Managers Declare Bond Bubble a Certainty
July 14, 2003
CHICAGO - The bull run for bonds is over, and stocks aren't exactly ready to pick up the slack. That was the sentiment expressed by some of the nation's top fund managers at the 2003 Morningstar Investment Conference last month.
"A bubble in Treasurys is no longer a question for debate," said Paul McCulley, managing director at Pacific Investment Management Co., in a panel discussion. "Bill [Gross] and I have been agnostic about it. But I think you can't be agnostic anymore."
Bond funds have generated solid returns for the last five years, having outpaced the S&P 500 index by nearly 7% on an annualized basis, according to Lipper. But given the Federal Reserve's aggressive cutting of interest rates, investment professionals believe that rates have bottomed and will eventually move higher, stirring up concerns about inflation. Indeed, the Fed funds target rate currently sits at 1%, its lowest level since 1958.
"It's all over for bonds," said Dan Fuss, manager of the $1.9 billion Loomis Sayles Bond Fund. "The economy has strengthened, and inflation will rise."
McCulley characterized the 1980's and 1990's as a celebration of capitalism, a period during which the government took a backseat to the private sector. Ultimately, it was a period of deregulation. During the last couple of years, however, there has been a rampup in regulatory activity with capitalism in retreat. In its attempt to stamp out inflation in a post-bubble economy, the Fed has created a bubble in bonds, the panel said.
"The bond market today is where the Nasdaq was at 5000," said Byron Wein, managing director and senior market strategist at Morgan Stanley. He believes that interest rates will remain low for the time being but will move higher at some point next year.
With the appeal of bond funds petering out, McCulley recommended that investors put their money in Treasury inflation-protected securities (TIPS) and keep away from government bonds. The difference between TIPS and other Treasury issues is that TIPS' coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). Thus, the return, albeit a low one, is guaranteed.
Fuss explained that fiscal security and geopolitical concerns are the two underlying themes in today's economy. He characterized economic conditions in North America as being "soft," with a similar situation in Europe. In other parts of the world, however, he sees a boom in China, Southeast Asia and India. At home, he expects the Fed to keep short-term interest rates down as long as possible.
On the equity side, there wasn't much cause for enthusiasm among the panelists. "We're in an extended trading range in the U.S. and possibly Europe," Fuss said. He believes that the market hit the low end of that range last October and that the high end is a few hundred points above the 9000 level. His biggest fear is that we will come out of this trading range with an inflation problem. "The days of 15% returns are over," Wein said.
McCulley stressed the importance of the purchasing managers' index (PMI) as an economic barometer. He said he would not be bullish on the economy until he sees a significant uptick in that benchmark. The PMI for June showed a reading of 49.8 according to the Institute for Supply Management. Typically, a reading below 50 signals the economy is generally declining, and it hasn't been above that level since February.
Wein said the recent rally in stocks was driven by attractive valuations, increased liquidity and bearish sentiment. But he cautioned that several key obstacles stand in the way of a recovery in stocks and the economy. "We don't make anything anymore," he said, referring to our nation's reliance on foreign goods. "The trade deficit is our most significant problem." The deficit swelled to a record $136.1 billion in the first three months of 2003 as war tensions sent prices of imported crude oil and other petroleum products soaring.
Compounding the trade imbalance, the dollar is inexorably going down, he said. And with China and Hong Kong experiencing extraordinary growth, we can't compete with them right now because their production costs are so low, Wein said. He pointed to the Industrial Revolution as the key turning point in history for the U.S. economy and said that industrial and manufactured goods will remain the nation's bread and butter.
Another problem is that the covenant of trust between investors and corporate America has been broken in the last three years, Wein said. Ultimately, price-to-earnings ratios are based on trusting corporate earnings projections. As well, the lingering threat of a terrorist strike against U.S. interests, both at home and abroad, remains a concern.