly 111.-, were very short lived and reversed in less than one week. Artificial government support for the Japanese stock market might relieve some of the pain for the book closing at the end of March, but it will not resolve the severe problems of the banking and insurance sector. We still believe in a lower yen over time.


So long as the situation in the Middle East fails to improve, the CHF will remain strong. Only technical corrections plus verbal interventions by SNB officials are temporarily helping to relieve pressure.


EUR/USD: It looks like that this pair will remain in a broad consolidation band of 0.8550 to 0.9030 for the foreseeable future. A clear break above 0.8880 might help the euro to test the upper side, direction 0.9000, while a move below 0.8780 would speak for a new downside test.


USD/CHF: Our price objective of around 1.6500 was soon reached. It looks like below that level good buying interest exists. A break 1.6780 on a weekly basis would be needed in order to retest 1.7000.


USD/JPY: The psychological barrier of USD/JPY 130.- needs to be held in order to open the door to direction 135.-again. Intermediate resistance is at 132.80 and 134.30. Any move below 130.- would spur a quick move down to 128.-, at least.


EUR/JPY: All the ground lost has been regained, and 114.80 and 114.20 remain key supports on the downside. If the rate goes above 115.00, it will be in a clear upturn again, with 116.30 followed by 117.50 and 119.- as the next targets.


USD/CAD: We are keeping our short position USD/CAD at 1.5955, with a S/L at 1.6300. The price objective is still around 1.5650.


AUD/USD: Higher commodity prices are giving some support to the Aussie. Major support is 0.5050. A weekly close above 0.5280 to 0.5330 would open the door for a higher Aussie, with the next objective at 0.5450.


GBP/CHF: With the break of 2.3850, our first price objective around 2.3500 has already been reached. Some consolidation is now expected in the 2.3400 to 2.3850 range; only a close above the latter level would take the pressure off the pound and again move it higher direction, 2.4000.



Current spot level
Current spot level
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