MARKET WATCH | 6.2003
by George Gasson, Assistant Vice President/Portfolio Officer, Mellon Private Wealth Management
george@miaminightout.com

Investment Update, September 2002
The differential in interest rates between lower quality corporate bonds and Treasury bonds reached its peak in early October 2002, within a couple of days of the stock market's bottom. An index of below investment grade or high yield corporate bonds yielded 14.2% in early October, over 10 percentage points more than the yield on Treasury bonds maturing in ten years. Since the October peak, the yield on below investment grade credits has fallen to about 9.5%, a difference that has shrunk to about 6 percentage points over Treasuries. The narrowing of the interest rate spreads between high and low risk bonds indicates that investors are more optimistic about economic growth, corporate cash flows, and avoiding deflation.

.stocks have fallen back from their level of early January, while the credit spreads continued to narrow. We believe a disconnect between the credit spreads and stock prices is a very clear indication of the impact of war concerns on the stock market. The reduction in bond quality spreads reflects an improving economy, while declining stock prices indicates war concerns. Once the Iraq issue is successfully resolved, stock prices should begin to reflect the improving economy and reduced risks, as reflected in the credit markets. In the interim, we believe that the decline in stock prices will be contained in the general area of the October 2002 low.

Investment Update, March 2003

The S&P 500 bottomed in early March, 25 points above the October low of 775. Once the war concerns became a reality, stocks began a substantial advance, reaching 18% in the S&P 500 as of this writing in late May. For stocks to do well after a peak in interest rate spreads between low and high quality credits is not unusual. Once spreads have begun to narrow, the median gain for the S&P 500, considering the last fifty years, has been 18% in six months, 21% at nine months and 27% twelve months after the interest rate differential started to tighten. The uncertainty about Iraq delayed stocks from reflecting the willingness of bond investors to accept a higher level of risk. However, the recent spurt in stocks has enabled a catch-up to the historical experience of stock performance once yield spreads began to narrow.

Investors would find difficulty in gaining much comfort from recently reported economic data. Clearly, the economy remains soft. Corporate profits, on the other hand, have given investors something to cheer about. First quarter operating earnings for S&P 500 companies are about 12% above their level of a year ago. These gains were well in excess of expectations. Energy company profits, benefiting from higher oil prices, and weakness in the dollar, were important contributors to the surprising rate of profit growth. Companies also are keeping expense growth at a minimum, which has given a boost to margins. Carefully controlled expenses have been responsible for the lack of job creation, which has been a distinguishing feature of the economic recovery thus far.

Jump the shark moment

About fifteen years ago, several University of Michigan students were attempting to identify the episodes in which their favorite television programs hit their peak and began a downhill slide. One of the students suggested that Happy Days peaked when Fonzie jumped over a shark while water-skiing in the Pacific Ocean. Thus, "jump the shark" became part of pop culture, initially relating to television programs, but in recent years applied to peak moments for musicians, sports teams, and politicians. For example, Gary Hart's jump the shark moment occurred when he met Donna Rice. Perhaps the Red Sox's jump the shark moment was when Babe Ruth was sold to the Yankees.

We could stretch the "jump the shark" term to asset classes, designating a turning point in price and performance. Only in hindsight can the moment be identified when an asset class peaks. We want to use the term to designate an asset in the process of topping out for perhaps several years. We believe that high quality bonds are at such a jump the shark time. Their prices are in the process of peaking and, correspondingly, their yields reaching a low. Geopolitical concerns, deflation fears, a soft global economy, and the bear market in stocks have driven investors to bonds. Interest rates on Treasury bonds maturing in five and ten years hit lows in May last seen in 1958.

Why might the present be a jump the shark period for Treasuries and other bonds of the highest quality? After all, the Consumer Price Index, excluding the volatile food and energy components, has been unchanged for the last two months, which has not happened in twenty years. The US economy is showing little strength. Japan is showing zero growth and Europe's prospects are not good, given the recent surge in the euro relative to the dollar. But, the following factors persuade us that interest rates on very high quality intermediate and longer term bonds are likely to be very near their lows.

• More fiscal stimulus has occurred during this recessionary period than in any other over the previous forty years. The swing from large budget surplus to deficit occurred very quickly and represented a larger portion of GDP than the fiscal policy push in the severe 1982 recession, when unemployment was double the present 6% rate.
• The presidential and congressional elections in 2004 will not encourage an austerity budget.
• The dollar has declined over the past 18 months by nearly 20% on a trade-weighted basis. The declining dollar should stimulate growth as more competitively priced US goods recapture sales that have leaked abroad to foreign producers. As the strong dollar stimulated an increasing amount of cheaper imported goods, inflation was constrained. With the weakness in the dollar, the reverse will occur.
• The Federal Reserve has been very aggressive in lowering short-term interest rates. A further reduction may be forthcoming in view of the Fed's recent comments. Rather clearly, the Fed will be loath to raise short-term rates for some time because of concerns about deflation.
• A strong correlation exists between growth in money liquidity and subsequent economic growth. Even though central bankers have been rather aggressive since the market crash in expanding the money supply, the declining velocity of money has neutralized much of this growth. Perhaps the way to think about the concept of velocity of money is to consider the rational actions of an individual under inflationary and deflationary conditions. If we think the prices of goods will continue to rise, we would be anxious to spend promptly because things will cost more next week. The velocity of money will be high. In a deflationary environment, our money will buy more the longer we delay our spending, so we are in no hurry. The expanding money supply has been rather neutralized because its use has slowed. The velocity of money has rebounded recently, which should encourage global growth.
• Extraordinarily low short-term interest rates have encouraged financial firms to borrow short-term and invest in longer dated high-quality bonds, earning the spread. The Fed seems to have signaled that short rates will remain low, which probably has stimulated recent purchases of Treasury securities. Although the economy is too fragile for the Fed to even think about raising short-term rates for months, eventually short-term rates will rise, requiring the unwinding of this so called carry trade. When this last happened in 1994, interest rates on Treasury bonds rose very quickly.

If interest rates on high-quality bonds stabilize or increase, rates on lower-quality bonds will not necessarily follow. Even though the yield spreads have narrowed substantially, they remain historically wide. However, spreads will not narrow to levels seen from 1995 to 1997. Investors are much more conscious of default risks from rapidly changing technologies and deflation. Most of the capital gains from high yield bonds likely have been realized, however, the income yields remain attractive. Given the very dramatic collapse in spreads in the last few months and more recently the substantial flow into high yield mutual funds, we would be cautious about new investments into this asset class.

While we believe the economy will have a cyclical pickup in growth and inflation, the outlook for the next several years remains constrained. The undertow of deflation will not disappear. Debt burdens, poor demographic trends in the developed world, the negative wealth effects lingering from the bear market, and excessive investments in capital goods will continue to be impediments to strong growth.

Article courtesy of George Gasson, Assistant Vice President/Portfolio Officer,
Mellon Private Wealth Management
george@miaminightout.com