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International Bond Market Update

Written by Peter Vutz, Head of Corporates;
International & Non-Dollar

The year 2009 will go down in history as the year governments around the globe successfully stared down the Great Recession. However, the cost of rescuing the world was enormous and future generations will have to foot the bill. While our outlook for the U.S. economy is optimistic, we expect an extreme dispersion of growth prospects around the globe.

The People's Republic of China came to the world's rescue in 2009. Not only did the Chinese help to fund our ever-growing budget expenditures here in the United States, but they also stimulated their domestic economy with aggressive investment programs. The Chinese economy is expected to grow at a rate of between 9% and 10% real GDP in 2010. The combination of easy money and an undervalued currency might cause the Chinese economy to overheat, and could also lead to a dangerous speculative asset bubble. Furthermore, there is a risk that politically motivated rhetoric from both U.S. and Chinese officials debating the "fair value" of the renminbi might flare up at any time, leading to threats of retaliatory trade sanctions.

In Japan, we expect an anemic recovery, which is threatened by chronic fears of deflation (the consensus forecasts for 2010 real GDP growth and CPI are 1.4% and -1.3%, respectively). The problem in Japan is further compounded by an aging population, which has created an insufficient demand for consumer products. In the age of the global debt supercycle, all eyes will be on the new government, its budget and any potential action by the rating agencies. While we do not expect it any time soon, we cannot rule out a downgrade of Japanese debt in the future.

The recovery of the eurozone economy continues to be a tale of the "haves" and the "have-nots." We expect Germany to grow by 2.5% (the consensus forecast is 1.9%), but fear that Spain's economy will continue to contract in 2010. Unemployment is expected to stay at high levels of around 10% in Europe (with Spain at an astonishing 20.3%). Inflation appears to be well contained for the time being, but we are concerned that the deterioration in public finances throughout Europe, whether at the federal or the municipal level, will lead to unprecedented increases in indirect taxes such as the fees levied for public services, including trash collection, permits, and parking.

When we look at Europe, we also have to address the "Greek Tragedy." The incoming, left-wing government was punished as rating agencies downgraded Greece from A- to BBB- with a negative outlook, and as Greek debt instruments experienced dramatic spread widening. A projected public sector debt-to-GDP ratio of 123% in 2010 and a budget deficit-to-GDP ratio of 12.7% not only violate the European Union stability criteria of 60% for the former and 3% for the latter, they are also a recipe for disaster. Greek debt came under pressure when market participants feared the worst: a path that would ultimately lead to default. The government presented a plan to reduce its debt burden and budget deficit to levels within E.U. criteria by 2012; but only time will tell if the administration will be successful, and we remain skeptical.

The turbulence surrounding Greece weighed on the euro at year-end. Some market participants even debated whether problems in Athens could force the country to abandon the common currency. While we do not underestimate the challenges ahead, we also do not believe that these fears are justified—there is simply too much at stake. The reintroduction of the Greek drachma would cause massive devaluation speculation in Greece that would likely lead to social unrest and put the country at risk of being ostracized by the rest of the European Union. On the flip side, a euro that excludes Greece would almost certainly have the foreign exchange speculators putting a bull's eye on their next target, which would most likely be either Spain or Portugal (whose budget deficits and domestic problems have already triggered downgrades by S&P). Notwithstanding clear language to the contrary in the European charter, we do not expect that other members of the eurozone would be willing to take the risk, and suspect that they will be supportive if necessary. Failing to do so would lead to a situation in which a euro issued in Spain, for example, could be worth less than one issued in Germany, and we do not believe this is a viable option.

Last but not least, the United Kingdom should finally have its long-anticipated elections in May. The prospect of a hung parliament makes the markets shudder, given the number of challenges the country is already facing. The economy is expected to grow modestly with a consensus forecast of 1.2%, but the United Kingdom is already experiencing a mild upturn in inflation that should be slightly concerning for the Bank of England. The public sector finances are worrying the financial markets and the rating agencies. While its coveted AAA rating seems to be safe for now, we believe that the United Kingdom is in real danger of losing it unless the incoming government is willing to make some unpopular choices to rein in its budget deficit.

The bet on virtually indifferent spread tightening has largely run its course, and security selection will be the key theme in 2010. The market will continue to pay close attention to the action of rating agencies and the perceived credit quality of government borrowers. Central banks are expected to carefully signal their intentions to mop up excess liquidity. Nevertheless, we continue to be concerned that central banks around the globe will not be able to strike the fine balance of effectively draining 2009's massive liquidity injection without pricking the next speculative asset bubble or endangering the recovery by tightening to soon. The global debt supercycle suggests that interest rates are going to continue their upward trend, driven by the massive supply of government bonds worldwide.

We expect the dollar to modestly appreciate versus most currencies due to the improving economic prospects in the United States. However, the recent dollar strength should not be seen as a ringing endorsement of American policies, but rather the result of the greenback profiting from troubles in other countries and currencies. Any further unexpected deterioration of our finances, such as massive expansion of entitlement programs, would undermine the potential for the dollar's recovery.