In retrospect, I guess, it was easy to see the administration was closely watching the bond market and interest rates. Look at Greenspan sitting next to Hillary at the State of the Union. Whenever Clinton’s economic advisers went on CNBC, it was obvious they were focusing on lower deficits and lower interest rates because there wasn’t much else they could do. They were put in a box by caps on government spending, and all they could do was to let the private economy grow itself via lower interest rates.
The problems that his health-care-reform legislation is having are positive for bonds. Perversely, bond investors feed off negative news – anything that signals slower growth or a lower budget deficit is positive for bonds. If the bulk of Clinton’s plan isn’t enacted, it means lower inflation, since businesses won’t raise prices to pay for employer mandates, and it means substantially lower budget deficits over time than would otherwise be the case. Now, that doesn’t speak to the social aspects – we’re not rooting for the defeat of health-care reform from a social standpoint. But from a cold economic standpoint, its defeat would be positive for bonds.
It caught us by surprise – we were prepared for a bear market, but not for a bear market like we had in the last six months. It was caused by a combination of factors. The economy did get stronger, which we expected, and the Fed raised short-term rates. That caused problems for a lot of the so-called hedge funds and produced a lot of volatility. In addition – and this hasn’t been publicized – the Clinton administration’s attitude toward Japan exacerbated the problem, in terms of talking down the dollar and trying to reduce trade barriers. The Japanese pulled money out of the U.S., and that reinforced the price fall. The drop in bonds led to a substantial drop in stocks, and I think there’s more to come. There is no way that stocks can survive at these levels unless we have economic growth for the next several years of 3 to 4 percent. And that really is not in the cards.
We’re forecasting continued low inflation and a fairly benign rate of growth in the economy – say, a 3 percent inflation rate and 2 or 3 percent growth for the next several years. The main reason for this is globalization. You have this genie of free-flowing capital around the globe – it really can’t be put back into the lamp once you’ve let it out. Businesses can migrate to different countries based on wage-rate differentials. That’s a huge disinflationary force. Bangladesh, for example, can manufacture apparel at a tenth of the cost that we can in South Carolina. Rising commodity prices have grabbed the headlines, but we figure that labor costs make up at least 75 percent of the total cost of a product. Take Coca-Cola. Sugar prices may go up, but it’s very difficult for Coca-Cola to pass on those costs by raising prices since wages aren’t going up. Cheap worldwide labor forces businesses to hold down prices and prevents inflation.
It suggests a scenario we call Butler Creek, as an analogy to a stream near my hometown in Ohio. It meanders, but isn’t volatile like the Mississippi. Likewise, we’re forecasting a narrower trading range for bonds. We think the long bond – the 30-year Treasury – will trade within a 6 to 8 percent range for the next several years. No return to 1981, when we saw 15 percent rates on long bonds. This narrow range calls for a different investment approach. Bonds increase in price as interest rates drop. And that was the phenomenon for the past 12 years – investors captured capital gains as interest rates dropped, and increased their returns over and above the “coupon,” or semi-annual payment a bondholder receives. The Butler Creek scenario suggests a different style of investing. Investors will want to capture yield as opposed to chasing capital gains.
I’m not advocating buying a lot of junk bonds, although a small percentage of them might be appropriate. But I am talking about owning a larger percentage of mortgage-backed bonds than you have over the past several years. The risk in mortgages comes from prepayments – when interest rates drop, homeowners refinance their mortgages, and investors holding mortgages get a lower return. If interest rates don’t change much, prepayments disappear. So if you can buy mortgages, like Ginnie Maes, that are guaranteed by the Treasury, or other guaranteed mortgages like Fannie Maes and Freddie Macs, you’re buying bonds that produce yields 1.25 to 1.5 percent higher than Treasuries. You’ll have a portfolio that beats the market simply by earning the coupon.
Since we’re forecasting continued growth in the economy, things look good for businesses. And that means you can take on some corporate risk by buying some lower-quality bonds. I’m talking about bonds that are just above junk level, or just on the fringe of junk. Time Warner bonds would be fairly typical of what I’m suggesting. They produce yields of maybe 2 percent more than Treasuries of a comparable maturity. They’re not triple-A quality, but they let you sleep at night.
It’s certainly a less treacherous time. It would be easier on the stomach, knowing that the value of your portfolio isn’t fluctuating as it would have in the past. But bonds can still be difficult vehicles to buy in small amounts, and the commissions involved can be substantial. So even now it’s not easy, but it’s certainly a better time than in the past 10 or 20 years.
You have to find the right balance. Most of my personal money is in emerging market equities, because that’s where you find the highest returns over the long term. At 50, I’m still relatively young, I can stand the volatility and I can hopefully look forward to a lot of years of growth before I need the income. But for many people, like our clients, who depend on investments for income and want to preserve principal, you definitely want to confine yourself to the Pete Rose approach that bonds offer. You want to go for the safe base hits, as opposed to swinging for the fences.
