Credit contraction will be good for gilts
The classic flight to quality as risk aversion mounts is from lower rated corporate bonds to sovereign bonds such as UK gilts. The value of the former becomes damaged whilst the value of the other rises, this is known as widening credit spreads. Therefore, it’s not a bit surprising that gilts have done very well. We have long said that this would happen. On further gilt strength, we will look to increase portfolio exposure to this asset class. Currently, most portfolios have exposure of about 20%.
According to the minutes just published, the MPC unanimously voted to hold interest rates at 5.75%. Surprisingly, it was reported that most members emphasised they had no firm view on whether rates would need to rise further. By then, they obviously knew what we didn’t know which was that the July Consumer Price Index rose much less than had been expected, 1.9% compared to 2.4% in June, analysts had expected 2.3%. It has been our view throughout that the inflation risk was credit and asset value driven and, in the same way that the credit expansion was inflationary, so the credit contraction would be equally deflationary. On further credit contraction the outlook for long-dated UK gilts is just tremendous.
David Rosenberg, US Economist at Merrill Lynch, has said that their model takes into account the risk of a 15% equity correction, a near 100 basis points widening in credit spreads and another 5% off US house prices. It forecasts the Fed to cut interest rates, by mid 2008, from 5.25% to 3.75%. The futures market seems to be in agreement, which is an emergency Fed cut before the September meeting and two more before August 2008.
It is an inevitable consequence of the credit contraction that short-term and long-term interest rates will head much lower whilst asset prices will become distressed because of much tighter credit markets.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit http://www.rhasset.co.uk/
