Islamic Debt to Rally on Nakheel Recovery, GE Sukuk

By Laura Cochrane and Haris Anwar

Oct. 26 (Bloomberg) -- Islamic bonds are poised for record gains amid confidence that Nakheel PJSC, the developer of palm- tree shaped islands off the Dubai coast and the market’s biggest issuer, will avoid default.

“Nakheel is the flagship,” said Yannick Lopez, who helps oversee Paris-based OFI Asset Management’s $30 billion in assets. “A default by Nakheel could have wider implications” on the Islamic bond market, he said. “Our view is that the probability of default on this name is quite low.”

Almost non-existent a decade ago, the Islamic bond market has grown to $130 billion, according to Moody’s Investors Service. Prices are rebounding after three defaults in the past year because investors expect Dubai’s government to prevent state-owned developer Nakheel from failing to make payments on its obligations. The company’s bonds due Dec. 14 rose to a record 108 cents on the dollar this month, up from 93.5 on Sept. 2 and 70 percent higher than a February low.

Securities that follow Shariah laws, known as sukuk, have returned 27 percent this year, an HSBC Holdings Plc index shows. Last year, the market fell four times as much as investment- grade corporate debt that doesn’t comply with religious edicts against interest payments as oil prices tumbled and credit markets froze.

Sales to Double

The bonds are climbing almost twice as fast as global companies’ non-Islamic debt and heading for the best annual gain since the benchmark HSBC/Nasdaq Dubai Sukuk Index’s introduction in 2005. Sales of international Islamic debt will double in 2010 to $14 billion as businesses including General Electric Co. plan debut issues, HSBC says.

The Dubai government yesterday set up a $2.5 billion Islamic bond program as part of a $6.5 billion fund-raising plan, as the emirate seeks to sell international bonds for the first time in more than a year. The sale may take place as soon as next week, said two investors who didn’t want to be identified because meetings are private.

Nakheel, a unit of government-controlled Dubai World, owes more than $5 billion by 2011 in Islamic bonds and is among the biggest losers in a real-estate crash that cut home prices in half. The company is a “litmus test” for the debt of other emirate-owned enterprises, Moody’s said in June.

‘Uncertainty’

Dubai World has guaranteed Nakheel’s December bond, the offering prospectus says. Standard & Poor’s in June downgraded Dubai World’s companies citing “uncertainty” over the emirate’s willingness to help the firms pay their debt. Dubai World may be able to sell bonds to refinance Nakheel’s obligations, two bankers familiar with the group’s plans said last week.

“The United Arab Emirates authorities are acutely aware of the amount of profile the Nakheel 2009 sukuk instrument has in the international capital markets,” said Chavan Bhogaita, head of credit research at National Bank of Abu Dhabi PJSC, the U.A.E.’s second-largest lender by assets. “In our opinion, they fully intend to repay this bond.”

Thomas Brund, who helps manage $3.5 billion in fixed-income assets at Sydbank A/S in Aabenraa, Denmark, said the region’s bonds have become too risky after the premium paid for owning them plummeted. The gap between average yields on Middle East debt and the London interbank offered rate for loans between financial institutions has fallen by half to about 300 basis points, or 3 percentage points, in the past six months, HSBC/Nasdaq indexes show.

‘Too Far’

“The spreads have gone too far,” Brund said. He has pared Gulf debt purchases in recent months because the premiums over Libor don’t “reflect the risks if things turn around again in the global economy,” he said.

Mohieddine Kronfol, the managing director at Dubai-based Algebra Capital Ltd., said his fund has returned 25 percent so far this year after buying Islamic securities when yields were near record highs in March.

“The question remains open of what to do from here? Decisions are harder than they were in March,” Kronfol said. Franklin Templeton Investments owns 40 percent of Algebra Capital.

Islamic debt is governed by Shariah laws barring investors from profiting from the exchange of money, as happens with interest payments on other bonds. Returns from exchanging funds for assets is allowed, as long as gambling, guns and alcohol aren’t involved. Bankers structure sukuk to generate income from real estate and other permitted investments.

Created in the 1970s after almost a 20-fold jump in oil prices over 10 years, the Shariah finance industry caters to the world’s 1.57 billion Muslims.

House Prices

Investors fled the Islamic-debt market last year. Sales of international and domestic sukuk plunged almost 55 percent to $14 billion as oil and real-estate prices slumped and eroded Middle Eastern wealth, Bloomberg data show.

Oil fell 54 percent in 2008, the most since at least 1987. Dubai home prices have tumbled about 50 percent from their peak in 2008’s second quarter and may drop another 20 percent this year after a construction boom created thousands of houses just as demand began to evaporate, Deutsche Bank AG said in June.

The HSBC/Nasdaq sukuk index declined 19 percent in 2008, the most since its inception and quadruple the 4.7 percent loss of investment-grade bonds in Merrill Lynch’s Global Broad Market Corporate Index. The slide worsened as investors fled all but the safest government debt after the collapse of subprime- mortgage securities froze credit markets in 2007.

Transparency

“Lack of transparency has become a hindrance in the market because the need for information and rating requirements are much higher these days,” said Harald Eggerstedt, a credit strategist in Edinburgh at bond broker and advisory firm RIA Capital Markets Ltd.

Some of the biggest Islamic debt losses were on Dubai-based companies’ bonds. DP World Ltd.’s 6.25 percent sukuk due 2017 lost 34 percent in last year’s second half and its yield spread over Treasuries reached 1,486 basis points in February, Bloomberg data show. Anything above 1,000, or 10 percentage points, is considered distressed.

Investors sold out of Dubai on concern it would struggle to repay $80 billion in debt after the credit crisis ended its four-year real-estate boom and forced the U.A.E. to work on a bailout of the emirate’s two biggest mortgage lenders. Sheikh Ahmed bin Saeed al-Maktoum, chairman of Dubai’s Supreme Fiscal Committee, said on Oct. 5 that he is confident the emirate can meet its obligations.

Aston Martin

The cost of protecting Dubai bonds from default has fallen to about 294 basis points from a peak of 977 in February, five- year credit-default swap prices show. The contracts, which get cheaper as perceptions of credit quality improve, remain the sixth costliest of 39 emerging markets, Bloomberg data show.

Several sukuk issuers have defaulted in the credit freeze’s aftermath. In May, Kuwait-based Investment Dar Co. reneged on a $100 million bond maturing in 2010, triggering concern about untested restructuring laws for such debt. The company, which owns half of luxury carmaker Aston Martin Lagonda Ltd. in Banbury, U.K., hasn’t reached a restructuring agreement with holders yet, the company said in an Oct. 12 e-mail.

Saad Group, in the Saudi Arabian oil city of Al-Khobar, also doesn’t yet have an agreement with holders of its defaulted $650 million sukuk, according to an Oct. 7 statement from bond trustee Citicorp Trustee Co. released by the Bahrain Stock Exchange.

