There are two very conflicting views over the attractiveness of bonds. In one camp you have Bill Miller of Legg Mason. He published an Op-Ed in the FT Tuesday making the case for stocks:
It’s clear that economically things are getting better, not worse. In addition to gross domestic product numbers, credit spreads have returned to some semblance of “normal”, and the bond market has seen record refinancing. Yet stocks still sell below where they sold after Lehman failed, when the world was falling apart. Even in the week after Lehman collapsed, the S&P 500 traded as high as 1,255, more than 10 per cent higher than it is today.
Miller concedes (and of course he has to, since it is a fact) that bonds have outperformed stocks over the last 10 years; however, he expects that trend to quickly reverse:
After spending 10 years in the wilderness, high quality US large capitalisation stocks are cheap compared to bonds.
In short, his argument hinges on "good" economic growth and the Fed removing the extraordinary monetary accommodation it provided during the crisis:
I think 2010 will be a good year for stocks, and a challenging one for bonds. Low inflation, good economic growth, ample liquidity, rising corporate profits, attractive valuations, and continued investor scepticism should combine to move the market higher, perhaps substantially so. The current consensus appears to have the market up high single to low double digits. If the consensus is wrong, I think it will be because it is too low, not too high. At least that is what the facts, data, and evidence would lead one to believe, if one were unencumbered by a theory that says otherwise.
Now let's move to the complete opposite end of the spectrum, Dave Rosenberg of Gluskin Sheff. In today's missive, Rosenberg makes the case for bonds in 2010. For all of the pundits' calls for an overload of government debt, he points out that in actuality there is plenty of demand of new government debt, and the amount of long term debt (10 years +) held by the public is actually at a 39 year low. According to Rosenberg the households have more than enough capacity to meet the government's funding obligations:
While we highlighted the future debt rollover burden in the USA, keep in mind that less than 10% of the outstanding U.S. Treasury debt is in maturities of 10 years and longer — $555 billion of the total outstanding debt held by the public of $6.2 trillion. The share of the debt pie 10 years and longer is actually at a 30-year low! So while it is going to be critical that the demand for Treasuries is strong as the refinancing calendar picks up steam (we think it is important to note that much of the supply is existing debt to roll over, as well as to cover the upcoming huge budget deficit) the general public has the capacity to meet the government’s obligations.
After all, the household sector did buy a net $400 billion of Treasury securities in 2009 and that was in a year that saw a huge rally in equities. Imagine what the demand will be this year if risk aversion comes back into vogue. Banks, insurance companies and pensions buy Treasury securities as well.
What Chart 4 below shows is that while the U.S. government has been ramping up record deficits to cushion the blow from the deleveraging in the private sector, when it comes to long-duration Treasury securities, they are actually less abundant than is generally perceived. This is why the consensus forecast for a rise in 10-year yields, to a 4-5% range, may be so far off base. There is actually a lack of appreciation for how little there is in terms of outstanding supply relative to potential demand for what must be characterized as the benchmark risk-free asset for funding actuarial liabilities.
(Click to enlarge)
Lacking any call risk or credit risk, long term Treasury bonds (and particularly zeros) are unique in their ability to deliver a specific cash flow exceeding the current rate of inflation for a Baby Boomer’s pension benefit in 2040. Inevitably, future rates of inflation will prove to be the key determinant of future levels of long-term bond rates. It is reasonable to expect that the inflation rate will be down for at least the next year or two, and given the demographic profile and the magnitude of unfunded pension liabilities in the U.S. (and internationally) it is very easy to underestimate the potential demand.
So, focusing solely on supply is akin to trying to call the winner of the Super Bowl based solely on a strong conviction that the Colts will score 17 points. It’s rather amazing that the asset class that delivered the greatest returns in the past decade is the one that is most detested. We just saw the JP Morgan survey of fixed-income investors. As of February 8th, a mere 10% were bullish — down from 16% a month ago — and 27% are bearish (63% are neutral). A month ago, 22% were bearish on bonds. But here we are, past the peak rate of growth for the cycle, the ISM already near the 60 level and policy reflation behind us, and there are nearly three times as many bond bears as there are bulls.
The primary trend is not to return to the 2002-07 parabolic asset and credit cycle, nor is it the brief interruption from last year’s unprecedented policy reflation — the primary trend is one of deflation, in wages, credit, rents and cyclically-sensitive goods and services.
It's interesting to see such divergent views. I think that is what makes this type of climate so difficult for investors, there are camps on polar opposites of the spectrum on every macro economic scenario. What the bond argument really boils down to is your belief in near term economic growth. At least for the issue of which asset class will outperform in the short run, say the next 12 months. The consensus and, thus, the market are expecting growth to be decent for 2010, somewhere in in the 2.5-3% range, with growth higher in the 1st half than in the 2nd half.
If you believe GDP growth can be better than 3%, you probably should be following Bill Miller. However, anything lower than 2.5% range, the market will view negatively and bonds are likely to outperform.
ETFs for Bill Miller' Camp:
ETFs for Dave Rosenberg's Camp:
- IEF iShares Lehman 7-10 Year Treasury Bond Fund
- TLT iShares Lehman 20+ Year Treasury Bond Fund
- SH Short S&P500 ProShares
Disclosure: No positions