Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.       

                 

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.” 

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.                                                                                                                  

China Watch: Is Goldilocks Waking Up?

Almost a year has passed since we issued a blog “International Stock Markets: Searching for Goldilocks” (May 12, 2010). Here we pointed out that recent steps taken by the Chinese government and central bank to cool their economy and tame inflation had halted the sharp advance of Chinese stocks in 2009. Some investors feared that the policy makers’ initiatives would prove to be too little and too late, resulting in an inflation spike and asset bubbles. Others were concerned that the government and the central bank would become excessively restrictive and cripple economic growth. We offered three views:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
• The “soft landing” would spark a strong stock market rally. 

Since our “Goldilocks” blog, Chinese inflation has continued its ascent from 2.8% last May to its current 4.9%. In response, the Chinese government has responded with a succession of interest rate hikes and bank loan restrictions, and Premier Wen Jiabao announced recently that the highest priority of government was to reduce inflation. Our forecast for Chinese stocks was lamentably correct: since the end of 2009, the Shanghai Composite Stock Index (CSEX) has retreated -11.3% and the exchange traded fund for Chinese stocks traded in Hong Kong (FXI) is off -1.4%. For the same period, the S&P 500 Index has risen 14.7%.

We think the Chinese policy makers are making progress and will be able to pilot successfully a soft landing. We also continue to expect this soft landing to renew the bull market in stocks dating back to March of 2009. We are not alone in these forecasts. In a March 15 report issued by Deutsche Bank titled “Turning Bullish on China,” Chief Economist Jun Ma argues that “recent developments are increasingly supportive of our view that year-over-year CPI inflation will likely peak in June at around 5.8%, then fall to around 4% in December.” He expects the policy makers to take their foot off the brake and considers the risk of a hard landing to be minimal. He concludes with the prediction that in the next twelve months the Chinese stock market will “rise about 25% from its current level.”

If Chinese inflation peaks in June, will the Chinese stock market anticipate this development and rally before the data confirms the fact? Is this already happening? Since January 25, the Shanghai market (CSEX) has gained 8.6%, whereas the S&P 500 Index has slumped -0.9%. We are very aware that anticipating events that do not materialize, or are delayed, can be very painful, but is it better to be too early than too late?

We are continuously reviewing Chinese stocks to identify the most attractive candidates to participate in a renewed stock market advance. Our focus is on companies that would benefit from the government’s massive infrastructure projects and/or would prosper from the rapidly rising demand for goods and services by the mushrooming middle class.

Current Challenges to the Global Economy and Stock Markets

Recent developments in the Mideast and Japan convey scenes of human misery and loss of life that are sad and disturbing. The question for investors is whether they also constitute so serious a challenge to the global economic expansion and stock market advance that a substantive change in strategy is required. As alarming as these momentous events are, we do not think that they will tip the global economy into recession and trigger a new bear market. At this point, we advise clients to maintain their long-term commitment to global equities and ride out the storm.

The global economy entered 2011 with considerable momentum. The leading emerging economies were expanding above their sustainable long-term growth rates, the U.S. economy was accelerating towards a healthy 3.5% or higher GDP growth, and the Euro Area was weathering better than expected its sovereign debt woes and austerity budget imperatives. In our view, it would take a severe jolt to reverse this momentum. On the other hand, the twin threats are real. Oil at $100/barrel is already elevating global inflation fears and could retard international and U.S. growth, and in the near term the Japanese economy may slip from our previous forecast of 1.3% growth in 2011 into a modest recession. Nevertheless, we continue to anticipate global growth this year in excess of 4%. Further, we expect reconstruction in Japan will provide a boost to global growth later this year and in 2012.

We expect markets to remain volatile in the immediate future, but at this stage we do not anticipate a significant and lasting decline. Predictions of what will happen next in the Mideast and Japan are difficult, and even more threatening storm clouds may materialize quickly. A further jump in oil and gasoline prices resulting from violent political confrontations in the Arab world will roil global financial markets. Additional setbacks in the earthquake, tsunami, and nuclear power catastrophe in the world’s third largest economy will add even more turbulence to already fragile markets. There is also the possibility of a new geopolitical calamity or natural disaster.