Defaults

Houston-based East Cameron Partners LP, which issued $165.7 million of sukuk, sought bankruptcy protection in October 2008. The debtor is working on a “consensual plan of reorganization,” according to a Sept. 3 filing in U.S. Bankruptcy Court in Lafayette, Louisiana. “The case is still in that same posture,” said Michael H. Piper, a Baton Rouge, Louisiana, lawyer who represents unsecured creditors, in an Oct. 22 interview.

“There are only three to four defaults in the Islamic market, not 3,000,” said Sheikh Nizam Yaquby, a board member of the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions, in an interview. “Standards are in place” for defaulted securities, said Yaquby, who serves on the boards of about 40 firms, including New York-based Citigroup Inc., HSBC of London and Paris-based BNP Paribas.

Sukuk Sales

International sukuk sales will total at least $7 billion in 2009 and $14 billion in 2010, up from $5 billion in 2008, said Mohammed Dawood, a director of debt capital markets at HSBC, this year’s second-biggest underwriter of such bonds. Including domestic issues, total sales may hit $15 billion in 2009 and $20 billion in 2010, said Wan Murezani Mohamad, a senior analyst based in Kuala Lumpur at Malaysian Rating Corp.

International Finance Corp., a World Bank unit, said Oct. 21 that it wants to sell larger sukuk issues after it completes a $100 million sale this week. The state-owned Dubai Civil Aviation Authority may refinance $1 billion of debt due Nov. 2 with Islamic and non-Islamic bonds, two bankers familiar with the transaction said. Indonesia said it will sell its second sukuk in 2010.

This year’s 27 percent gain for the HSBC/Nasdaq sukuk index compares with a 14.7 percent increase for investment-grade corporate bonds in Merrill Lynch’s global gauge.

“We are seeing an extremely bullish and optimistic market,” Dawood said.

The recovery of global markets and investor appetite is encouraging borrowers outside the Gulf region to consider issuing sukuk for the first time.

General Electric Capital Corp., whose parent last year formed an $8 billion venture with Abu Dhabi’s investment company Mubadala Development Co., met with potential Islamic debt investors last week, said two bankers who declined to be identified because details are private.

‘New Entrants’

Asian companies and governments, which Standard & Poor’s says account for 60 percent of 2009’s Islamic bond sales, will lead the increase, said Mohd Effendi Abdullah, head of Islamic Capital Markets in Kuala Lumpur at AmInvestment Bank, the third- largest underwriter of sukuk this year.

“We have seen new entrants in Singapore and Indonesia, and potentially Korea and Japan as well,” he said.

Hong Kong’s government said in May it is changing its laws to facilitate Islamic finance. Abu Dhabi’s Tourism Development & Investment Co. offered $1 billion of sukuk Oct. 13 and ended up getting orders for $7 billion.

“The sukuk market is maturing,” said Yavar Moini, executive director of global capital markets at Morgan Stanley in Dubai. “Investors aren’t shying away.”

To contact the reporters on this story: Haris Anwar in Dubai on Hanwar2@bloomberg.net To contact the reporter on this story: Laura Cochrane in London at lcochrane3@bloomberg.net

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Ukraine’s Bailout Loan Depends on Policy, IMF Says

By Daryna Krasnolutska

Oct. 26 (Bloomberg) -- Ukraine’s government must endorse a package of policy steps and veto a wage and pension law approved by lawmakers before it gets the fourth chunk of a $16.4 billion bailout loan, the International Monetary Fund said.

The eastern European nation was due to receive $3.4 billion after a mission from the Washington-based fund arrived in Kiev on Oct. 12 to review implementation of economic reforms.

The IMF is demanding an “agreed policy package, including assurances that the wage and pension law approved by Ukraine’s parliament, which is at odds with the objectives of the authorities’ program, will be vetoed,” the fund said in an e- mailed statement yesterday.

Ukraine is relying on the loan, approved in November, to stay afloat after the global recession and credit crisis undermined demand for exports such as steel and hammered its banking industry. The IMF program was suspended for three months this year because of government disputes over state spending.

“Ukraine is interested in getting the IMF money as soon as possible as part of it is likely to be used to cover the state budget gap,” said Olena Bilan, an analyst at Kiev-based investment bank Dragon Capital. “I think it may take between two to three weeks for Ukraine to solve the issue.”

Failure to Comply

The loan program was renewed in May after Prime Minister Yulia Timoshenko pledged to narrow the state budget deficit. The country has received $10.6 billion in loan payments to date.

Ukraine’s 7.65 percent bond maturing in 2013 fell to 90.230 as of 10:15 a.m. in Kiev from 90.437 on Oct. 23 and its yield rose to 10.990 from 10.912, data compiled by Bloomberg show.

Ukraine has failed to comply with the loan’s terms, including raising natural gas prices for households and adopting laws needed to stabilize the financial system. At the same time, Ukraine’s parliament approved a law on Oct. 20 increasing social payments, including the minimum wage, in an effort to win voter support ahead of Jan. 17 general elections.

The IMF said in July that reducing the budget deficit would be key to releasing the next tranche. The government will run a budget gap equivalent to 8.6 percent of gross domestic product this year, the IMF estimates. That figure excludes the cost of rebuilding the financial industry.

“The mission found that the economic and financial situation in Ukraine is stabilizing as a result of policies under this program,” the IMF said yesterday. “Preserving these gains will require policy discipline and corrective actions in some areas.”

Wage, Pension Law

Timoshenko said on Oct. 21 she would ask President Viktor Yushchenko to veto the wage law adopted by the parliament as it “undermines the budget and fuels inflation.”

Yushchenko’s economic aide Roman Zhukovskyi declined to comment when asked whether the president will veto the law when called on his mobile phone today.

The economy contracted an annual 17.8 percent in the second quarter, after shrinking 20.3 percent in the three months through March.

Yushchenko and Timoshenko have clashed over fiscal policy. The president has criticized the government running a “huge” budget gap, while the opposition has blocked the passage of legislation through parliament until its demands for higher social spending are met.

To contact the reporters on this story: Daryna Krasnolutska in Kiev at dkrasnolutsk@bloomberg.net;

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Pound Is Poised for Goldman Rally Not Helping Brown

By Ye Xie and Anchalee Worrachate

Oct. 26 (Bloomberg) -- The U.K. pound, trading at the cheapest level against the euro in a decade, is making everything from Ipods to Toyotas less expensive for foreigners and turning Goldman Sachs Group Inc. into a sterling bull.

Purchasing power parity, a measure of the relative cost of goods, shows the currency is 22 percent below where it should be, according to data compiled by Bloomberg. Sterling hasn’t been so inexpensive since 1999 after Bank of England Governor Mervyn King flooded the economy this year with 175 billion pounds ($285 billion) buying government bonds to keep borrowing costs from rising as the economy shrinks.

“The U.K. is cheap, its properties are cheap, its companies are cheap,” said Stephen Jen, a money manager at BlueGold Capital Management LLP in London and the former head of foreign exchange at Morgan Stanley. “Friends and family who have visited me always complained about the cost of living in London, but they have since stopped complaining.”

