With all eyes on tomorrow’s inflation data (will Mervyn be forced to write a somewhat embarrassing letter explaining why inflation has breached its upper target ?) a report from the Virgin Money Group show football fans are suffering more than most. The Football Fans Price Index shows that the cost of attending games has risen 8.3% in the last three months and a whopping 17.1% in the last twelve. According to the survey it now costs a massive £91.29 to attend a Premiership game once you account for tickets, travel and other expenses. Having attended most of Liverpool’s away fixtures this season I cant say I’m surprised to learn that England tops the league for the most expensive average match ticket in Europe; what a shame we can’t transform that supremacy onto the pitch!

I thought it would be useful to explain the key positions in the new M&G Optimal Income Fund and how I am making use of the “wider powers”, so that readers can get a better understanding of my strategy for international bond (and indeed equity) markets.

A prevailing view over the past 18 months has been that the market’s expectations of interest rates have continually been too low, and my long-only bond funds have been very short duration since summer 2005. Back in August 2005, the Bank of England had just cut rates from 4.75% to 4.5%, and the market was pricing in one interest rate cut. How wrong the market was – yesterday’s rate hike was the third since August 2005 and there are very likely to be more on the way. This duration call turned out to be spot on and the M&G Corporate Bond Fund achieved top quartile performance in 2005 and 2006, although frustratingly, the fund only just succeeded in breaking even last year. In a long-only bond fund you are always a victim to market conditions.

I believe there are likely to be at least two more rate rises in the UK, and the bond portion of Optimal Income has an exceptionally short duration of just 3 years. On top of this, I sold a significant amount of sterling interest rate futures in December and the beginning of January, which has added to performance since launch (particularly yesterday)

With wider powers, I am now able to accurately express my yield curve view for the first time. I believe global investors are being too conservative on their interest rate forecasts and expect short dated bond yields to continue rising as interest rates go up. Long dated bonds should fare much better, thanks to ongoing support from pension funds. In the US and Europe, I have sold short and medium-dated bond futures, and have bought long dated bond futures. In the UK, long dated bond futures do not exist so I have sold 10 year gilt futures and bought 30 year gilts, which still accurately reflects this view.

As for asset allocation, investment grade corporate bonds form just over 50% of the portfolio. High yield bond valuations are not overly enticing on the whole, and high yield forms 30% of the fund. This is only slightly above the 20% minimum that must be held in high yield corporate bonds in order for the Fund to qualify for the IMA UK Other Bond sector.

Equity exposure stands at just over 10%, and I expect to build this up closer to the maximum 20% limit as opportunities become available. Equity markets still look relatively cheap versus bond markets (and very cheap versus high yield bonds). The equity holdings in the fund are all where a company’s earnings yield looks very attractive versus that company’s bond yield. Equity selection is made in close consultation with M&G’s Equity fund managers and analysts, particularly with the Global Equity team.

The Bank of England has just hiked to 5.25%. Their statement is here. The Bank expects inflation to rise further in the near term, with limited spare capacity in the economy. However they do expect the impact of falling oil and the stronger pound to lead to inflation falling back in the medium term. The risks however are “more to the upside”. We think the Bank still has more to do.

Moody’s this week published its December 2006 default report showing a fall from 1.8% to 1.7% marking its fifth consecutive annual decline and its lowest year-end level since 1996. Accommodative monetary policy, high levels of liquidity and a willingness to come to the aid of companies in financial difficulty has helped keep rates at historical lows. Worldwide in 2006, a total of 27 Moodys rated corporate bond issuers defaulted on $7.8bn equivalent of bonds compared with 34 and $29bn the previous year. In fact in Europe a mere four corporates (Damovo (telco equipment), Dura & GAL (auto suppliers) and Luxfer (engineering)) defaulted on their obligations in 2006 to the tune of $1.2bn.

