Happy Holidays
2011 Outlook
The Holidays are here and 2011 will soon be upon us. With liquidity scare from now through year-end 2011 should be the focus of all fixed income investors. 2011 is going to tell us much. It will tell us if the EU will hold together. It will tell us if the euro can survive as a currency. It will tell us if centralized monetary policy and localized fiscal policies is a feasible model in the long-term. 2011 will also tell us what a non-bubble U.S. expansion looks like.
Europe is going to be interesting. Its problems are not going to be solved with bailout funds and strong language. Troubled countries are either going to cut benefits to its citizens, adopt pro-growth policies or leave the euro and try to devalue their way out of their problems. The list of troubled countries may be expanding. Belgium may join the PIIGS among troubled European countries. I still haven’t come with a new acronym. The bottom line is that Europeans have some difficult choices to make.
One choice which will probably not be available is to continue with their market / welfare state hybrid while being part of a common currency. The ECB can do little to help distressed countries because it can’t ease or engage in QE to help a country like Greece without damaging the economies of countries like Germany. One way to solve this dilemma would be to give the EU the authority to dictate both fiscal and monetary policy for the entire bloc, a United Stated of Europe if you will. However, that would require member countries to give up their sovereignty and adhere to rules set by a central governing body. This will not go over well among the European populace. Although its demise is not certain make no mistake, the euro is in trouble.
Closer to home we will soon see what the economic potential of a non-bubble-fueled U.S. economy looks like. Economic data during the first half of 2011 will be positively affected by the extension of the Bush-era tax cuts and the suspension of the worker portion of the payroll tax. However as with all temporary stimulus measures, the benefits are likely to be short-lived and less affective than anticipated. By the end of 2011, the U.S. economy will have to fly on its own power. Not all stimulus will be removed. It is unlikely that the Fed will engage in QE3, but it is unlikely to raise rates in 2011.
Long-term rates may not have far to rise in 2011. The recent rise of long-term rates is mostly a correction following a smaller than anticipated QE2 program and better growth outlook. Current long-term rates probably have GDP between 3.50% and 4.00% mostly built in. We could see a 4.00% 10-year note by the end of 2011, but maybe not much higher. If the economy cannot gain more traction, long-term rates could languish in the mid-3.00% area. In fact, Philadelphia Fed President Charles Plosser, who has been one of the more hawkish and optimistic Fed officials gave his 2011 estimate today. He forecasts that 2011 will be in the 3.00% to 3.50% area.
Fixed income investing in this environment is not that difficult, if one manages expectations. Ladder your portfolio. Resist swapping into “sexy” products or overweighting on the long end of the curve (or the short end of the curve). Invest new money on the belly of the curve (5-10 years) unless that runs counter to your goals, objectives or risk tolerances. TIPS are rich. The break even between 10-year TIPS and the 10-year treasury is 230 basis points. With inflation likely to be tamer than what the alarmists are predicting us TIPS only as hedging vehicle. Watch out for bubbles in very-low-rated bonds (low B and CCC) and a correction in investment grade industrials. Financials, insurance and, to a lesser extent, telecom offer the best values.
Investors should consider callable agency bonds, including step-ups. I also believe that corporate step-ups offer value, more than do LIBOR-based floaters. CPI corporate floaters may be a better option. Not because inflation is going to run, but because even modest increases in inflation will be greater than what occurs in three-month LIBOR (the typical benchmark for floaters) as it is joined at the hip with Fed Funds and the Fed is not budging in 2011. Not unless housing takes off, removing significant headwinds facing the economy, but that probably will not happen.
Until next year.
1 comment:
Fifteen year flashback to a daily conversation I would have. Them: I want to buy some of those ECU bonds that TV/Magazine/Newsletter (or that new thing called Prodigy(you remember, the JV between Sears and IBM) or the Interweb) told me I should buy. They say it is going to replace the US dollar. Me: I'm glad you'd like to diversify your holdings, but don't buy it for the reasons you cited. A single currency without the political will to back it up is doomed to failure. Them: What do you mean? They are all coming together now in this European Union thing. Me: The EU won't have the power to tax anyone or direct mechanisms to enforce its decisions. They rely on the goodwill of memeber states. It's one thing for Germany to prop up and support the former East Germany, but it is a whole other thing to expect them to continually pump money into Belgium to fund their deficits or build endless amounts of roads in Ireland. Just buy Germany instead, its 1/3 of the ECU anyway.
The Euro has gotten as far as it has, like everything else in Europe basically, because of the existence of the US. It is actually pretty amazing it trades at the level it does (shows how bacd the dollar is). The biggest initial loser in a more freely traded Yuan is the Euro, followed Yuan itself and then maybe the dollar.
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