U.K. assets from houses to soccer clubs have been discounted as the seizure in credit markets drove the economy into its worst recession since World War II, forcing Prime Minister Gordon Brown’s government to take stakes in two of the nation’s biggest banks. Brown, whose Labour Party trails behind the Conservative opposition by 17 percentage points according to an Ipsos-Mori Ltd. poll last week, must call an election by June.

Gross domestic product unexpectedly shrank 0.4 percent in the third quarter, the Office for National Statistics said on Oct. 23, continuing the longest contraction since records began in 1955.

Mergers, Acquisitions

Sterling declined 0.3 percent against the dollar to $1.6266 today, and fell 0.4 percent versus the euro to 92.38 pence on speculation the faltering economy would prompt the central bank to expand its asset-buying program. The pound had gained 1.2 percent versus the dollar and 0.7 percent compared with the euro in the four days before the GDP report.

The pound’s slide is fueling mergers and acquisitions in the U.K., bringing the first net inflows to the country in three years, Bloomberg data show. The last time that happened, in 2006, the pound jumped 2.1 percent versus the euro and 13 percent against the dollar, the biggest gain in 16 years.

Goldman predicted this month that sterling will appreciate 9 percent versus the euro to 84 pence by year-end, and by 14 percent to $1.85, even as U.K. debt quintuples as a percentage of gross domestic product. Jen sees the currency climbing 7.6 percent to $1.75.

Taylor Rule

Investors underestimate the risk of the Bank of England increasing its key interest rate from the current all-time low of 0.5 percent, according to a study by Frankfurt-based Deutsche Bank AG based on the Taylor Rule, an economics equation for predicting central bank moves based on policy makers’ tolerance for inflation and unemployment.

The Taylor Rule shows the rate should be about 2.75 percentage points higher, Deutsche Bank said in the report. Futures contracts predict less than a quarter-percentage point increase by April 2010, the biggest disparity among the Group of 10 economies, according to the study.

“The Bank of England is the most out of line among the G- 10 nations in terms of policy,” said Henrik Gullberg, a strategist in London at Deutsche Bank, the world’s largest currency trader.

King’s Comment

The rate is likely to rise to 1.25 percent by the end of 2010, with increases starting in the second quarter, according to the median of 10 economists’ estimates compiled by Bloomberg. The European Central Bank and Federal Reserve probably won’t boost borrowing costs until the third quarter, separate surveys show. Rates will rise “at some point,” King wrote in an opinion piece in Scotland’s Herald newspaper on Oct. 21, adding “it would be wise to take this into account.”

Consumer prices are poised to rise faster in the U.K. than in any other developed economy. The inflation rate in Britain will be 2.1 percent this year, compared with 0.3 percent in the euro region and a decline of 0.4 percent in the U.S., according median estimates in surveys by Bloomberg News.

The pound fell 4.4 percent against the dollar in August and September, the steepest two-month drop this year, amid speculation King and his Bank of England colleagues favor a weaker currency and expanding the central bank’s asset-purchase program. It lost 6.9 percent versus the euro, prompting Citigroup Inc. and BNP Paribas SA to predict sterling would reach parity with the 16-nation European currency by the first quarter of 2010.

Borrowing Binge

Brown is committing unprecedented amounts of cash to spur growth and rescue banks such as London-based Lloyds Banking Group Plc, the nation’s largest mortgage provider, and Royal Bank of Scotland Group Plc in Edinburgh, the 282-year-old lender that was Europe’s biggest bank by assets.

His Labour Party had the support of 26 percent of voters compared with 43 percent for the Conservatives and 19 percent for the Liberal Democrats, the London-based Ipsos-Mori market research company said on Oct. 20. Mori polled 996 people between Oct. 16 and Oct. 18.

The government’s budget deficit will climb to 175 billion pounds in the year ending March 2010, or 12.4 percent of gross domestic product, the most in the Group of 20, according to an April forecast from the U.K. Treasury. The deficit was 77.3 billion pounds in the first six months of this year, the largest for any half-year period since records began in 1946.

‘Ridiculously Cheap’

“The story in the U.K. is not great,” said Peter Lucas, an investment strategist in Jersey, Channel Islands, at RBC Wealth Management, which has $430 billion in assets. “There might be scope for the pound to rise in the near term, but these underlying issues do require the pound to be an undervalued currency for some time.”

Hedge funds and other large speculators held record wagers this month that the pound will decline against the dollar, with so-called net shorts increasing eight-fold from the end of August to 65,346 on Oct. 13, before declining to 43,318 last week, data from the Washington-based Commodity Futures Trading Commission show. The figures reflect holdings in currency- futures contracts at the Chicago Mercantile Exchange.

“Sentiment for sterling is extremely negative,” said Nigel James Rayment, a money manager in London at JPMorgan Asset Management, which oversees $1.3 trillion, including $60 billion in foreign-exchange assets. “Against the euro, it looks ridiculously cheap,” with fair value at about 80 pence, he said.

The pound may rally to $1.80 by year-end, according to Rayment, who co-manages the JPMorgan Sterling Managed Currency Plus Fund, which beat 89 percent of its peers this year with returns of 13 percent, according to Bloomberg data.

Foreign Buyers

Kraft Foods Inc., the Northfield, Illinois-based maker of Oreo cookies, bid 10.2 billion pounds for Cadbury Plc on Sept. 7. A Saudi Arabian investment firm backed by Prince Faisal bin Fahad bin Abdullah al-Saud, the chairman of sports investor F6, is considering buying a stake in Liverpool, the English Premier League soccer team, F6 director Barry Didato said Sept. 29.

Overseas companies announced or completed $34.7 billion of U.K. company takeovers this year, bringing a net $4.1 billion into the country, according to Bloomberg data. That compares with outflows of $2.3 billion in 2008 and $152 billion in 2007.

“Fresh money is coming into the U.K.,” said Thanos Papasavvas, who helps oversee $4 billion as head of currency management at Investec Asset Management Ltd. in London and increased bets this month that the pound will appreciate. “There’s enough doom and gloom on the pound, but investors are wrong-footed.”

Overseas investors bought 4.27 billion pounds more U.K. gilts than they sold in August, the most since February, Bank of England data show.

Stock Bargains

For Europe-based money managers, the average cost of buying U.K. stocks dropped 13 percent from a year earlier as the pound depreciated, according to Bloomberg data.

U.K. stocks outperformed their peers in Europe and the U.S. in the third quarter. The FTSE 100 Index rose 21 percent, its best performance since at least 1984, compared with a 17.8 percent gain in Europe’s Dow Jones Stoxx 600 Index and a 15 percent advance in the Dow Jones Industrial Average.

Consumers can snap up bargains too. A Toyota Motor Corp. three-door Yaris hatchback costs 9,905 pounds in the U.K., compared with 12,090 euros, which is the equivalent of 10,909 pounds, in France, according to the Web site of the Toyota City, Japan-based carmaker. A 160-gigabyte Apple Inc. Ipod Classic is priced at 183.90 pounds at Amazon.com in the U.K., versus 214.95 euros, or 193.97 pounds, in Germany.

‘Too Bearish’

Goldman Sachs advised clients to buy the pound in March, and dropped the recommendation when the currency climbed to $1.65 in June, a bet that returned 12 percent when accounting for changes in interest rates. It began backing the pound again on Oct. 15.

