The 14 Percent Solution

Bond Mavens United

Stock analyst Meredith Whitney grabbed headlines recently with her perilous prognostications for the U.S. Municipal bond market. Hundreds of billions in municipal defaults will plague the country over the near term is essentially what she has been saying to the media.

While I disagree with her headline grabbing prediction (as do most reasonable analysts), many purveyors of municipal debt have said the effect of this will be to move municipal rates up thereby creating a buying opportunity for tax-free income investors. It is true municipal rates have jumped over the last few months, but is this a buying opportunity? I don’t think so.

Currently, the major risk with municipal debt (corporate and government included) is not credit risk but interest rate risk. Yields have recently increased but are still deep in the pygmy range. That is what will eventually hurt you (your net worth specifically).

James Grant, a leading authority on interest rates and bond markets, along with Bill Gross from PIMCO and others have essentially been saying the same thing. Stargazers beware; a bear market in bonds is in the offing - a secular move from decreasing interest rates to an environment of sustained interest rate increases.

Central bankers have lowered the cost of money for 30 years now, following global disinflationary forces downward, but also allowing for increased leverage due to lower real interest rates. Today however, yields have less to do with disinflation and more to do with providing fuel for an asset-based economy. 10-year real interest rates fell from over 5 percent in the early 1980s to just less than 1 percent recently.

But the tide is at the turn. U.S. Government debt has experienced recent price declines (yield increases) as the European Central Bank said monetary policy has to be monitored, and if needed, corrected. China’s central bank raised reserve requirements for lenders for the second time this year to counter inflation and curb property-price gains. German producer prices are increasing at the fastest pace in more than two years.

Inflation will be a dominant theme as we look ahead, global inflationary forces will generally push rates higher around the world. A Morgan Stanley gauge of stocks such as Archer Daniels Midland Co. and Deere & Co. meant to rally when inflation expectations match Federal Reserve targets added 46 percent since August 2010, almost double the Standard & Poor’s 500 Index.  While emerging-market equities beat developed countries every year in the past decade, except in 2008, you should not count on that now as Brazil, Russia, India and China battle higher food and commodity inflation.So what is one to do? Confront the risk and reward tradeoff, look hard at alternative strategies. Shorten the average maturity (duration) of your fixed income investments. Look at alternatives, such as a high quality mortgage REIT like Annaly Mortgage (NLY). This company greatly weathered the great recession, ROE looks good and using measured leverage has kept the stock in a fairly tight range, all while paying a 15 percent dividend. Buy blue chip stocks that pay higher dividends. There are options to explore that can mitigate the deleterious effects of higher interest rates and inflation.

C Blakely CFP®, CTFA 02/2011

Sources: Grant’s Interest Rate Observer, PIMCO, Bloomberg LP

Where to Invest Now for the Next 30 Years (Give or Take)

The largest economies 2011:

U.S., China, Japan, Germany, France, UK

The largest economies 2041: (30 years from now)

China, U.S., India, Japan, Brazil, Russia

If you have a long-term investment perspective and think globally about asset allocation, it may be time to review where you are invested internationally. If you are considering international investing you may want to consider a deeper analysis of these up and comers. Growth generated by the large developing countries, particularly India, China, Brazil and Russia could become a much larger force in the world economy than it is now – much larger than many investors currently expect.

Goldman Sachs issued an optimistic research report on global economies in 2003 which illustrated how China’s economy would overtake Japan’s economy as early as 2016. Well, they were right, kind of, it did happen, it happened in 2010. Maybe Goldman wasn’t optimistic enough.

A lot can happen over 30 years and there is a good chance that the right conditions in one or another countries economy will not fall into place and any projection will not be realized. However, if the BRICs (Brazil, Russia, India, and China) pursue sound policies (I’m talking mostly to you Russia) these projections may indeed become a reality. Remember, fifty years ago Japan and Germany were struggling to emerge from reconstruction. Thirty years ago South Korea looked a lot like North Korea looks today.

The progress of the BRICs will be critical to how the world economy evolves; they could become a dominant force in generating spending growth over the next few decades.

As developing economies grow, they have the potential to post higher growth rates as they catch up with the developed world. China's economy during the past 30 years has changed from a centrally planned system that was largely closed to international trade to a more market-oriented economy that has a rapidly growing private sector and is a major player in the global economy, not to mention the green economy.

There is a well-known existing econometric model from Levine and Renelt (http://www.fordham.edu/economics/mcleod/LevineandRenelt1992.pdf) based on cross-country econometric research that explains average GDP growth over the next the next thirty years as a function of income per capita, investment rates, population growth and secondary school enrollments. This closely matches the Goldman projections (in parenthesis) which employ a very different technique. The results are as follows:

Brazil – 3.3 (3.7) Russia – 3.5 (3.9) India –5.3 (5.8) China -5.8 (5.6)

These numbers predict robust average growth for these countries over the next several decades. Higher growth may lead to higher returns and increased demand for capital in these markets.

What are the implications? Well, the weight of BRICs in investment portfolios could rise sharply. The movement of capital might move further in their favor and significant currency realignments would take place.

As we become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for many global companies like Coke and Caterpillar. Being involved in emerging markets is likely becoming an important strategic choice for many firms large and small.

Therefore, being invested in and involved in the right markets –particularly the right emerging markets may become an increasingly important strategic choice. While international investing does not reduce portfolio risk by a significant amount, it is measureable. And it does increase a portfolios expected return slightly and in the long run that’s what equity investors are looking for – whether stocks are 20 or 80 percent of the portfolio.

CP Blakely - CFP®, CTFA, CMFC 12/2010

Sources: CIA The World FactBook, Global Economics Paper Number 99 - Goldman Sachs, American Economic Review Vol.82 pp. 942-963