Bonds dominate outlook forecast

Bonds are boring, but they also may be the single most important asset class in the coming year, according to two seasoned strategists.

The Empire Club of Canada, held its annual outlook luncheon in Toronto on Thursday. Despite a massive rally in stock markets, the tone was quite bearish.

Peter Gibson, managing director of portfolio strategy and quantitative research opened with the first salvo, suggesting the market is in the midst of a bear market rally; a bear market that has been in place for more than ten years.

For Gibson, the key to understanding the direction of the market is the yield on U.S. ten-year Treasuries. He told the audience the U.S. Federal Reserve deliberately targets a rate band that continually drifts lower, so that buyers of U.S. debt see appreciation in their investment.

“We started in the 1970s with a period of inflation. From 1980 to 1998, we entered an environment of disinflation, but since 1998 I would argue we have entered into a period of deflation, a generalized decline in prices, which is what the Fed has tried to manage,” he said. “Even from 1988 to 1998, when rates were falling, that was generally good for stock prices. Lower rates meant bonds and fixed income instruments were less competitive.”

He added, “However, in order to keep the bond market happening, we have to keep lower interest rates too, in order to sustain the downward trends in interest rates. None of you, if you individually held the U.S. government’s $13 trillion in debt, would accept an upward trend in interest rates because [it would] nullify your investment.”

Gibson said stock investing over the short term will likely be profitable while the yield on ten year Treasuries stays below 4%. He expects a hard floor on interest rates at 2%. As long as the rates hover between these pegs, Gibson expects the U.S. government to continue a policy of quantitative easing — essentially printing money to buy bonds, loosening up credit for wide scale investment.

“The trend in interest rates generally has to fall over time. However there is a level on ten year Treasury Bills, probably somewhere between 3.5% to 4%, where we can deliver a level of interest rates to the debt markets to keep bond investors happy, but unfortunately the economy needs a higher interest rate process and that’s where we are today,” he says. “In order to satisfy the bond market, you have to pay a price in the economy, unless we have some massive productivity growth breakthrough such as something like inventing cold fusion [the cycle will continue].”

Gibson suggests that when inflation eventually sets in, rates will necessarilly rise above the Fed’s band of comfort. That’s when crisis will hit.

“After a number of years of accelerating growth, the Fed tightens [rates] until they break something. It’s not a coincidence that something got broken, in ’87 and ’88, ’97 and ’98, and ’07 and ’08,” he said. “They break something, the bond yield collapses. The response is always the same they come back with massive fiscal and monetary stimulus when it’s available. They restart the cycle; it goes with the rising bond yields. How long that rising bond yield goes is what will determine how long the Fed has before it has to tighten again.”

Gibson expects China to be the inflection point for the next moment to sell. He anticipates that if Treasury yields go above 4.6% it will cause a collapse of a growing real estate bubble in China.

“If that bond yield can remain below 4%, than I believe the Fed will continue to pursue credit easing,” he says. “Until rates gets to 4.4% or 4.6%, stocks should do well. If they hit that ceiling I want to reverse course. I want to ask myself then if this is the coming of the end of real estate bubble in China.”

Avoid stocks altogether, Rosenberg says

David Rosenberg, chief economist of Gluskin Sheff + Associates, believes income yielding securities offer the best bet for investors, due to a long secular trend of baby boomers requiring a more conservative portfolio outlook and the risk/reward profile of bonds vis-à-vis equities.

“If you look at the latest Barrons poll, you see what everybody is bullish on. Everybody is bullish on equities. They are sort of agnostic when it comes to gold to or corporate bonds,” Rosenberg says. “It’s ironic that the only asset class that people are bullish on is the only asset class that lost money in the last ten years. Gold and corporate bonds are the parts of the market that actually did quite well.”

Rosenberg argued that the S&P 500 has been perpetually over-optimistic as a forward indicator of economic growth. The only time it seems to have forecasted economic growth with some degree of accuracy was during the lows of 2009.

“The S&P 500 was pricing in -2.5% growth back in 2009; it’s interesting that the market was fairly valued for about two months. Fast forward to today and the S&P 500 is forecasting 5% growth (versus a consensus forecast of between 2% and 3% growth),” he says. “Corporate bonds are priced in for about 2.5% growth, which is about roughly where I would be. Stock markets are pricing in 5%. If you’re talking about risk versus rewards, corporate bonds are probably where you want to be.”

Rosenberg says bond growth is attached to a much more profound secular trend which is the growing need of income for aging boomers. Rosenberg broke down the stats of employment growth in 2009 for the U.S. The only group that had positive employment growth was made up of the oldest workers, above age 55. He suspects there is a direct correlation between cracked retirement nest-eggs and boomers reentering the workforce.

“The level of household net worth is still $13 trillion dollars lower today than it was two years ago,” Rosenberg says. “First it was the NASDAQ nest-egg, that was followed by the residential real estate egg — that couldn’t go wrong — now that egg is a just a ball and chain.”

Rosenberg points out that the typical portfolio is still weighted much more heavily in equities than fixed income. He expects a seismic shift to income producing vehicles to fill that need for the baby boomer generation.

Indeed, fixed income funds accounted for a record high inflows last in the U.S. last year.

“This is the time of income as opposed to capital appreciation,” he says. “I’ve very bullish on anything that can derive an income.”

Gold expected to continue rise

Nick Barisheff, the president and CEO of Bullion Management Group, expressed a sense of vindication that gold had returned to its currency status, something he’s been calling for a number of years as a reoccurring speaker at the outlook luncheon.

“In 2009, gold resumed its historical monetary role — as the anti-currency. Therefore the influences and events that affect its price are not simple commodity supply/demand fundamentals, but the more complex global monetary issues,” he said. “It was the first time in 20 years that gold purchases of investment purposes outpaced gold purchases for jewelry demand. However in terms of significance, central bank buying of gold this year upstaged all other events. For the first time in 20 years, central banks became net buyers rather than net sellers of gold. This is a watershed event.”

Barisheff said it’s not out of the realm of possibility for gold to trade at $5,000 an ounce, if the investment community continues to make long-term purchases of gold.

“If the world’s pension funds and hedge funds moved only 5% of their assets into gold, which these days seems quite conservative, gold would trade above $5,000,” Barisheff said.

Rosenberg was also bullish on gold. He argued that the intrinsic value of the commodity was a simple calculation of how much physical gold existed versus the total U.S. money supply.

In this regard it’s easy to see gold continue to rise, because the government has drastically grown the money supply, and physical gold mining production peaked more than ten years ago.

“How do you value gold? You can’t use the dividend discount model, there’s no P/E multiples, there’s no income stream. It’s a currency, that’s what it is, and you measure it in U.S. dollars,” he says. “Gold is a currency. To value it, take a look at the money supply.”

(01/08/10)