“The market is way too bearish on the U.K. economy and way too short sterling,” said Thomas Stolper, an economist at Goldman in London. “The Bank of England has a history of surprising the market.” King may boost rates as soon as April, said Stolper.

Barclays predicts the pound will rise about 8 percent to $1.76 in March, and gain 7.6 percent to 85 pence per euro.

“There’s more inflation pressure in the economy than people realize,” Paul Robinson, a currency strategist at Barclays Capital in London who worked as an economist at the Bank of England for 11 years until 2006. “The BOE is likely to tighten policy a bit earlier than the market thinks. Sterling has to appreciate as the clouds clear.”

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net

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Dollar Declines on Signs of Economic Recovery; Krona Advances

By Lukanyo Mnyanda and Yasuhiko Seki

Oct. 26 (Bloomberg) -- The dollar fell to a 14-month low versus the euro as an advance in stocks boosted confidence that the global economy is recovering, sapping demand for the U.S. currency as a refuge from the financial turmoil.

The dollar dropped the most against the Swedish krona as Stockholm-based Electrolux AB, the world’s second-biggest household-appliance maker, almost doubled third-quarter profit on demand in Europe and North America. South Korea’s won rose after the nation’s economy grew at the fastest pace in seven years. The yen and euro gained after China’s Financial News said the nation should boost reserves in the currencies.

“We’re back in the familiar role of the dollar weakening alongside stocks that are picking up,” said Neil Mellor, a currency strategist in London at BNY Mellon Corp., the world’s biggest custodian of financial assets. Currency markets may “be locked and loaded into this sort of frame of mind where the dollar goes lower as stocks edge up,” he said.

The U.S. currency weakened to $1.5031 per euro as of 8:41 a.m. in London from $1.5008 in New York last week. It earlier dropped to $1.5063, the lowest level since August 2008. The dollar also declined to 91.82 yen from 92.06 yen. The yen traded at 137.99 per euro from 138.15.

The MSCI World Index of shares climbed as much as 0.3 percent. Standard & Poor’s 500 Index futures expiring in December added 0.2 percent, indicating the benchmark for U.S. equities may open higher.

Shaking Off Recession

The dollar also declined against 12 of its 16 major counterparts on speculation reports this week will add to evidence that some of the world’s biggest economies are shaking off the worst of the recession.

A gauge of French household sentiment improved to minus 35 in October from minus 36 in September, a Bloomberg survey of economists showed before the Paris-based national statistics office releases the report tomorrow. The Conference Board’s index of U.S. consumer confidence increased to 53.5 this month from 53.1 in September, a separate Bloomberg survey showed before tomorrow’s report.

The Beijing-based Financial News, a newspaper affiliated with China’s central bank, said the nation should raise the amount of yen and euro in its foreign-exchange reserves while keeping the dollar as the main component.

“The Chinese article revived concern over the status of the dollar and triggered knee-jerk selling of the greenback,” said Yuichiro Harada, senior vice president of the foreign- exchange division at Mizuho Corporate Bank Ltd., a unit of Japan’s second-largest lender.

Korean Won

China is the biggest international owner of U.S. government debt followed by Japan. The nation’s foreign-exchange reserves, the world’s largest, surged in the third quarter as an economic recovery attracted speculative capital and a weakened dollar boosted valuations of its yen and euro assets. The holdings climbed about $141 billion to a record $2.273 trillion, the central bank said this month.

South Korea’s won climbed after a higher-than-forecast expansion in its economy spurred expectations its central bank will raise borrowing costs. Gross domestic product increased 2.9 percent in the third quarter from three months earlier, the central bank said today in Seoul. That was the fastest since the first quarter of 2002 and compared with a median estimate of 1.9 percent growth in a Bloomberg survey.

The won climbed 0.3 percent against the dollar to 1,177.90.

Higher Rates

The dollar traded at the highest level in more than a month versus the yen earlier on speculation the Federal Reserve will boost interest rates sooner than some economists forecast. The Wall Street Journal said Fed officials are likely to discuss next month how and when to signal the possibility of higher U.S. interest rates.

Members of the U.S. central bank are contemplating the best way to let the market know that a period of record-low rates will draw to an end, the Journal reported Oct. 24, without saying where it got the information. The issue may be “on the table” when the Federal Open Market Committee meets Nov. 3-4.

The Fed will increase the target rate for overnight bank loans to 0.5 percent in the second quarter of 2010, according to economists surveyed by Bloomberg. The Bank of Japan is projected to maintain interest rates at least until the end of the first quarter of 2011.

“Given the likelihood that the BOJ will lag behind other central banks in exit policies, there is a chance that the yen may replace the dollar as the most-favored funding currency for risk trade,” said Osao Iizuka, head of foreign-exchange trading at Sumitomo Trust & Banking Co. “This will put potential downward pressure on the yen going forward.”

BOJ Report

Benchmark interest rates are 0.1 percent in Japan and as low as zero in the U.S., making the yen and dollar favored targets for investors seeking to fund so-called carry trades. The risk in such transactions is that currency-market moves will erase profits.

The Bank of Japan will probably forecast this week that deflation will extend into fiscal 2011, an indication that borrowing costs are likely to stay near zero.

Consumer prices excluding fresh food, the bank’s preferred gauge of inflation, will tumble 0.5 percent in the year starting April 1, 2011, and economic growth will accelerate to 1.2 percent, according to the median estimate of 15 economists surveyed by Bloomberg. The central bank will release its semiannual outlook on Oct. 30.

To contact the reporters on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net; Yasuhiko Seki in Tokyo at yseki5@bloomberg.net

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S&P 500 Overvalued by 40%, Set to Fall, Smithers Says

By Patrick Rial

Oct. 26 (Bloomberg) -- The U.S. Standard & Poor’s 500 Index is about 40 percent overvalued and headed for a drop as central banks pull back on securities purchases that pushed up asset prices, according to economist Andrew Smithers.

Declines are also likely because banks will need to sell more shares to raise capital and restore their financial health, the economist and president of research firm Smithers & Co. said in an Oct. 23 interview at Bloomberg’s Tokyo office. A 40 percent tumble from the S&P 500’s price at the end of last week of 1,079.60 would take the gauge to 647.76, below its March low.

“Markets are very vulnerable to an end of quantitative easing,” said Smithers, 72, who recommended avoiding stocks in 2000 just as the U.S. benchmark entered a two-year bear market. “Central banks, they’ve got to stop some time and if that happens everything will come down.”

Central banks from the Federal Reserve to the Bank of England last year embarked on unprecedented measures to flood credit markets with cash in order to rescue the global financial system from the worst crisis since the Great Depression.

Those purchases may be nearing an end. The Fed’s emergency liquidity programs including the Term Auction Facility and commercial paper purchases have shrunk as the central bank completes the scheduled purchases of housing debt and Treasuries. Bank of England policy makers voted unanimously at their latest meeting to leave the asset purchase program unchanged, rather than move to increase it, minutes showed.