The obvious question then is where will the default rate head in 2007 and onwards? Moodys has 2.6% pencilled in for year end ’07 though they had been projecting a rise during most of 2006 and got that one wrong! I think the answer requires a two part explanation. Firstly the larger macro picture will prove to be key. If monetary policy remains accommodative through 2007 then liquidity is unlikely to disappear and prove supportive of a low default rate. Secondly the arithmetic behind the default calculation is worth a mention. The default rate during the early part of 2006 was particularly low. Even if we were to see default rates at the same pace of H2 2006 then the default rate is likely to tick up.

In my opinion the likelihood is that Moody’s will be proved correct. It doesn’t take a genius to conclude that the path of least resistance from a 10 year low is higher, but as ever, timing will be key!

I took Monday off to look after the nipper, and took him to see The Wizard of Oz at the wonderful Electric Cinema on the Portobello Road. You all know the film, but less well known is that L. Frank Baum wrote the book as a parable about US monetary policy. In the late 1890s presidential candidate William Jennings Bryan campaigned to have silver’s ratio to gold fixed at 16 ounces silver to 1ounce gold (ounce = Oz, geddit?) in order to stop the banks manipulating the relative prices.

The Tinman represents US manufacturing industry, rusted up as the result of the 1893 depression. The scarecrow represents the naive farmers. The yellow brick road is the gold standard. The wicked witches are the bankers. Finally the Emerald City represents the illusion of paper (green) money, the power of which proves to be all smoke and mirrors.

Anyway, for the record the ratio of silver to gold now stands at 49:1 rather than 16:1, the power of paper money seems to have been relatively durable, and the nipper had a nice afternoon out.

Germany hiked its rate of VAT on the 1st January, from 16% to 19%. Given the size of the German economy, the impact of this will be to raise Eurozone inflation by around 0.3-0.4%. Eurozone inflation is running at 1.9% year on year, only just below the ECB’s comfort zone (“below but close to 2%”), so during 2007 we’re likely to see price rises sufficient to provoke further rate hikes. There are two other issues – will German consumption collapse as the result of this price shock, and will wages rise to compensate workers for these higher prices?

Firstly consumption. The big worry is that Germany behaves like Japan did in 1997 – the economy there was only just showing signs of recovery, and the authorities optimistically decided that it could withstand a rise in consumption tax from 3% to 5%. It couldn’t, and whilst there was a consumption boom immediately before the tax hike came into force (consumption growth ran at a +6.6% yoy rate), it collapsed subsequently, and has really yet to recover fully. There’s evidence that Germans have also brought their major purchases forward into November and December, with new car registrations in November up 18% year on year, and retail sales also growing. There’s therefore a real risk that there’s payback in the next few months, and if the ECB hikes into this consumer weakness Germany’s fragile recovery could go the same way as Japan’s did in 1997.

Secondly wages. Germany’s most important trade union, IG Metall, believes that its workers have had a raw deal over the past year. There’s been a significant increase in productivity, yet wage growth has been modest – in other words German company profits have been boosted at the expense of labour. Probably helps explains the great performance of the DAX in 2006 (up over 20%). Union officials are looking for wage rises of 4% for the economy overall, and up to 7% in highly profitable sectors. “The wage increases have to cover the inflation rate, and the VAT of 19% in January has to be taken into account as well. And beyond that workers want to participate in profit growth” said Juergen Peters, IG Metall chairman.

The market’s expectation for Eurozone rates in 2007 is that the ECB will hike once or twice, from 3.5% to 3.75% or 4%. Wage hikes of 7% for significant numbers of German workers would certainly put the upper end of this range at risk.

As many of you will be aware we have been concerned about the high yield market for a while now. Historically tight spreads do not, we believe, adequately reward investors for the risks that they are being asked to take although we have been well aware of the technical picture which has proved supportive of spreads. However, a piece put out by JP Morgan yesterday highlighted a few interesting points.

