Rocky Markets Inspire Another Look at Bonds

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

Attempting to latch onto an investment thesis these days is like trying to grab a bar of soap in the bathtub: The data are slippery at best, invisible at worst.

Over the past two weeks, the S&P 500 has tumbled 4.4% – the worst showing since the start of 2003. Why? The conventional explanation is that investors are worried about inflation creeping up and the economy slowing down.

However, the rise in the bond market last week suggests that the cause lies elsewhere. Benchmark treasuries had been trading with a 5.20% yield; at the end of the week, they were down to 5.05%. That doesn’t sound like a market too consumed with inflation fears.

The angst about inflation stems from the April CPI reading, which showed a surprising annualized rise of 3.5%. However, the economists at ISI report that the CPI in May, June, and July usually trails down from April, so it’s quite likely that the news will get better from here, not worse. The latest reading on manufacturing prices, from the Philadelphia Federal Reserve Bank’s May numbers, demonstrated weak prices, fueling optimism about the May CPI report.

As for slowing growth, other than slumping housing starts and an upturn in unemployment claims, adjusted for some oddities, most indicators still project continued expansion.

Our view is that the market slump started with an overdue correction in certain commodities markets and spread to other areas as investors took a hard look at the soft core of recent gains. Copper, in particular, became overblown and more or less collapsed under its own weight. Having enjoyed an extraordinary multiyear price increase, the commodities markets suffered their worst correction in 25 years. Speculators pulled out, causing anxiety across the board. Equities markets had also benefited from the upsurge in commodities; oil and mining shares, among others, had been huge winners this year. They were bound to take a pounding.

The continued tightening by the central bank fed the fears of those looking for reasons to be nervous, with the move suggesting that inflation was indeed worse than generally perceived. Others are nervous that the further ratcheting up of rates could weaken demand. That ugly word “stagflation” is beginning to pop up.

Where do we go from here? In confusing times like these, we like to check in with one of Wall Street’s favorite economists, Edward Hyman, the head of ISI, who can usually create a melody from the cacophony of data.

Mr. Hyman says he thinks the economy is indeed slowing, and that the Fed will consequently not raise rates at the next meeting. He is fairly sanguine about inflation, because companies to this point are not boosting wages. On this front, though, he is keeping a sharp vigil. He said a resumption of wage inflation would change his outlook.

Let’s assume for the moment that Mr. Hyman’s forecast is correct. What does it mean for the markets? One idea is that recent events may start moving investors back toward bonds. Bonds are so out of favor that no one even talks about them anymore. A bond manager we know recently went on a golf outing with a number of men in their 60s and 70s. When he brought up bonds as a possible safe haven, they laughed. They wanted to buy growth stocks.

We all know that when interest rates go up, bonds go down. Still, as rates climb, current yields become more alluring. It’s a lot easier to attract investors with a 5% yield than 3%.

Robert Poll, the chief investment strategist for Castleton Partners, a bond management firm, agrees that the marketing climate is improving as yields go up. He is shifting his clients’ portfolios to take advantage of the steepening of the yield curve. He has kept investors “short and liquid” for the past couple of years, as there was no premium for going longer term. Now, however, he thinks yields are higher enough to extend holdings out to eight or nine years in municipal bonds. Holdings in treasuries, too, are being stretched out along the maturity curve.

He is not investing in lower-quality instruments. Yields are still compressed in terms of credit quality. “You’re not getting paid to take on risks,” Mr. Poll said.

Mr. Poll does think the Fed will raise rates again, at the June 28 meeting. In his view, Chairman Ben Bernanke has to establish his inflation-fighting credentials. The futures market agrees with him; futures prices are predicting with a 60% probability that the Fed will raise rates.

He said he agrees that investors may start moving money into bonds. The higher yields are increasingly appealing, and the gyrations of the stock market may remind people that owning equities exclusively can lead to stomach upset. Also, as Mr. Poll points out, demographic trends are positive; graying boomers should be planning for retirement and seeking conservative incomeproducing instruments.

Martha Pomerantz, who manages money at Lowry Hill in Minneapolis, is recommending that her clients keep about 30% of their assets in bonds. She is keeping people fairly short-term, and buying “ladders” of bonds that offer different maturities in order to spread risk. Ms. Pomerantz, who started out on Wall Street as an equities analyst, maintains that doing your research also pays off in the bond markets.

She has been recommending that clients buy callable agency bonds, which tend to offer higher yields but are harder to find. One bond she has invested in recently has a “continuous call” feature, but consequently yields about 6%. Because she does not expect rates to come down, she does not consider the call provision problematic.

Ms. Pomerantz also thinks stocks are attractive. This cycle’s sharp upturn in corporate profits has not yet been reflected fully in the equities markets. Profits for the S&P 500 companies are ahead 85% since 2002; the index is up only 17%.That suggests plenty of room for further gains.

However, given the anxieties in the marketplace, owning some bonds is not a bad idea, Ms. Pomerantz suggests. Now we just have to get over the feeling that real men don’t own bonds.

The New York Sun

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