Consequently, our optimism is wrapped in caution. Clients should be concerned but not alarmed, remain vigilant and flexible, and maintain a longer-term perspective.

China, India, and Brazil: When Too Much Growth is Bad

On December 25 the People’s Bank of China (PBOC) hiked both the key 12-month lending rate (from 5.56% to 5.81%) and the 12-month deposit rate (from 2.50% to 2.75%). This marked the latest effort in the Chinese government’s year-long campaign to ward off inflation by cooling its overheated economy. Although these steps were widely anticipated, the Shanghai stock market immediately retreated and triggered selling in many other emerging-country stock markets.

The related issues of strong economic growth, rising inflation, restrictive initiatives implemented by policy makers, and a disappointing stock market have been building for a year and are not limited to China. A similar set of conditions has plagued the leading emerging countries of India and Brazil. At the beginning of the year, consensus 2010 GDP growth projections were 8.6% in China, 6.3% in India, and 3.8% in Brazil; economists currently estimate 2010 growth of 10.2% in China, 8.8% in India, and 5.5% in Brazil (The Economist, 1/2/10 and 12/18/10). Along the way, inflation and fears of asset bubbles have spread: inflation in China is currently running at an annual rate of 5.1%, in India at 9.8%, and in Brazil at 5.6%. In all three countries the governments and central banks have reversed the economic stimulus initiatives of 2008-09 and are now applying the brakes.

In a May 12 blog on International Stock Markets: Searching for Goldilocks, we highlighted the negative impact that these restrictive policies in China, India, and Brazil were having on their previously sizzling stock markets. Since May, the inflation threat has grown and clouds have continued to hang over these markets: The Shanghai Composite (CSEX) is down -15.1% for the year to date, the Brazilian Bovespa (BSPI) is off -0.1%, although the India BSE 100 Index has mustered a respectable 12.9% gain. For the same period, the S&P 500 Index has rallied 12.7% despite unimpressive GDP growth of about 2.8%.

At this point the consensus view, which we share, is that in early 2011 the policy makers in each of these 3 countries will escalate their war on inflation with additional measures, and the consequence could well be stalled or disappointing markets. There will be many investors who fear that the steps taken by the policy makers will be too little and too late, and the result will be destabilizing inflation and asset bubbles. Many other investors will be convinced that the policy makers will go too far and cripple economic growth. To the contrary, our view is that the policy makers will be able to pilot a soft landing, i.e. to cool their economies to healthy and sustainable growth with reduced inflation. We note that most economists predict modest slowdowns in 2011 sufficient to arrest inflation fears: the latest poll taken by The Economist forecasts slowing 2011 GDP growth to 8.9% in China, 8.6% in India, and 5.1% in Brazil. If our view is correct, then we expect a buying opportunity lies ahead for the stock markets of these leading emerging countries and the multinational companies that supply the rising demand of their mushrooming middle classes.

International Stock Markets: Searching for Goldilocks

Heading into 2010, we shared the view of a majority of international investors that the best performing stock markets this year would be China, India and Brazil. This expectation was based on the consensus forecast of economists polled in December by The Economist that these 3 countries would enjoy 2010 GDP growth of 8.6%, 6.3% and 3.8% respectively. In contrast, the major developed economies of the U.S., Europe and Japan were projected to experience anemic, subpar growth ranging from 0.6% to 2.4%. Since then, the economic performance of each of these leading emerging economies has exceeded expectations, and growth estimates in the latest poll of The Economist have been raised to 9.9%, 7.7% and 5.5% respectively. Nevertheless, the stock markets in these countries have been disappointing: for 2010 through May 10, the Shanghai Index (CSEX) has retreated -17.6%, the India Sensex (IBSI) is off -0.8% and the Brazil Bovespa (BSPI) has fallen -8.3%. In the much slower growth U.S., where 2010 GDP growth is currently pegged at 3.1%, the S&P 500 Index is down only -0.4%.

