It never takes long for those contemptuous
"the-sky-is-falling" articles to surface, does it? Almost
immediately after the ten-year Treasury yield rose to 5% on June 7 for
the first time in nearly a year and then violated 5.3% just four
trading days later, The Times of London roundly proclaimed that the
cheap-money era was over, its death ready to extract a dickens of a
vengeance. At hand was "a watershed" of change in global financial
conditions, the Brits cried. And they crowed that highly levered
products and structures would soon succumb to dearer money
Yet for all the brouhaha over systemic chinks in the armor that may or may not ever buckle, the benchmark yield finished the second quarter at 5.03%, a modest eight basis points higher than at the start of June and up 38 bp on the quarter. Still, 2Q's final month had witnessed a sudden, violent change in market opinion that reversed itself nearly as quickly.
If the markets seem more confused than usual, they have a right to be. "We are six years into the current economic cycle, and it is not atypical for investors to question whether a cycle can continue the further into it that you are," says Christopher Molumphy, Franklin Templeton Fixed Income Group's chief investment officer.
Exacerbating this natural insecurity is the situation with housing. Whether it betters or worsens, it surely could tip the economy's direction. But until then, boy, what a wild card. Think about it: Almost-unheard-of drops in property prices. Mushrooming foreclosures. Teaser loans resetting to higher payments. Tightening credit standards. It's a constellation of conditions previously unseen.
And disagreement over whether equilibrium will be achieved quickly and benignly or on less forgiving terms has fostered "an unusually wide divergence of opinion in U.S. economic forecasts," according to Nuveen Asset Management's John V. Miller, a managing director who oversees $50 billion in muni portfolios. "For example, for the ten-year Treasury, I've seen predictions ranging from 4.2% to 6%," he says.
Supplemental uncertainty doesn't make investing any easier, of course. But to get an idea of what lies ahead for the markets, it's helpful to start with a notion about the larger forces at work here.
June '07: The Instant Replay
June's rate spike has been ascribed to many, many causes. These include a rise in real yields, a temporary drop in demand for Treasuries by Asian investors, technical factors and even bearish comments by bond celebrity Bill Gross. Perhaps the most-stated reason, though, is a change in market expectations for the Federal Reserve.
As June neared, the market's prevailing view for some time had been that Bernanke's Bunch was likely to lower the Fed funds target rate from its 5.25% perch, given the U.S. economy's lackluster performance (a revised 1Q GDP of 0.7%). But then a spate of surprisingly strong economic data shifted sentiment 180 degrees, forcing the spike on worries about potential tightening by the Fed as well as by the many overseas central bankers who are shepherding economies growing faster than ours.
However, within days there was disappointing news about housing. It dashed hopes that the weakest sector of the American economy was on the mend. "The possibility of a Fed rate cut became priced into the market once again, and yields drifted back down," says William Knapp, a managing director and chief investment strategist for MainStay Investments. What do money pros think is next?
The Crystal Ball, Please
Nuveen's Miller thinks second-quarter GDP will settle in at about 2.5%. "Inventories were pared down to very low levels in the first quarter, therefore production has to increase." Also, as the dollar continued to weaken in the second quarter, it encouraged exports that narrow our trade deficit, he explains. "That helps GDP." Miller adds that a 2.5% second-quarter reading would render trailing 12-month growth at about 2%.
Looking ahead a few quarters, growth of about 2% is what Dan Fuss, vice chairman of Loomis, Sayles & Co., expects. That's a little below trend, which is 3%, Fuss points out. "You can list government spending as very supportive of growth and wince. Capital spending, you have to watch. It's a highly volatile number, so it's just not possible to have a lot of confidence in forecasting it," Fuss says.
Consumer spending, of course, accounts for the lion's share of the domestic economy, and at PIMCO, another investment house that's forecasting 2% growth, it's considered vulnerable. "We believe the housing market is turning significantly negative and that will adversely affect consumer confidence and spending, which ultimately feeds into corporate profits and job creation," says Mark Kiesel, head of PIMCO's investment-grade corporate bond desk and a senior member of the firm's strategy team.
