The economy has shifted from falling off a cliff to merely sliding downhill. Business confidence measures have bottomed across the developed world after free-falling late last year. Over the next few weeks, stocks and bonds will continue to price higher from their oversold levels, but sustained upside will require a meaningful economic recovery. Aggressive fiscal stimulus in most countries, combined with a restocking of corporate inventory, should stabilize GDP. However, real growth is reliant on fixing the global banking system and credit channels and allowing liquidity to begin flowing to the real economy. Thus, policymakers will need to continue their aggressive actions. Fixed income has attractive interest rates with relative long-term value because a sustainable up-leg in yields may take time to develop.
Corporate bonds are more attractively valued than stocks. High yield spreads have blown out massively since June 2008, a sell-off only matched in 1934, when the Great Depression was at its deepest. Thus, unless the U.S. economy falls into a downward spiral, in which case the default rate will skyrocket, the corporate bond market has over-discounted the recent economic fallout. In addition, all measures of inflationary pressures are deeply muted; prices are either deflating or flirting with deflation. Headline CPI has already dropped to zero in many countries, and global traded goods prices are falling. Thus with inflation being non-existent, the spread pickup available in the corporate bond market is more than enough to compensate for the risk of prolonged defaults and/or downgrades, particularly for the investment grade sector. Therefore, consider adding further risk exposure amongst investment-grade and high-yield corporate bonds as well as munis.
From a social-political perspective, there is an enormous backlash from Main Street to Wall Street. If Main Street wins the upper hand, capital owners may pay a heavy price in the years to come, and profit as a share of GDP may begin a structural decline as major social and economic forces turn against free-market capitalism. The prospect of a “double dip” recession and an impending public-sector finance crisis could interact with domestic politics, creating a highly uncertain and potentially unfriendly environment for equity investors. It is possible that the broad equity-market trend in the developed markets will be flat with tremendous price gyrations. From a regulatory standpoint, status quo is definitely not an option.
Looking forward, investors must shorten their time span and be willing to shuffle their portfolios much more frequently than ever. Equity prices have seen their cyclical lows, but the current rally is not indefinite. Expect high volatility to continue until uncertainties are resolved around the ultimate depth of the recession, the stabilization of the housing and credit markets, and the effect of the stimulus package going forward. The often preached “buy and hold” strategy for equities has mildly disappointed for the last quarter-century. Since 1983, the real total return for equities is 6.7% per annum, while government bonds have generated 8.5% per annum. From this perspective, “long only funds” have been at a disadvantage versus hedge funds, which have the option to generate profits from falling securities and markets and can implement a repeatable rotational strategy to capture advantageous market opportunities and incremental gains.
Michael Ashley Schulman, CFA
Hollencrest Capital Management