Over There

Many historians believe that World War II began the day World War I ended. By this it is meant that the terms of Germany's surrender sewed the seeds of the next European war. The same may be said regarding this recession. This recession may begun when the last ended.


The parallel is there. To get a stubbornly moribund economy moving again, the Fed kept the Fed funds rate at 1.00% for a year (June, 2003 to June, 2004) and then raised it very gradually. This fueled the housing boom. An extended period of easy money and low bond yields led to much borrowing and reaching for yield. Investors, strategists and ratings agencies began justifying ever risky credits as being acceptable risks. Consumers believed the low rates were here to stay. This is much like the tech bubble's "New Economy" where old rules no longer applied. Much as then, investors, strategists and ratings agencies were incorrect.


Some historians now consider World War I and Word War II to be essentially the same war with a 21-year lull. It may be that the recession of the early 90s is the same as today's interrupted by the excess of the Tech Bubble (like the Roaring Twenties) and the Fed-fueled real estate bubble. The question now becomes: What will a "normal" economy look like.


This is a good and frightening question. Many businesses, such as Home Builders, Auto Makers, Retailers and investment banks are presently constructed to exist in an economy where credit flows like water. What happens to home builders if buyers actually have to prove they can pay mortgages and investors only buy MBS backed by these mortgages and then only with GSE backing? What happens to the auto makers when buyers choose less expensive vehicles because their payments are higher now that their credit history and ability to pay is being scrutinized (along with the fact that there is no home equity to be used to purchase a vehicle)? Gone are the days when one saved enough money to buy a car for cash. Relatively few Americans can amass $30,000 in a reasonable amount of time to buy a car for cash.


Many people long for the simpler time of the 1950s. A world of Ward and June Cleaver, frugal spending and conservative investments and business models. Except for pipes, slippers and a Bel-Air wagon in the driveway, they may be here. The economy will stabilize, but save for a new technological breakthrough, growth will return to a more modest and steady pace. This will make high-quality bonds, blue chip stocks with high-dividends and bank products the preferred investment vehicles.

Bill Gross has been in the news touting TIPS. He is correct. Although the best opportunities have passed, The 1.375% due 7/15/18 TIP is cheap at about a 1.65% yield a an inflation index below 1.00. This means that if one purchases this TIP and it is held to maturity, one will experience a principal gain due to the fact that a TIP's inflation index cannot be below 1.0 at maturity. If we have positive inflation, this is a relative home run. Inflation needs only to average about 1.0% to equal the return one could earn on the 10-year treasury. This is an attractive break-even.