7/11/05 Barrons -- bond bulls (Gary Shilling, Van Hoisington, and another guy)
Barron's
Monday, July 11, 2005
Bad-News Bond Bulls See Further Yield Declines
By JONATHAN R. LAING
THEY COME FROM VERY DIFFERENT CORNERS of the investment world, Texas-based fixed-income manager Van Hoisington, market strategist Gary Shilling and Merrill Lynch North American chief economist David Rosenberg. But what the far-flung threesome have in common is an uncommon view: They've been unabashed bulls of the long-term bond market -- despite near-universal opinion from Wall Street and beyond that long-term yields would head higher (lots higher) and send bond prices skidding lower.
And although bearishness on bonds has been a classic no-brainer, with opinion to the contrary inspiring derision, this intrepid trio has had the last laugh.
Imagine the embarrassment of the overwhelming majority of the prominent economists surveyed by The Wall Street Journal, who predicted that long-term rates were going to rise markedly during 2004 -- only to have 10-year Treasury bonds rates dip slightly over the succeeding 12 months by three basis points (0.03 of a percentage point), to 4.22%, and the 30-year Treasury yield drop by 24 basis points, to 4.83%.
This year, the same redoubtables in the Journal survey were at it again with their consensus forecast that 10-year Treasury rates would reach 5% by year-end. But as of last week, they appear to be wrong again, as the 10-year note hovers around 4%.
What makes the drop in long rates all the more amazing is that it has occurred in the face of aggressive Federal Reserve hikes in the key short-term federal funds rate over the past year, from 1% to 3.25%, inflation scares from soaring oil and other commodity prices, spirited U.S. economic growth and worrisome U.S. budget and current-account deficits. No wonder a clearly frustrated Fed Chairman Alan Greenspan several months ago declared the seemingly aberrant behavior of the bond market to be a "conundrum."
But to the Barron's three musketeers, there's no mystery at all on why long-term yields are falling, rather than soaring. And they assert that long rates may stay at current levels or even decline further for years to come. "Most bond forecasters pay far too much attention to cyclical forces, while ignoring the big secular picture," Hoisington claimed in a telephone interview with Barron's. "Though the secular bull market in bonds began in late 1981, we think that long rates could remain at current levels or even go lower for decades to come, short of the outbreak of a major trade war or global spate of rapid monetary growth."
AS BOND BULLS, the Barron's three tend to look through an economic glass darkly for signs of an impending slowdown. Bond yields, of course, rise and fall on inflation expectations. And nothing ultimately leaches inflation from the system as effectively as tepid economic growth or recessions.
(caption below a photo that cannot be seen on this SI message) :
Aging baby boomers needing income and guaranteed return of principal are becoming huge buyers of long bonds. --David Rosenberg, Merrill Lynch
To the three forecasters, signs of menace abound, despite nearly five years of economic recovery bolstered by decent job growth and rising consumer confidence and spending. Hoisington and Rosenberg worry, for example, that the index of leading indicators has gone negative on a year-over-year basis in recent months. This has occurred eight other times in the past four decades. Recessions occurred in the ensuing year on five occasions, while gross domestic product growth slowed markedly 90% of the time.
Moreover, a flattening yield curve (which occurs when short-term interest rates rise to levels near those of long-term rates) has historically presaged economic weakness.
New York-based Rosenberg points out that the Fed has hiked short-term rates 175 basis points or more four times since 1984. On each occasion, real GDP growth slowed to an average of 3.1% from 5.4% in the preceding four quarters. "And this has hardly been a barn-burner recovery anyway. Private, nonfarm payrolls thus far are still 82,000 below their pre-recession high in 2000 even five years later," Rosenberg noted prior to the release of the June jobs report on Friday.
Shilling, an economist who runs his own firm in New Jersey, contends that the U.S. consumer, yeoman of the current economic recovery, won't be able to bolster economic growth much longer with ever-bigger dollops of spending. Indeed, record household-debt levels and no new tax cuts or rebates in the offing militate against consumption surges in the near future.
But all three assert that the fall in long-term bond rates reflects sea changes in U.S. and global economic dynamics that could persist for years. And indeed the decline in long rates is a global phenomenon, belying the contention that the recycling by Asian central banks of U.S. trade and current-account deficits into Treasuries is the primary factor keeping American rates so low. Bond rates have plummeted to multidecade lows in much of Europe and Australia and in China, Taiwan, Singapore and Japan are below U.S. long rates.
