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As a rule, commentaries from bond fund managers can be fairly gloomy reading. The lengthy report that Pimco just issued — Secular Outlook: Driving without a spare — is no exception to that rule. The author, Pimco’s CEO, Mohamed El-Erian, sees risks ranging from deflation to inflation. He does have a little optimism in his discussion of the U.S. and certain emerging markets, but that does not last long [emphasis added]:

Secular Outlook: Driving without a spare (Pacific Investment Management, May 2010, Mohamed El-Erian)

…The picture for the U.S. (and the U.K.) is more mixed, especially when compared with other regions. The country retains its position as one of the most dynamic and entrepreneurial economies in the world, with a proven ability to adapt and re-invent itself. Its corporate sector (and, especially, the large companies) has lowered its cost structure, increased cash cushions and termed out debt. It is still the provider of global public goods, including the world’s reserve currency. And, with the help of policy measures, its banks have undergone a meaningful balance sheet rehabilitation.

At the same time, however, the U.S. faces large and mounting structural headwinds.

The structural headwinds have a lot to do with excessive debt, political infighting and a few other issues you may have noticed. El-Erian continues:

The country’s public finances have taken a serious turn for the worse that will not be corrected anytime soon. Private sector credit creation remains hampered and the banking system will become more utility-like. Meanwhile, the household sector is still burdened by excessive debt, suggesting that further deleveraging lies ahead. Unemployment is high and will likely remain so for the foreseeable future, accentuating concerns about skill erosion and loss of labor market flexibility.

Politics are not helping, especially when it comes to confronting these structural issues in a timely manner...

Our concerns about the muted outlook for industrial country growth brings us to another focus of our discussions – whether there is an unencumbered balance sheet – another spare tire – that is both willing and able to maintain the leverage in the system, and do so with little collateral damage and few unintended consequences.

A 1963 Chrysler with no spare tire

His spare tire analogy is a good one. When I was 19, my first car was a faded salmon-colored 1963 Chrysler with four bald tires. I had a spare, but it was bald too. Eventually, I saved up enough money to buy decent tires, but I spent the first several months suffering from flats, changing tires, getting crummy tires patched and so on.

Essentially, our government is now running on four worn tires, with no spare at all. That is, we have gone ‘all in’ for this crisis and we do not have any more spare capacity to take on new debt if something else happens. Over in Europe, we see the same process at work.

…Last weekend’s drama in Europe is yet another illustration of this phenomenon. Policymakers are now forcefully using the balance sheets of the EU (ultimately Germany) and ECB to compensate for the debt excesses in the periphery (particularly Greece) and the related overexposure of European banks.

…An even larger-scale use of central bank balance sheets, if it were to materialize, would provide only a temporary respite, and the collateral damage and unintended consequences would be serious, including the impact on inflationary expectations.

…This potential evolution – from disinflation to inflation – will likely proceed at different speeds in different parts of the globe. It is already well in train in emerging economies and will remain so. Over the medium term, the U.S. will be next, with Europe and, even more, Japan lagging…

Reading between the lines, I believe Pimco sees governments everywhere doing their level best to reflate. He believes this will work in emerging economies such as China. Unfortunately, some countries or even regions may not be reflatable, at least any time soon. In that group, he would put Japan and Europe.

The U.S. should make the transition from a deleveraged economy that has strong deflationary tendencies to an inflationary one, but that won’t happen right away.

The sweet spot for fixed income

I agree with El-Erian that inflation lies ahead at some point, but I don’t see much evidence of that now. And, deflationary forces are still strong.

As a result, I think intermediate bond funds represent the sweet spot now in fixed income. This maturity level carries significantly higher yields than short-term instruments. Also, it avoids-- to a significant degree-- the high volatility of long-term bonds. I also believe that high quality bonds should make up the majority of an income portfolio, with modest commitments to other more volatile sectors such as high yield, emerging markets and distressed securities.

Disclosure: No positions

Source: Intermediate Bond Funds: The Sweet Spot for Fixed Income