Asset Prices

Asset purchases have doubled the size of the Fed’s balance sheet to $2.1 trillion since the start of the current financial crisis. The Bank of England has spent 175 billion pounds ($286 billion) over the last seven months to rescue the economy.

The boost to asset prices globally helped send the S&P 500 up by 60 percent from its 12-year low on March 9. Crude-oil prices have more than doubled from last year’s bottom in December, reaching as high as $82 a barrel. This month, a Hong Kong apartment sold for a record price-per-square foot.

“Quantitative easing has set off another sharp, and so far containable asset bubble,” Smithers said. “But if it gets too high and starts to come down then we’ll go straight back” into recession.

The economist said that he stopped buying equities in the 1990s because of expensive valuations and began purchasing them again only for a brief period during the lows of the current crisis.

Tobin’s Q Ratio

Smithers, along with fellow economist Stephen Wright, argued that U.S. equities were grossly overvalued in a March 2000 book the two co-authored entitled “Valuing Wall Street.” The S&P 500 Index plunged 49 percent over 2 1/2 years from a record high reached that month.

He based his prediction in the book on Tobin’s Q, an indicator of whether the market is overvaluing or undervaluing company assets compared with their replacement cost. He uses both the Q ratio, as well as a cyclically adjusted price-to- earnings ratio compiled by Yale University’s Robert Shiller, for his estimate that U.S. shares are 40 percent overvalued.

In his latest book published in July, “Wall Street Revalued,” Smithers argues central banks need to police asset prices such as equities, real estate and debt in order to prevent the bubble and crash cycle seen in recent years.

Imperfectly Efficient

In the book he proposes a successor to the efficient markets hypothesis, naming it the imperfectly efficient market hypothesis. Smithers, who worked for 27 years at S.G. Warburg & Co. where he ran the investment management business, contends that asset prices rotate around a fair value level that can be objectively measured, whereas efficient market theorists postulate assets are always valued at the correct price and therefore need no regulation by authorities.

Central bankers may be catching on. Federal Reserve Chairman Ben S. Bernanke said on Oct. 19 asset bubbles present a challenge that Asian governments will have to deal with in the future. That contrasts with his 2002 statement that monetary policy can’t be “directed finely enough to guide asset prices.”

Not all equity markets are as overpriced as the U.S., Smithers said. Japan may be the world’s cheapest major market though he doesn’t forecast short-term gains from betting on the nation’s stocks.

Cheap Japan?

Profit margins at Japanese companies are likely to improve as companies invest less, lowering depreciation costs, he said. Depreciation eats up about two-thirds of earnings in Japan, compared with less than half for U.S. corporations, according to Smithers. Firms plan to cut capital spending 10.8 percent this year, the Bank of Japan’s quarterly Tankan survey released this month showed.

“It’s quite likely that Japan is the only significant market in the world that is not seriously overvalued,” he said. “When investment comes down, depreciation comes down.”

The economist also said banks such as Goldman Sachs Group Inc. will likely break up when they become subject to sliding- scale capital requirements that penalize them for being too large. Rising profits at financial institutions has largely been the result of shrinking competition in market-making, which has in turn provided banks with inside information on trading patterns, Smithers said.

“Market-making has become a doomsday machine,” Smithers said. “People are arrogant and think they can do wonders and they’ll be all too happy to split off. And you should raise the capital requirements until they do split off.”

To contact the reporter for this story: Patrick Rial in Tokyo at prial@bloomberg.net.

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Cotton, Sorghum Regions in Australia Get ‘Handy’ Rain

By Madelene Pearson

Oct. 26 (Bloomberg) -- Australia, the world’s fifth-largest cotton exporter, received some “handy” rain in recent days in growing areas and more falls are expected, the Commonwealth Bank of Australia said.

There may be as much as 25 millimeters (1 inch) to 50 millimeters of rainfall locally in southeast Queensland and northeast New South Wales in the four days through to Oct. 29, Robyn Duell, a climatologist with the Bureau of Meteorology, said today in an e-mailed statement. Widespread rainfall totals of 10-15 millimeters are likely in those areas, she said.

Australian farmers traditionally plant summer crops, including sorghum and cotton, at this time of year in the eastern states of Queensland and New South Wales. Rain was needed within a month for cotton farmers to plant a bigger crop than last year, industry group Cotton Australia said Oct. 13.

“Some handy rain has been experienced in Australian sorghum and cotton regions yesterday and this morning,” the bank said in a note to clients. “Further rain is expected over the next couple of days, providing a much improved environment for planting and emergence.”

Sorghum is mainly used as a livestock feed.

To contact the reporter on this story: Madelene Pearson in Melbourne on mpearson1@bloomberg.net

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China’s Refined Copper Imports Climb 29% in September

By Bloomberg News

Oct. 26 (Bloomberg) -- Refined copper imports by China, the world’s largest consumer, climbed for the first time in three months in September as increasing demand outweighed the higher costs of overseas material.

Shipments increased to 282,828 metric tons in September, the Beijing-based customs office said today. That’s 29 percent more than August, according to data compiled by Bloomberg.

Copper, used in pipes and power cables, has more than doubled in London this year as China’s 4 trillion yuan ($586 billion) stimulus spending and state stockpiling boosted imports to a record, and the world recovered from its worst recession since World War II, increasing demand for raw materials.

“Shanghai copper prices will continue to stay weak compared with London because of the gains in imports as well as in domestic production,” Li Ye, an analyst at Minmetals Starfutures Co. said from Shenzhen today. “That doesn’t seem to be stopping China from buying though.”

China’s copper output gained 8 percent to 395,000 tons in September, from a month ago, the statistics bureau said last week. That’s a record, Li said.

Exports of refined copper were 10,705 tons, 70 percent more than a month ago and the highest this year, the data showed.

“The monthly figure was quite a lot and was a result of inbound shipments remaining money-losing,” Zhao Kai, an analyst at Jinrui Futures Co. said today.

Copper for delivery in three months on the London Metal Exchange gained 0.5 percent to $6,680 a ton at 9:49 a.m. Shanghai time. The metal for January delivery on the Shanghai Futures Exchange added 0.4 percent to 51,550 yuan ($7,550) a ton at the same time.

--Li Xiaowei. Editors: Richard Dobson, Matthew Oakley.

To contact the Bloomberg News staff on this story: Li Xiaowei in Shanghai at Xli12@bloomberg.net

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Soybeans Gain as Rain, Cold Weather May Delay U.S. Crop Harvest

By Jae Hur

Oct. 26 (Bloomberg) -- Soybeans climbed, extending the previous three weeks’ 15 percent advance, on speculation that rain, snow and cold weather may delay the U.S. harvest, threatening to damage crop yields. Corn and wheat also gained.

Futures rose on the possibility of a snowstorm extending from the central and southern Rockies into the Plains in the middle of this week, forecast by AccuWeather.com yesterday. The oilseed advanced 3.1 percent last week, capping the longest weekly rally since early June.

“Soybeans were underpinned by forecasts for rain and cold weather in the U.S. Midwest, prompting speculation the oilseed harvest may be delayed further,” Takaki Shigemoto, a commodity analyst at research and investment company JSC Corp. in Tokyo, said today by phone.

