The debate rages as to whether the economy is improving or is it merely settling at its cyclical bottom. I believe the answer is "yes". By this I mean that the economy is worsening at a slower pace and that is a good thing, but it should not be surprising. After all, the economy can not drop forever. There is such a thing called replacement.
Replacement is the level of economic activity generated by consumers subsisting. Industrial production cannot go to zero as consumers need to replace broken appliances, fix leaky roofs and replace worn-out vehicles. What they are not doing is spending on discretionary items. Consumers are not upgrading appliances for the sake of convenience or enjoyment. They are not remodeling their homes nor and are waiting to make repairs until they cannot wait any longer. Car buyers are taking advantage of incentives and being most frugal when replacing vehicles which have seen better days. Few are opting for a loaded Tahoe. Watching the equity markets could lead one to believe that a V-shaped recovery was just around the corner. However, equity markets (and equity-like markets) are not necessarily the best indicator of forthcoming economic conditions, in spite of their inclusion in the list of leading indicators. Permit me to explain.
Of all the markets, the equity markets are most influenced by emotions such as fear and greed. When an economic downturn is at hand, equity investors tend to abandon the markets irrationally out of panic. When the worst appears to be over, they rush back into the market assuming that the economy must recover as rapidly as it declined. This strategy has sometimes worked, especially during the past 25 years of Fed induced recoveries. However, that did not necessarily apply before the days of Paul Volcker and probably will not apply this time around.
The fixed income markets are generally less prone to irrational fears or blind optimism. Of all the markets, the fixed income markets tend to reflect well-thought-out decision making. This is mainly due to whom are the market participants. Among these participants are foreign central banks, pension funds, insurance companies, etc. Smaller, less sophisticated investors have only a minimal impact on the fixed income markets. Notable exceptions have occurred in the T-Bill markets last winter when panicked retail investors, many of them equity oriented (or fixed income yield hogs) purchased treasuries at negative yields. Small investors acting en masse generated enough demand for treasury bills that yields for retail-sized T-Bill purchases when negative. That was a rare occurrence, a stampede if you will. Bond dealers were all too happy to sell bonds to the on-rushing herd as they drove themselves over a financial cliff.
False or premature hope can also occasionally appear in the high yield bond market. Many speculators or income-oriented yield hogs will rush in and buy high yield bonds hoping to score big on a recovery. What they don't realize is that high grade bonds and companies usually recover first and more quickly. Also lost on these investors is that corporate defaults often lag economic data. Companies often default after experience an extended period of time with poor earnings and either run out of cash and can no longer pay their debt or are sufficiently weak that they cannot refinance their debt. Think of high yield companies as salmon. During a recession they swim against the current trying to survive. When they finally get through these companies are so impaired that they fail. When one considers that we have just finished our sixth quarter of recession it is unlikely that many high yield companies will be able to refinance their debt at the sweetheart rates and with the easy covenants typical of several years ago if at all. That debt starts coming due on 2010. Hold on to your hats boys and girls, the defaults are coming.
Note: High yield bonds should be purchased for a total return, equity-like strategy. Relying on junk bonds for income is just plain foolish.
I have been of the opinion for quite some time that the recovery will be long and gradual. San Francisco Fed president Janet Yellen agrees. Yesterday, she stated that the Fed Funds Rate could stay at 0.00% for years and that, if the Fed could, it may take the Fed Funds Rate negative. That is not indicative of a V-shaped recover. Ms. Yellen also noted that China really doesn't have an alternative to the U.S. dollar as a reserve currency. This means that China and other exporters will probably keep supporting the dollar and help to keep long-term rates reasonably low for the near future. A few years from now, the amount of debt issued and dollars printed should push rates higher, but don't expect rates seen in the early 80s or even early 9os.
Welcome to your grandfather's economy. One which cannot be rekindled simply by making leverage cheaper and more available. The 25 year trend of lower rated ended when the Fed eased to 0.00%.
There are opportunities in fixed income. 5-10-year corporate bonds, especially non-TARP banks and, to a lesser extent, telecom and utilities offer attractive values, not only on an absolute yield basis, but also on a spread basis. As we know, credit spreads are the real keys to corporate bond investing
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