The European High Yield Market (EHY) was characterised in 2006 by a supply demand imbalance. Issuance during the year totalled €28bn. At the same time we saw redemptions of €22bn (ie bonds that matured or were refinanced), coupon payments of €5-6bn as well as what JP Morgan describe as a ‘significant capital inflow’ into the market. These technical go some way to explaining the 11.10% total return for the Merrill Lynch European High Yield Index in 2006. The obvious question, will they persist in 2007?

JP Morgan calculate that €6.2bn of paper is due to mature in 2007. Currently a further €3.5bn of high yield debt is trading above its call price incentivising companies to repay this debt which suggests €10bn may be repaid to investors. This is significantly less than what we saw in 2006. Clearly there will be further unexpected refinancings though I’d suggest these are unlikely to make up the shortfall. Could a large LBO and subsequent EHY issuance prove to be the straw that breaks the camels back?

Looking at the broad categories of the UK’s RPI numbers here’s a brief breakdown of where the inflationary – and indeed deflationary – pressures are occurring. The most recent inflation number we have is for November. The headline RPI was +3.9%, year on year.

Components rising more quickly than average
– Fuel and Light: up 29.5% from a year earlier. Although crude oil prices were only up 11% over the same period we’ve experienced significant rises in utility bills.
– Housing: up 6.6%. Driven by higher house prices, higher council taxes, and higher mortgage interest payments. These are excluded from the narrower CPI measure, which in part explains why CPI is lower than RPI. See here for the Office of National Statistics explanation for the differences in the measures.
– Housing Services: up 5.3%. Probably related to the stronger housing market. New migrant workers from the new EU members might put downward pressure on this component as they join the UK labour force?
– Food: up 4.5%. A major component of food prices is the cost of energy. Transportation costs are a big input, and fertilizer is often petrochemical based. Difficult weather conditions have also caused food prices to rise. Seasonal food price rises were extremely strong (+10.7%).
– Tobacco: up 4.1%

Components rising slower than the average
– Leisure Services: up 3.1%
– Personal Goods & Services: up 2.9%
– Alcoholic Drink: up 2.8%
– Catering: up 2.7%
– Travel Costs: up 1.5%. May be upward pressure on this as the result of significant rail fare increases in January. However, demand for air travel may fall as a result of recent travel chaos (terror alerts, fog, baggage problems, potential strike action in Q1), which may lead to some bargain flight deals.
– Household Goods: up 1.4%. The China effect – although less pronounced than in 2005 where we had deflation here.

Components currently in deflation
– Clothing and Footwear: down 0.4%. Again the impact of cheap production in the far east is a major factor, but deflation in this sector is much lower than it used to be. In 2002 this sector saw year on year price falls of 6%. Some very mixed signs from UK retailers over the Xmas period means we need to pay close attention to discounting here.
– Motoring Expenses: down 0.9%
– Leisure Goods: down 1.6%

If you’re looking for future bargains, the biggest acceleration in deflationary pressures appear to be in TVs (falling at around 20% pa) and cameras (down around 5% pa).

Enron is still a case study for the rating agencies – they rated it investment grade 5 days before it went bust. Malcolm Gladwell has written an article (click here to read article) in the current New Yorker about the perils of having too much information to analyse and how everyone was missing what was going on at Enron even though the financial statements were revealing a lot of it.

A recent report from the Pensions Regulator states that the UK’s pension fund liabilities exceed pension fund assets by £440bn. The calculation is now a little out of date as it was made on March 2006, so given that bond yields and equity markets have both risen since then, an up-to-date calculation would likely show that pension fund deficits are now marginally smaller. Nevertheless, the estimate of £440bn is considerably higher than many of the deficit figures that have been published in the media over the past few months.

As we have previously argued in this blog, pension fund deficits will shape financial markets and particularly bond markets over the coming years, as companies purchase long dated assets to match with outstanding pension fund liabilities. The £440bn estimate suggests that the pension fund crisis will have an even larger impact than we thought – to put this number in context, the size of the long dated gilt market and long dated corporate bond market combined is around £210bn.