Soybeans for January delivery added as much as 1.2 percent to $10.1925 a bushel in electronic trading on the Chicago Board of Trade and were at $10.18 as of 2:08 p.m. Tokyo time.

About 30 percent of U.S. soybean crops were harvested by Oct. 18, up from 23 percent a week earlier, and below the average of 72 percent over the previous five years, the U.S. Department of Agriculture said last week.

Corn for December delivery gained as much as 1.1 percent to $4.02 a bushel and last traded at $4.01. The grain touched $4.135 on Oct. 23, the highest for a most-active contract since June 22. The price climbed 6.9 percent last week, the third- straight weekly increase.

About 17 percent of the corn crop was collected as of Oct. 18, compared with 28 percent a year earlier and an average of 46 percent over the previous five years, according to the USDA.

China’s animal feed production in September gained 17.3 percent from the same month last year to 12.88 million metric tons, the China National Grain & Oils Information Center said in an e-mailed message, citing data from the Bureau of Statistics.

Wheat for December delivery added as much as 1.6 percent to $5.5625 a bushel in Chicago and last traded at $5.5525. The price reached $5.7475 on Oct. 23, the highest level since Aug. 4. The contract rose 9.8 percent last week, the biggest weekly advance since early April.

To contact the reporter on this story: Jae Hur in Tokyo at jhur1@bloomberg.net

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Japan Stocks Rise on Outlook for Train Orders, Profit Recovery

By Akiko Ikeda and Masaki Kondo

Oct. 26 (Bloomberg) -- Japanese stocks rose on speculation Chinese infrastructure spending will fuel growth for the rail industry and as earnings reports added to evidence companies are rebounding from the recession.

Kawasaki Heavy Industries Ltd. and Nippon Sharyo Ltd. gained more than 4 percent after the Nikkei newspaper said Japanese trainmakers will benefit from licensing fees and equipment orders. Toyota Industries Corp. climbed 7.4 percent after the car assembler posted a profit. Nippon Express Co. soared 10 percent after saying it will sell a unit, prompting at least three brokerages to boost their investment ratings.

The Nikkei 225 Stock Average rose 0.8 percent to 10,362.62 at the close of trading in Tokyo. The broader Topix index gained 1 percent to 910.72, as more than three stocks advanced as retreated.

“Companies’ desperate efforts to cut costs have resulted in a lower break-even point, and we’re about to see these positive effects in coming earnings reports,” said Hisakazu Amano, who helps oversee the equivalent of $19 billion at T&D Asset Management Co. “The scale of emerging economies has become significantly larger and there’s still room for personal consumption to grow.”

Kawasaki Heavy jumped 4.4 percent to 240 yen, its biggest increase since Aug. 13. Toyo Electric Manufacturing Co., which makes parts such as inverters for train cars, advanced 4.9 percent to 859 yen. Nippon Sharyo Ltd., which produces rolling stock, climbed 5.6 percent to 606 yen. A measure of trainmakers in the Topix had the biggest gain among the index’s 33 industry groups.

‘Brisk Auto Sales’

China has allotted 45 billion yuan ($6.6 billion) for high- speed rail cars, some of which will go to Japanese companies supplying technology and parts to Chinese manufacturers, the Nikkei newspaper reported.

Toyota Industries climbed 7.4 percent to 2,530 yen. The maker of cars and car parts posted net income of 200 million yen for the six months ended Sept. 30, exceeding its projection of a 9.5 billion-yen net loss, helped by government measures to boost demand for vehicles.

“We believe the upward revision was attributable to brisk sales in the auto-parts segment” and cost cuts overseas, Arifumi Yoshida, an analyst at Citigroup Inc., said in a note to clients. “Toyota Industries’ revisions to guidance have also raised expectations about results announcements from Toyota- affiliates scheduled for next week.”

Futaba Industrial Co., a muffler maker, added 3.9 percent to 486 yen. NGK Spark Plug Co. rose 6.4 percent to 1,042 yen.

Nippon Express Soars

Nippon Express soared 10 percent to 382 yen, the most since January 2000 and the sharpest advance in the Nikkei 225. The delivery company said on Oct. 23 after the market closed that it had cut its stake in JP Express, an unprofitable venture with Japan Post Holding Co., to 14 percent from 34 percent.

“We now believe the company’s ROE outlook for the next three years will improve,” Yasuhito Tsuchiya, an analyst at Bank of America Corp.’s Merrill Lynch & Co., wrote in a report. ROE refers to return on equity. Tsuchiya raised the shares to “neutral” from “underperform.”

Analysts at Mitsubishi UFJ Financial Group Inc. and Deutsche Bank AG also boosted their recommendations on the stock.

Chiyoda Corp. plunged by the daily limit of 100 yen, or 13 percent, to 694 yen, the sharpest decline in the Nikkei. The plant-engineering company slashed its full-year net income outlook by 60 percent because of project delays.

Acom Co., a consumer lender, fell 4 percent to 1,282 yen, the lowest since the stock went public in October 1993. The company said fiscal first-half net income was 85 percent less than forecast on interest-refund costs and reserves for possible loan losses. Acom had its 12-month share-price estimate slashed to 706 yen from 1,240 yen by Takehiro Tsuda, an analyst at Citigroup Inc.

K’s Holdings Corp., a chain of home-appliance stores, climbed 6.3 percent to 3,020 yen after raising its forecast for annual net income. DIC Corp. advanced 10 percent to 143 yen, the steepest advance since Oct. 28, 2008, after the maker of chemicals narrowed its forecast for a full-year net loss.

To contact the reporters for this story: Akiko Ikeda in Tokyo at iakiko@bloomberg.net; Masaki Kondo in Tokyo at mkondo3@bloomberg.net.

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Asian Stocks Rise on Toyota Industries Profit, South Korea GDP

By Masaki Kondo

Oct. 26 (Bloomberg) -- Asian stocks gained for a second day, led by automakers and consumer companies, after Toyota Industries Corp. reported an unexpected profit and South Korea’s economy grew at the fastest pace in seven years.

Toyota Industries, a parts manufacturer controlled by Toyota Motor Corp., jumped 7.4 percent in Tokyo, while Toyota Motor, the world’s biggest carmaker, rose 1.7 percent. JTekt Corp., another Toyota affiliate, climbed 3.4 percent after posting a narrower-than-estimated loss. Kia Motors Corp., South Korea’s No. 2 carmaker, added 1.9 percent after Credit Suisse Group AG upgraded the stock. Lotte Shopping Co. gained 1.6 percent after posting a 19 percent gain in third-quarter profit.

The MSCI Asia Pacific Index advanced 0.5 percent to 120.12 as of 5:51 p.m. in Tokyo, with four stocks rising for every three that fell. The gauge has climbed 70 percent from a five- year low on March 9 amid signs the global economy is bouncing back from its worst slump since World War II.

“Companies’ desperate efforts to cut costs have resulted in a lower break-even point, and we’re about to see these positive effects in coming earnings reports,” said Hisakazu Amano, who helps oversee the equivalent of $19 billion at T&D Asset Management Co.