BETTING ON SUCH A DISINFLATIONARY brave new world, Hoisington has sat by placidly with the overwhelming bulk of his now $4 billion managed portfolio in long-term government bonds since 1990, even through periods of vicious rises in rates, such as the ones that occurred during 1994, 1996 and 1998.
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A global surfeit of goods and services could push down prices, which would be hairy, as massive U.S. debt gets liquidated. --Gary Shilling, A. Gary Shilling & Co.
In fact, during these rate rises, Hoisington increased the rate sensitivity or risk of his position by loading up on zero-coupon Treasuries (now 50% of his portfolio). Overall, he has been amply rewarded, producing a net compound annual return over the past 15 years of 9.8%, compared with 7.7% for the benchmark Lehman Brothers Aggregate Bond Index in that span.
Key to the Hoisington strategy was his and economist partner Lacy Hunt's apercu that the game had changed dramatically with the fall of both the Bamboo and Iron Curtains and the "integration" (Greenspan's favorite word) of India into the global economy. Hence, inflation and inflationary expectations were likely to wither over a number of years as huge new reservoirs of productive capacity and cheap labor were unleashed.
As a result, Big Business and Big Labor, the oligopolistic bulwarks of the post-World War II affluent society, would lose their pricing power. Mass migrations of rural workers to higher-wage areas like China's coastal cities, South American and Indian urban centers and across the Mexican border to El Norte would continue unabated for years, putting a lid on labor costs. And the economies of scale now possible in today's vastly larger global trading markets would only bolster the disinflationary forces at work.
In fact, Hoisington and Hunt argue that the last time such an integrated global market existed was from 1871 to 1949, when long-term Treasury bond rates averaged 2.8%; annual inflation, 0.7%. This even with two World Wars and debilitating trade wars that flared up during the 'Thirties. But all of that ended with the onset of the Cold War in the late 'Forties and the splitting asunder of the global economy.
ADDING TO THE DISINFLATIONARY FORCES has been the capital-spending boom since the 'Nineties in the U.S. and overseas, which has created sharp rises in productivity and mountains of excess capacity. Hunt notes that from 1994 to 2004, real, non-residential fixed investment averaged 10.9% of real U.S. GDP, compared with an average of 7.6% from 1919 to 2004.
The other period that nearly matched this spate of investment was 1919-1928, when implementation of Ford assembly-line techniques and the electrification of industry and homes revolutionized American society. Meanwhile, Chinese capital spending recently hit an off-the-charts 40% of GDP.
"Look at the efficiency gains and disinflation that occurred after the 'Twenties capital-spending boom or even deflation that took place in the decades after the post-Civil War railroad boom, and one gains an inkling of what may lie ahead for the U.S. and perhaps the global economy," Hunt asserts. "It's certainly fair to expect that the IT [information technology] and Internet revolution of recent years will have as profound effect on inflation and interest rates."
Demographic trends inform much of David Rosenberg's bullishness on long-bond rates. As the Merrill Lynch economist sees it, aging baby boomers -- some 76 million strong -- are on the cusp of becoming huge buyers of Treasury bonds and other long-dated fixed instruments.
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"Most bond forecasters pay far too much attention to cyclical forces while ignoring the big secular picture." --Van Hoisington, Hoisington Investment Management
According to Rosenberg, the boomers have ruled the economic roost in the U.S. for more than four decades. For example, auto sales surged in 1962 as the first wave of boomers reached the driving age of 16, and kept soaring in seven of the next eight years in response to the demand from would-be James Deans. Ten years later, in 1972, housing starts hit their all-time, annualized high of 2.6 million units almost to the year the leading edge of boomers moved into its prime household-formation period.
He ascribes the surge in inflation between 1973 and 1980 to loose monetary policies, largely designed to ease the financial burdens of Ward Cleaver families encumbered by big mortgages and consumer debt by inflating the value of their assets and allowing them to service their obligations with cheaper dollars.
Financial rectitude only returned to the U.S. in the early-'Eighties, just about the time the boomers entered their prime earnings years. By then, stocks had become that generation's focus. Inflation became anathema as the stock market in 1982 shook off its somnolence and began an 18-year run to glory.
Now, another dramatic shift impends.
The leading edge of the boomers hits 60 next year and begins to seriously consider retirement. Income will become paramount over growth. Thoughts will also turn to assets' staying power, with life expectancies anticipated to increase several years a decade from the current level of around 78. Finally, says Rosenberg, capital preservation will become an imperative. The time to make up any losses will be dwindling. "In short, no assets serve all these needs quite as well as Treasury bonds," he asserts.