Why is this happening?

The problem with the stock markets of China, India and Brazil is that their economies are too hot. That is, accelerating growth is giving rise to fears of excessive inflation and asset bubbles. In China, for example, the government recently announced that April year-over-year consumer prices rose a more-than-expected 2.8%, producer prices jumped 6.8%, and property prices soared 12.8%. Consumer prices in Brazil are projected to rise 5.2% in 2010, and India inflation could top 12%. In response, the central banks in these countries have initiated policies designed to cool their economies. Some observers think the steps taken by the policy makers are too little and too late, and the result will be the dreaded inflation and asset bubbles. A contrary opinion is that the central bankers will be excessively restrictive and cripple economic growth. It is normal in the economic cycle for governments and central banks to reverse stimulative polices in the aftermath of recessions as recoveries gain strength. It is also normal for investors to question the outcome of a change in policy, and there is ample historical precedent in the U.S. and abroad of investors pulling back to wait and see if the policy makers are able to pilot a soft landing.

At the opposite extreme are the economies of Europe and Japan, which are too cold. Growth outlooks for these countries were weak at the beginning of the year, and the future now appears to be even bleaker. The highly publicized debt problems of Greece, Portugal and Spain will surely lead to austerity measures that will further retard growth, and quite possibly push the countries back into recession. Italy, Ireland and even Great Britain also have severe deficits that will require government action. The massive holdings of these countries sovereign bonds held by the leading banks of Germany, France, and Switzerland could spark a further crisis if the debt laden countries are unsuccessful in implementing adequate austerity programs. The consensus foresees 2010 Euro and GDP growth of only 1.1%, and we suspect that this gloomy assessment may be revised downward. It thus comes as no surprise that for 2010 through May 5 the Euro Area (FTSE Euro 100) stock index suffered a -9.6% decline. As for Japan, we expect another year of very modest growth (2.0%) and debilitating deflation (-1.0%).

Positioned comfortably between the too-hot Asian economies and the too-cold Euro Area and Japan, the U.S. economy is providing a propitious environment for common stocks. Favorable employment, consumer spending and manufacturing data indicates that the recovery is picking up steam, and the 2010 GDP growth outlook is now above 3%. Corporate profits have been above Wall Street expectations, and research analysts are raising significantly their 2010 earning estimates. On the other hand, growth has not been so strong that inflation forecasts have become ominous and, of great importance to investors, the Federal Reserve has repeatedly expressed its intention to keep interest rates at a historically low level “for an extended period.” To be sure, the major headwinds buffeting the U.S. stock markets thus far in 2010 have emanated from Asia, South America and Europe.

What lies ahead? Can investors anticipate a change?

We think the policy makers in China, India and Brazil will successfully guide their economies to a soft landing, and will then halt their restrictive measures in order to usher in long-term sustainable economic growth with controlled inflation. The Economist’s latest poll supports this view: consensus 2011 GDP forecasts for China, India and Brazil are 8.1%, 8.0% and 4.5% respectively. We expect the governments and central banks to complete their braking activities some time in the next 6 months, and investors will likely anticipate this green light and restore bull markets for the duration of a multiyear expansion. It makes sense that investors will migrate back to these geographic areas where growth is greatest once government and central bank policies are no longer threatening.