Japan’s Nikkei 225 Stock Average rose 0.8 percent. The Kospi Index advanced 1 percent in Seoul after the central bank said the nation’s gross domestic product grew 2.9 percent in the third quarter from the preceding three months.

Australia’s S&P/ASX 200 Index lost 0.6 percent, with BHP Billiton Ltd. falling 1.2 percent after oil prices declined. Hong Kong and New Zealand markets are closed for holidays.

Toyota Industries

Among shares that slumped, Shin-Etsu Chemical Co. declined 2 percent in Tokyo after reporting a 65 percent tumble in first- half earnings. Acom Co. dropped 4 percent after Japan’s largest consumer lender by market value cut its dividend and reported first-half profit that missed its estimate.

Futures on the Standard & Poor’s 500 Index added 0.4 percent. The gauge lost 1.2 percent in New York on Oct. 23 as lower oil prices drove down Exxon Mobil Corp. and Schlumberger Ltd. Capmark Financial Group Inc., the lender owned by companies including Goldman Sachs Group Inc. and KKR & Co., filed for bankruptcy protection yesterday in the U.S.

Toyota Industries, 24 percent owned by Toyota Motor, jumped 7.4 percent to 2,530 yen in Tokyo. In a preliminary earnings statement, the company reported 200 million yen ($2.2 million) in net income for the six months to Sept. 30, compared with its forecast for a loss of 9.5 billion yen.

Kia Upgrade

The unexpected profit “was attributable to brisk sales in the auto parts segment,” Arifumi Yoshida, an analyst at Citigroup Inc., wrote in a report on Oct. 23. The company’s earnings “also raised expectations about results announcements from Toyota affiliates scheduled for next week.”

JTekt, 23 percent owned by Toyota, added 3.4 percent to 1,054 yen. Its six-month loss was probably 32 percent narrower than it had forecast because of cost cuts, according to a preliminary earnings statement from the company.

Toyota Motor added 1.7 percent to 3,650 yen and Honda Motor Co., which gets 47 percent of its sales in North America, climbed 3.4 percent to 2,900 yen. Both were the biggest contributors to the MSCI Asia Pacific Index’s advance.

Kia Motors added 1.9 percent to 18,650 won after Credit Suisse lifted the stock to “neutral” from “underperform.” Hyundai Motor Co., South Korea’s largest carmaker, climbed 4.1 percent to 114,000 won.

South Korean Growth

Lotte Shopping, the country’s largest operator of department stores, rose 1.6 percent to 326,500 won. The company’s third-quarter net income increased 19 percent as margins improved at its discount stores.

South Korea’s third-quarter gross domestic product rose 2.9 percent from the previous quarter, the central bank said today. That was the fastest pace since the first quarter of 2002 and compared with the 1.9 percent growth estimated by economists.

This month, reports showed an export decline slowed in China and U.S. service industries grew for the first time in a year. Amid signs the global economy is improving, Australia’s central bank unexpectedly raised its benchmark rate on Oct. 6 and has signaled further increases in coming months.

Shares on the MSCI Asia Pacific Index traded at an average of 23 times estimated earnings, compared with 18 times for the S&P 500 and 16 times for Europe’s Dow Jones Stoxx 600 Index. Higher valuations on Asian equities have caused concern among investors including T&D’s Amano about whether the current share prices can be justified.

Oil Producers Drop

“There is a doubt as to whether the fundamentals of the global economy and company earnings will improve as fast as share prices indicate,” he said. “It seems to me that the stock market is ahead of an actual fundamental improvement.”

BHP declined 1.2 percent to A$39.73, while Woodside Petroleum Ltd. lost 1.8 percent to A$50.85 in Sydney. Inpex Corp., Japan’s largest oil and gas explorer, fell 1.3 percent to 791,000 yen. Crude oil for December delivery declined 0.5 percent, adding to a 0.9 percent drop in New York on Oct. 23.

Shin-Etsu, the world’s largest maker of silicon wafers used in semiconductors, retreated 2 percent to 5,310 yen and was the second-biggest drag on MSCI’s Asian equity gauge after BHP. Net income tumbled 65 percent in the six months to Sept. 30. The global economy was still in a “severe” situation, the company said, refraining from giving a full-year forecast.

Mitsubishi UFJ

Acom, a consumer lender 37 percent owned by Mitsubishi UFJ Financial Group Inc., fell 4 percent to 1,282 yen. The company said first-half net income was 85 percent lower than its forecast on a preliminary basis and slashed its planned annual dividend by 83 percent. Citigroup reduced its 12-month share- price estimate on the stock by 43 percent to 706 yen.

Stocks on the MSCI Asia Pacific Index trade at the equivalent of 2.3 percent of the dividends the companies have paid during the past 12 months, the lowest level since June 9, 2008, according to data compiled by Bloomberg.

Hitachi High-Technologies Corp., a trader of electronics goods, dived 14 percent to 1,589 yen and was the biggest loser on the MSCI World Index. The company widened its full-year loss forecast by 11 percent after posting a loss in the first half.

To contact the reporters for this story: Masaki Kondo in Tokyo at mkondo3@bloomberg.net.

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U.K.’s FTSE 100 Gains; Rio Tinto, Lonmin Shares Pace Advance

By Alexis Xydias

Oct. 26 (Bloomberg) -- U.K. stocks advanced for a second day, as mining shares followed metals price higher. Rio Tinto Group and Lonmin Plc increased.

The benchmark FTSE 100 Index added 10.22, or 0.2 percent, to 5,252.79 as of 8:47 a.m. in London. The FTSE All-Share Index rose 0.2 percent and Ireland’s ISEQ Index increased 0.4 percent.

The FTSE 100 has surged 50 percent since this year’s low on March 3 amid speculation the worst of a global slowdown is past.

Rio Tinto, the world’s third-largest mining company, gained 0.8 percent to 3,024.5 pence. Lonmin, the third-biggest platinum producer, added 1.5 percent to 1,737 pence.

Copper for three-month delivery gained 1 percent to a 13- month high of $6,712 a ton in London. Lead, nickel and tin also rose on the London Metals Exchange.

British Airways Plc dropped 3.2 percent to 203.2 pence. Europe’s third-largest carrier was cut to “sell” from “hold” at Deutsche Bank AG, which said a merger with Iberia Lineas Aereas de Espana SA and anti-trust immunity with American Airlines “are at risk.”

To contact the reporters on this story: Alexis Xydias in London at axydias@bloomberg.net.

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Junk Bond Rally Signals Profits for Stocks as Markets Diverge

By Alexis Xydias

Oct. 26 (Bloomberg) -- The worst performance by U.S. stocks compared with junk bonds since at least 1986 is making investors even more bullish on equities.

While owning debt in the riskiest companies has paid about the same as the Standard & Poor’s 500 Index over the last 23 years, bonds are returning more than twice as much in 2009, according to data compiled by Merrill Lynch & Co. and Bloomberg. When high-yield credit beat the S&P 500 by 32 percentage points in the 12 months ending March 11, 2003, stock gains exceeded bonds by 19 percentage points for the rest of the year.

