Bond Outlook [by bridport & cie, July 30th 2003]

Last week we got our vexation about the "greenscam" off our chests. This week we have to come to terms with a recommendation to long maturities two months ago which proved wrong. The quality bond is not such an attractive investment at present. Not that there are many great alternatives for investors in this world of poor returns and greater downside risk than upside potential. We address a question today which we first alluded to in early 2000, when we wrote that the financial world was entering a decade of poor returns, in which "lower interest rates alone" could not solve the problems created by the imbalances of the US economy. All the imbalances have worsened since then, with the only glimmer of light being the weaker dollar, which should, in two or three years after the currency's fall, wash through to improved US exports. We had thought that corporate indebtedness was declining, but have been sharply disillusioned by an analysis by Independent Strategy which shows that the debt to equity ratio of non-financial corporations is still rising, and that, if the pension fund shortfall is added back in, corporate indebtedness is even worse. When corporate debt is issued, la GMC, specifically to cover pension shortfalls, it is another sign that capital expenditure is very low on corporations' agendas.


Let us summarise the bridport view of the economy as developed over the last months and years, but updated by our experience of the greenscam:


  • The US economy is fatally flawed because of over-indebtedness
  • If yields were going up because of credit demand for productive investment, it would be a good thing
  • If, as we believe, yields are going up because of increased borrowing needs by Federal and State Governments, and corporate borrowing for non-productive debt adjustment, it is bad thing
  • Economic expansion is therefore destined to remain slow for years to come
  • The Fed will keep short-term rates low, so the yield curve, already steep, will steepen further
  • The dollar will weaken further
  • The yen, renminbi and other Asian currencies must eventually revalue
  • The mortgage refinancing boom in the USA has ended, removing the main support for US consumers spending more than they earn
  • Real property prices in the USA and UK are ready for a fall
  • Inflation will return to the USA as the cost of inputs (commodities) increases with the falling dollar and the price inflation already seen at producer level washes through to consumer prices
  • For future economic salvation, look not to the USA but to Asia (and to lesser extent) to the former Soviet bloc, where domestic demand is ripe for expansion
  • Europe will be somewhere in-between: many of the USA's problems affect Europe, too, but the deflationary risk remains a serious "competitor" to the stagflation risk (consumers have room to consume, but Government borrowing will, as in the USA, push up yields).


In such an environment, there are not many places to run to. Bond portfolios must be quite short in maturity. In changing our recommended average maturities to three years, we are bowing to the inevitable. In practice, it means fixed-income investors should put new cash into floaters, privileging the euro over the dollar. Indexed bonds have taken a beating recently, but the return of consumer price inflation that we expect implies an honourable place for them in fixed-income portfolios. A play on Asian currencies (rather than bonds) also seems appropriate. Otherwise "cash is king".


In further reminiscence of our views when the bubble burst over three years ago, we said then that asset protection had to be put before the search for return. In fact, bonds have given returns, but their glory days look like they have ended for a while. The post-Iraq equity bounce is losing steam even in technical terms, never mind fundamentals. Our 2000 stress on asset protection is more than ever appropriate. If you are worried about a return to the 1930s, switch at least some of the "worry factor" to the early 1970s.


Recommended average maturity for bonds in each currency



As of 02.07.03
As of 30.07.03

Dr. Roy Damary
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