Outlook For Interest Rates, Inflation And Bonds
Deteriorating economics will allow the Fed to lower rates, perhaps as soon as the end of this year, Kiesel predicts. "The Fed hasn't cut rates [despite growth below the trend] because unemployment has stayed low, but we think that that will change. The unemployment rate has been falling mainly due to a decline in the labor force participation rate."
Over the next year or so, PIMCO sees emerging a widening spread between the short and long ends of the yield curve, the primary cause being the falling rates at the front end. For that reason, Kiesel is presently favoring maturities in the two- to three-year range. "That's where you want to be to benefit from Fed rate cuts," he says.
MainStay's Knapp agrees that the economy will limp along, but says the anemia will keep long-term yields soft. The June peak of 5.32% "was a brief aberration. We're not going higher than that," he asserts. It is noteworthy that at 5%, the ten-year Treasury would be at roughly its historical average of 250 basis points above current inflation.
And what of inflation? It's coming down and getting close to the Fed's 2% goal, where it is likely to stay for a while, according to Russell Investment Group Senior Portfolio Strategist Stephen Wood. He says, "The Fed has tapped the brakes lightly 17 times to slow the economy and get a handle on inflation, and guess what? We're there."
In the longer term, though, the strong growth from foreign lands will export inflation to America's shores, according to PIMCO's Kiesel. "Commodity prices are being supported by the growth in emerging countries and ultimately, that is reflationary for us," he says. Treasury inflation-protected securities are too dear for Kiesel to buy today. "But we are watching them because in three to five years it is likely we'll be living with slightly higher inflation," he says.
The dollar appears headed further south. "Other countries are paying you more to own their currency in the form of higher [local] interest rates, and they are likely to pay more yet because of tightening," says Wood. "It shouldn't be terribly surprising that the dollar is weak now, and I don't see it rallying."
For Franklin Templeton's Molumphy, these vectors will continue to benefit global and nondollar-denominated bonds, the fixed-income areas that he says offer the greatest opportunity for the next few years. A falling dollar aids U.S. investors when they convert foreign investments into greenbacks. "So outside the U.S., we are focusing on countries where we see potential currency appreciation against the dollar, and at the same time we're keeping duration short" to mitigate the effects of potentially rising interest rates abroad, Molumphy says.
Bonds Or Stocks?
Until recently, Fuss, who co-manages a balanced a fund, was happily overweight in equities. "Now I'm starting to think defensively," says the co-manager of the Loomis Sayles Global Markets Fund, which is deployed in both stocks and bonds. "While corporate earnings look phenomenal, I am worried about the effect of a contraction in the excess liquidity that's out there from all the leveraging. If cracks start to appear, you could see a flight to quality as well as financial problems for some bond issuers in the financial sector. As a result, I'm thinking about cutting back on the stock allocation, and on the bond side I'm getting more conservative on credit."
At Russell Investment Group, though, equities continue to be viewed as more attractive than fixed income, although less so than earlier in the year when bonds provided less yield.
A soft interest rate environment benefits stocks, too, not just bonds, because it keeps pressure off the discount rate that investors use to value equities, says Bill Fries, a portfolio manager and managing director at Thornburg Investment Management. Using a higher rate depresses stock prices, but that's less of an issue when the economy is plodding. "If corporate America's earnings come in higher as forecast, and the discount rate doesn't increase, stock prices should move higher for those companies with improved profitability," Fries says.
In a slowdown that stops shy of recession, it's your larger-cap growth stocks that tend to shine and during the second quarter, "we began to see a change of market leadership reflecting that," says John P. Calamos Sr., chairman of Calamos Investments. Beyond a push in market value from their earnings growth, he says that "these stocks could also benefit from an expansion of P/E ratios, which we have not yet had, even though it has occurred in the past."
Calamos is particularly keen on companies serving global markets. That way you participate in the higher growth rates that other parts of the world are experiencing, he says. "Such companies are less vulnerable to a weak dollar and they have low debt-to-equity ratios, so they're also less vulnerable to increases in the cost of debt." Companies fitting this description that Calamos owns include Nike, Nokia and Apple (got iPhone?)
Tech is a theme that Fries also likes, partly because it's been out of favor for so long. Moreover, he says, one way for businesses to offset the effects of inflation is through higher productivity via investments in technology. Take Intel. "It's reasonably priced," Fries says, "has an enviable market share, and the PC isn't going away."
Even if the cheap money does.