Barclays Plc and ING Groep NV are increasing share purchases on speculation that improving corporate earnings will prolong the rally in equities and shrink the gap again. Profits for S&P 500 companies are forecast to climb 53 percent over the next two years as the Federal Reserve holds interest rates close to zero to end the worst recession since the 1930s, according to analyst estimates compiled by Bloomberg.

“For the first time in a long while, equities appear inexpensive relative to corporate bonds,” said Kevin Gardiner, the London-based head of investment strategy at Barclays Wealth, which lowered its rating on fixed-income securities to “neutral” this month and recommended owning stocks. “Valuations and the likely news flow over the coming period will inspire people to take more risk.”

Fixed Income

Bonds rated below Baa3 by Moody’s Investors Service and BBB- at S&P are returning more after the worst recession in 70 years spurred purchases of securities that wouldn’t be erased in a bankruptcy. They rose faster than stocks as companies in the S&P 500 reported two years of declining earnings, the longest stretch since the Great Depression.

Merrill Lynch’s High Yield Master II Index has climbed 51 percent in 2009, extending an advance from last year that pushed returns to the highest level ever relative to the S&P 500, which has increased 22 percent, including dividends. That compares with average annual gains of 9.3 percent for equities and 8.4 percent for high-yield credit since 1986, when monthly data on Merrill’s index begins.

“There was a flight up the capital structure that swelled the interest in high-yield bonds,” said Kevin Starke, a CRT Capital Group analyst in Stamford, Connecticut. “Why own the equity of a company, which is almost a guaranteed wipeout in most bankruptcies, when you could own the bonds and have a shot at a recovery and still have an equity-like return?”

The cost of insuring bonds with credit default swaps fell 62 percent since March 9 to the lowest level since May 2008, according to Markit Group Ltd. New York-based S&P lowered its 12-month default-rate prediction on Oct. 21 for U.S. high-yield corporate credit to 6.9 percent, from 14.3 percent in April.

Mean Reversion

Returns evened out in the third quarter, when signs the U.S. economy was rebounding pushed the S&P 500 up 15.6 percent with dividends, compared with 14.8 percent for junk bonds. The gain was the first time the S&P 500 beat the high-yield index since the third quarter of 2008, the data show.

Investors say equities may outpace debt as the economy recovers. Gross domestic product is projected to expand 2.4 percent in 2010, according to the average estimate of economists surveyed by Bloomberg, compared with a prediction of 1.8 percent in March. Consumer confidence, U.S. retail sales and industrial production all grew more than economists forecast in reports released last month.

“Normally we had more 50-50 in stocks and bonds, and now we have two-thirds in stocks,” said Roland Schwab, a partner at Kraemer, Schwab & Co. in Zug, Switzerland, which oversees about $1.5 billion. “Stocks are definitely better valued now. In this situation, high-quality stocks are the place to be.”

Relative Value

Junk bonds beat shares by the most on record even with the S&P 500’s 62 percent return since March, according to data compiled by Bloomberg and Merrill Lynch. Before this year, the 23-year-old high-yield index had only once traded for more than half the price of the S&P 500, in 1994.

The gauge rose to 645.96 at the end of September, or 61.1 percent of the S&P 500’s price of 1,057.08. When the same ratio reached a record low of 23.9 percent in March 2000, junk bonds beat equities for three years.

McMoRan Exploration Co.’s 11.875 percent notes due in 2014 have returned 0.69 percent in October following a 54 percent rally this year through September, according to Trace, the bond- price reporting system of the Financial Industry Regulatory Authority.

Gas Rally

Shares in the New Orleans-based oil and gas producer soared 22 percent this month, compared with a 23 percent decline in the previous nine months. The rally followed a 21 percent advance in natural gas in September, the biggest gain since at least 2003, according to data compiled by Bloomberg.

The 8.75 percent notes due in 2012 of St. Louis, Missouri- based retailer Brown Shoe Co. jumped 33 percent between January and the end of September, excluding reinvested interest, according to Merrill Lynch & Co. data, while its stock retreated 5.3 percent. Shares in the company, which beat analysts’ profit estimates for three quarters, have rallied 46 percent since Sept. 30, compared with a 0.8 percent advance in the bonds, the data show.

“From a pricing standpoint, junk bonds have absolutely run their course,” said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $50 billion. Brady manages both stocks and bonds in the $3.8 billion Thornburg Income Builder Fund, which has beaten 98 percent of its competitors in the past five years.

Still Cheap

Peter Acciavatti, who runs the top-rated junk-bond research team at New York-based JPMorgan Chase & Co., said on Oct. 16 that high-yield debt is still cheap. Slowing job losses and an improving housing market will narrow yields relative to benchmark rates, he said. His team has been ranked first among its peers in Institutional Investor’s annual poll for the past seven years.

The Federal Reserve said Sept. 23 that it will slow its $1.45 trillion program of buying mortgage securities as an economic recovery takes hold. Chairman Ben S. Bernanke indicated for the first time since August 2008 that the economy is accelerating.

Executives are shifting their focus to expansion after preserving cash for most of the year, a strategy that will profit shareholders more than bond investors, according to Edmund Ng, a strategist at Morgan Stanley in London. U.S. companies are emerging from the worst recession in seven decades with a record $1.5 trillion in cash after slashing more than 7 million jobs since December 2007.

Beating Estimates

More than 80 percent of S&P 500 companies that have reported third-quarter results have beaten analyst earnings estimates, exceeding the record pace of 72.3 percent for the period ended in June. Gross domestic product grew in the U.S. at a 3.2 percent annual rate last quarter after shrinking during the previous year, according to the median estimate of economists surveyed by Bloomberg.

“While nine months ago it was time to prefer credit over equities, we think now it is time to flip the trade around,” said Ng. “The rapid repricing of credit in 2009, and a shifting economic and earnings backdrop, suggest that a strong asset allocation argument for credit which existed at the start of the year has now largely vanished, or even reversed.”

The S&P 500 has returned 2.2 percent in October including dividend payments, beating the 1.9 percent gain in Merrill Lynch’s high-yield index. The Dow Jones Industrial Average rose above 10,000 for the first time in a year after profits from JPMorgan Chase and Intel Corp. in Santa Clara, California, topped analyst estimates and the price of oil added 14 percent.

Rising Profits

Profits in the S&P 500 will increase 67 percent this quarter, according to analysts polled by Bloomberg. S&P 500 earnings will increase 25 percent in 2010 and 22 percent in 2011, the analyst data shows.

ING Investment Management, which oversees $507 billion, has equal amounts in stocks and fixed income, with a preference for investment-grade debt over high-yield bonds. Equities may outperform as dividends rise with earnings and mergers and acquisitions gain pace, according to Patrick Moonen, the firm’s senior equity strategist in The Hague.

“Performance year-to-date started in the credit space and equities followed,” said Moonen. “But relative to credit, equities still have room to improve. Equities may be the better investment proposal.”

To contact the reporters on this story: Alexis Xydias in London at axydias@bloomberg.net.

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