We are less positive regarding the stock market prospects of the developed countries over the next year. Japan and the Euro area will simply not have sufficient growth to attract investors. On the other hand, some of Europe’s leading export-oriented companies, aided by the weak euro, deserve investors’ attention. We expect the U.S. stock market, which has rallied for 14 months without a 10% correction, to stall, or possibly retreat, when the Federal Reserve signals its decision to gradually restore long-term norm interest rates from the current recession lows. There is much debate as to when this might occur, but most Fed watchers believe it will be within the next 9 months. We think the Fed may wait until after the November election, by which time job growth and a stabilized housing market will put the recovery on firmer footing. We further expect the Fed to alert investors of a new tightening policy several months in advance by eliminating the “extended period” language in statements regarding their interest-rate deliberations. Worth noting is that 1-2 years into the past 2 recoveries from recession, in 1994 and again in 2004, the Fed commenced to hike rates, and on each occasion stock market rallies abruptly halted as investors turned more cautious.

We remain convinced that investors who take a global perspective will be amply rewarded.

Threats to Global Economy and Markets

The blood pressure of the investment community has been elevated several notches in recent weeks as threats to the global economic recovery have surfaced. Stock markets around the world have slumped with unnerving volatility, even though a consensus of economic forecasters have reassuringly continued to project a solid if not spectacular global recovery in 2010 and the latest batch of corporate earnings reports have been well above analysts’ expectations. Creating additional palpitations has been a sharp drop in commodity prices and a corresponding rise in the dollar as risk-averse investors have responded with a flight to safety.

The Economist (February 13-19, pp. 13, 70-72) provides an excellent, succinct overview of the dangers confronting the world economy and offers pragmatic recommendations to government and central bank policy makers. In its cover article, the magazine emphasizes the gulf between the troubled U.S., European, and Japanese economies “where there are few signs of strong private- demand growth,” and the leading emerging economies of China, India, and Brazil, where there is “strong growth in domestic demand and scant spare capacity.”

The challenge for the policy makers in the developed countries is to engineer growth even as they are forced to come to grips with massive budget deficits. The problem is especially vexing for European leaders, who are under pressure to formulate a rescue plan for Greece and, possibly, for Portugal and Spain as well. We think the European Union will successfully if grudgingly provide a solution that will calm jittery currency markets, although the remedy may result in painful austerity for the indebted countries and political fallout for those governments, notably Germany, that may be called upon to finance a bailout.

In sharp contrast, the Chinese, Indian, and Brazilian governments are concerned that rapid growth will trigger inflation and create asset bubbles. Policy makers here are taking steps to rein in growth, which in turn worries some investors that their braking activity will become excessive and produce a slowdown that endangers the global recovery. The focus is on bank lending restrictions imposed by the Chinese government since the beginning of the year. We share The Economist’s view that “for all the market’s worries, there are few signs that it [the Chinese government] will tighten too much too fast. A slowing is possible, but a serious stumble seems unlikely.” We also note a recent article in The Wall Street Journal (2/8/2010), which reports that last week Citigroup, Bank of America Merrill Lynch, Goldman Sachs, and J.P. Morgan Research all issued reports touting upside expectations in emerging markets this year.

Although we think these threats to the world economy and equity markets will eventually be resolved without calamity, we also acknowledge that investors should not become overly sanguine. We will continue to monitor closely these international developments and we remain flexible. We also alert clients to expect market volatility until these matters are resolved.

China and Brazil Watch

In our January 4 Outlook, we contrasted the accelerating economic strength of China, India, and Brazil with the struggling U.S. and European recoveries. Fresh evidence of Chinese prosperity is the surprising surge in both exports and imports in data released overnight. Another indication may be found in today’s Financial Times in an article “China lenders eclipse U.S. rivals.” The article reveals that all 7 of the world’s top valued banks (ranked by bank share price to book value) are Chinese or Brazilian, and concludes the data “reflect growing [investor] confidence in emerging markets, particularly China and Brazil.” In 2000, 5 of the top 6 highest valued banks were American. To highlight the contrast among economies, another article on the same page of the Financial Times, “Lingering doubts over recovery keep European inventories low” reveals that European business executives continue to have very low confidence in their own economic future. To be sure, the latest The Economist poll of forecasters (1/9/2010) foresees an anemic 1.4% real GDP growth for Euro area in 2010.