If so, the transition could have a galvanic impact on future government-bond rates, according to Rosenberg. For one thing, the latest Federal Survey of Consumer Finances (done in 2001) shows that the boomers, in particular, are wildly overweighted in stocks and underinvested in bonds for the stage of life they are in. Secondly, the quantity of long-dated U.S. government bonds has dwindled since the Treasury suspended in 2001 the sale of 30-year maturities to $458 billion from a peak in 2000 of $562.5 billion.
Tentative plans by Uncle Sam to resume issuing some $20 billion or so a year of 30-year bonds may help alleviate the supply problem. Still, Rosenberg expects voracious demand for the long paper -- not only from personal investments by boomers, but also from pension funds, endowments and other institutions seeking to match their assets with long-term liabilities.
WITH AGING POPULATIONS, France in February issued 50-year government bonds and Germany is considering a similar move. The French issue was wildly oversubscribed, and has rallied sharply to a yield lower than the current U.S. 10-year bond. The U.K. also recently issued 30-year debt in response to market demand, and is mulling a 50-year issue.
Finally, notes Rosenberg, boomer political pressure will keep U.S. policymakers hawkish on inflation for years to come. After all, inflation would be deadly to boomers, once they load up on long-term bonds and begin to live off a fixed income. Inattention to inflation would quickly replace cuts in Social Security as American politics' third rail.
Gary Shilling has been bullish on the long bond since long rates began their now decades-old descent in 1982. His sunny disposition oddly contrasts with his often saturnine views of the U.S. economy. He has often erred in predicting recessions, even during periods of unambiguous boom like the late 'Nineties.
But his optimism about the long bond arises more from his long-held conviction that the U.S. will soon see deflation, after more than seven decades of generally medium to hot inflation. After a close brush with deflation in late 2003, Shilling thinks U.S. prices could actually fall during the next recession, which, naturally, he thinks is likely to come next year or the year after.
BUT THIS WILL BE A GENERALLY GOOD kind of deflation, reflecting new prodigies of global productivity and a growing abundance of global goods and, increasingly, services. Of course, the transition to deflation could be a bit hairy, given the excessive debt in the U.S. economy that will have to be liquidated first.
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Farther to Run? The great bond bull market, which started in 1981 with yields at record levels, isn't over yet, even with long yields down around 4%, say this trio of consensus-bucking seers.
Yet in such an environment, Shilling sees the 30-year Treasury dropping to 3% from a current level around 4.30% over the next two years for a total return of about 30% on regular bonds and 45% on zero-coupons.
He enumerates eight factors that will bring about his brave new world of disinflation, followed by mild falling prices. The list hasn't changed in years. The end of the Cold War has freed up resources formerly needed for defense spending. Central banks are consumed with stamping out inflation. Corporate cost-cutting and restructuring is taking hold on a global scale. Ongoing technological innovation promises further productivity enhancements. Super-efficient mass retailing promises further consumer savings as it spreads globally. Privatization and deregulation continue to spur healthy competition. Globalization is fueling worldwide excess supply. And finally, the U.S. consumer will begin to boost the national savings rate, reducing somewhat insensate growth in consumption and debt.
Shilling concedes that the last of his eight dynamics hasn't kicked in yet. Americans are still shopping 'til they drop and running up huge mortgage and consumer debts. That could quickly change, he avers, if the housing bubble is pricked. That would shut off the credit spigot afforded by cash-out refinancings and fat home-equity lines.
Will Shilling and our other long-bond pundits will be proven right in the years ahead? Long-bond rates have been coming down precipitously since the end of 1981. Rallies don't continue for ever.
To be sure, there have been some recent defections to the bull camp, notably Bill Gross of Pimco and Steve Roach of Morgan Stanley. And there have been some other bulls, such as Robert Kessler of Kessler Investments of Denver, which manages only Treasuries for wealthy investors. Kessler contends that the U.S. consumer, the ultimate linchpin of the global economy, eventually will give way and will have to be bailed out by even lower interest rates.
Nevertheless, the consensus view of the bond market is still overwhelmingly bearish. Our three stalwart bulls, correct though they've been in recent years, are still regarded by some bears as charter members of the flat-earth society. But one thing is for sure: In markets, the conventional wisdom is rarely vindicated by subsequent events.
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