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Dicam sticks to bonds and cash

The mature world economies are expecting slower world growth and falling inflation, with the risk of deflation in the Japanese economy. World growth in 1996 and 1997 was approximately 4% per annum. The latest consensus forecasts for world GDP growth are closer to 1.5% for 1998 and 1999: the lowest figure since the early 1980s. Forecasts for inflation suggest that the eurozone will have stable levels of inflation over the next couple of years. In Japan, the consensus is for inflation to be negative next year, ie, prices are expected to fall by 0.3% overall.

Weak political leadership in the major economies suggests no significant co-ordinated response to global crisis and problems will probably continue. Last month was one of the worst for Fed Chairman Alan Greenspan's credibility with the bailout of Long Term Capital Management. With Western analysts encouraging Asian governments to let weak financial institutions fail, Greenspan appears to have lost some moral authority by supporting an institution that was aware of the risks it was taking. The moral hazard argument suggests the whole system of risk and return will be distorted if companies believe the Fed will support them if they get things wrong. Clearly, Greenspan felt the systemic risk to the banking system outweighed the negative implications of bailing out LTCM.

Contagion problems affecting global markets may spread to Brazil, which may in turn have a profoundly negative impact on the US equity market. Brazil is the focus of attention as the next potential victim for currency devaluation. It has a large current account deficit, a significant amount of short-term debt outstanding and the currency is estimated to be overvalued by as much as 20%. With the current rate of capital outflow, analysts estimate that Brazil has enough foreign exchange reserves to last until the year-end to sort out its problems.

There is evidence of global liquidity drying up. Investors are winding up their international positions and retreating home. Countries most dependent on regular inflows of international capital fare worse. The risk premium for high-yielding assets has been rising. Looking at the spread on emerging market bonds versus US Treasuries and the spread on single A-rated industrial bonds versus US Treasuries, we can see that the spreads are at historically wide levels.

A further sell-off in emerging and mature bond and equity markets may occur if hedge fund and other leveraged positions continue to unwind. Nobody knows the full extent of how much global leverage there is in the financial system. Whatever the level, it is now being unwound at a rapid pace. The authorities are not concerned to try and prevent this destruction of excess liquidity, but are concerned to prevent it infecting the whole economy with a full-blown liquidity crunch. The outlook for major currencies is now unclear. Despite the negative fundamentals for the yen, the impact of leverage unwinding has led to yen strength.

There is a higher probability now of interest rates falling sharply in the Anglo Saxon economies. They may also start to come down in Europe soon, as the huge level of global leverage requires much easier real interest rates to alleviate the problems. Extreme investor risk aversion and the unwinding of leveraged trades suggests that the markets are going through a period of declining liquidity possibly leading to a credit crunch. As global liquidity shrinks, the expected bid-offer spread on bonds will widen.

Stephen Inkley is head of fixed income at Dicam in London

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