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Fuss: Interest Rate Policy Will Shape Recovery

BOSTON -- Longtime industry veteran Dan Fuss, the 76-year-old vice chairman and managing director of Loomis, Sayles & Co., knows that the Federal Reserve has to raise interest rates eventually. This could dramatically affect credit spreads, yield curves and other macroeconomic issues. But until such a move takes place, there is no need to get excited.

With the advantage of more than 52 years of experience in the financial industry, Fuss sees many similarities to previous recoveries and believes a careful, measured approach can position his firm and shareholders for long-term success. Money Management Executive Senior Editor John Morgan recently sat down with Fuss in his office in downtown Boston to talk about how Loomis Sayles' global outlook and how his firm is preparing for the inevitable shift in interest rates.

MME: Have emerging markets become overcrowded and overpriced?

Dan Fuss: No, but the term emerging markets is very general. We like Southeast Asia, plus Brazil, but there are many exceptions. Our basic guess underlying this is a secular uptrend of the interest rates in the U.S. dollar running 20 years or more. That quickly puts things into perspective. Once you have that guess, then a lot of other things quickly fall into place. If you have market risk going against you-such as interest rates going up-you can substitute specific risk or specific opportunities for market risk. For 30 years, you had interest rates going down. If I'd known that 30 years ago, I would have probably done things differently.

We are now in a stock-picking, bond-picking environment, not a general asset allocation environment. Asset allocators in this market got badly bruised because their models were built around specific opportunities and risks based on the last 30 years. Today, it's a whole different environment. We have to focus on specifics.

The comparability by rough-drawn asset classes just doesn't work, and you should try not to get caught up in it, although most people have to. Most institutional and individual mandates are drawn along these lines and don't have a choice. If the mandate says to buy bonds, they have to buy bonds, and if the mandate says to buy stocks, they buy stocks.

MME: Do you think a significant amount of capital will switch from bond mutual funds back into money market mutual funds when interest rates eventually rise?

Fuss: Probably, because when the yield curve starts to flatten, people have more incentive to go to the shorter end of the yield curve. It tends to be a mistake, but once in a while it's good. That's a different type of asset allocation. It's called "guess the market." Human nature will prevail. Treasury financing will be so heavy that it will pull people over there, whether it's to the money market or to short-term government bonds.

MME: Are you still worried about the heavy financing going on in the corporate bond sector?

Fuss: No, because on a net basis, it's not that heavy. We are in a very forgiving environment at the moment. Funds flows into mutual funds and life insurance companies are very strong, and there's a shift in the defined-benefit pension side to more fixed income. You put those all together against a low-net-financing corporate sector, and the new issue calendar and the corporate cycle-investment grade and below-investment grade-is humming as a result. This will probably continue for another year or so.

Eventually, you start to have a problem on the corporate side. Treasuries will garner more and more money, and the price will probably go up, along with interest rates. Eventually, you'll probably start to get rationing of credit by price.

The No. 3 and 4-ranked fund companies don't have the same economics or clout in the markets as the No. 1 and 2 market shares, so they will do the intelligent thing, which is stop expanding.

As the smaller firms pull back, the strong get stronger. The market leaders will access money and expand capacity. Cost-per-unit drops and profit margins widen. It becomes a very good environment for fewer and fewer companies.

This is not completely comparable to what happened in the late '60s and early '70s, because this time it's global, so it gets more complicated. You also have to consider what it costs to borrow money elsewhere, as well as where your own base of activity is. There are many different variables.

MME: What will happen to credit spreads when interest rates rise?

Fuss: They actually narrow, which is one of the confounding things for people. The Treasury itself becomes the incremental borrower of funds. As the net demand for funds in the corporate sector starts to diminish and net demand for funds in the government sector expands, the absolute level of spreads between one and the other narrows.