Fighting The Next War
In last month‚s issue, Financial Advisor reported that Morgan Stanley senior strategist Byron Wien told attendees at Morningstar‚s annual mutual fund conference that the bond market reminded him of the Nasdaq at 5,000.
A few weeks later in mid-July, I had breakfast with Tom Atteberry from First Pacific Advisors, where he works with Robert Rodriguez. The fund has not had a down year in the last 20 years, which helps explain not only its success but also the recent popularity of bonds in general.
Atteberry remarked that when it came to bonds, his firm was now on a buyer‚s strike. He also noted that anyone who purchased a five-year Treasury bond yielding about 3.1% in mid-June had suffered a 6% loss in the value of that bond in less than one month. Therefore, it would take at least two years to get their money back.
When I asked Atteberry what his view of equities was, he was more constructive, though not wildly optimistic. Stocks, in his view, are likely to benefit from cost-cutting in corporate America that would make earnings increases relatively easy to achieve. Atteberry didn‚t foresee any type of raging bull market, but rather a more mundane period in which stocks struggle to churn out pedestrian 6% or 7% annual returns. That could look very good compared with monthly losses of 6% in bonds.
The prospect of a sustained, powerful decline in bonds is the subject of Nick Murray‚s column this month on page 35. Recalling what happened to bond prices in 1994 (the worst year for bonds since 1927), he urges advisors to conduct lifeboat drills with clients by explaining how much their bonds and bond funds could decline and asking them if they could hack it.
These days the bond market is sending signals that the worst is yet to come. On August 12, the Federal Reserve Board announced that it would leave the discount rate unchanged at 1% and might leave it there for some time. But the bond market is no longer treating Saint Alan as the oracle it once did. Shortly after the announcement, the prices of ten-year Treasury notes continued to fall and yields rose to 4.4%.
Of even greater significance is the lackluster demand for Treasury issues. Apparently, Atteberry, Rodriguez and their FPA funds aren‚t the only buyers on strike. At a recent auction of Treasury securities, the government wasn‚t able to sell nearly as many bonds as it had hoped. With annual federal budget deficits of $450 billion, that could be a problem. And foreign buyers are spooked by another demon, the falling U.S. dollar, which means they get whacked twice when they buy U.S. bonds while we only get whacked once. As Atteberry told me at that breakfast, what‚s to stop five- and ten-year Treasury yields from going to 5.5% or 6.0%, hardly high by historical standards.
Certainly not the political climate. If interest rates continue to rise and the economy starts to reflate, partly to finance the war on terrorism, that is preferable to most Americans than penny-pinching when it comes to national security. Who cares if your home‚s value declines? The soccer moms have become security moms, the Washington pundits tell us. And as a nation, our priorities have changed and the tailwinds that propelled financial assets for two decades have turned into headwinds. The equity market has faced these headwinds for more than three years; the bond market is just starting to grapple with it.
Evan Simonoff, Editor-in-Chief