Friday, July 30, 2010

Are Treasuries the Last Diversifier Left?

Luca Di Leo and Darrell Hughes of the WSJ report, U.S. Growth Slowed in 2nd Quarter:
The U.S. economy slowed in the second quarter as the government said the recession was deeper than earlier believed, adding to concerns over the recovery's strength.

The Commerce Department Friday said U.S. gross domestic product, or the value of all goods and services produced, rose at an annualized seasonally adjusted rate of 2.4% in April to June. In its first estimate of the economy's benchmark indicator, the government report showed growth was lifted by business investments and exports. Consumer spending, a key growth engine for the U.S. economy, made a smaller contribution to growth.

Economists polled by Dow Jones Newswires were expecting GDP to rise by 2.5% in the second quarter. Stock futures weakened after release of the data; Standard & Poor's 500 futures were recently down about 11 points to 1086; Dow Jones Industrial Average futures were off 82 points to 10327.

In the first quarter, the economy grew by 3.7%, revised up from an originally reported 2.7% increase. But growth estimates all the way back to the start of 2007 were revised lower.

The report showed a bright spot continuing in the economy: the growth of business spending on equipment and software. This spending continued to surge, increasing by 21.9% in the second quarter, compared with a 20.4% rise in the first three months. The figures highlight the contrast in the economy between high company profits and a persistently feeble jobs market keeping consumers at bay.

Business spending actually climbed at the fastest rate since 1997, but the big story was the downward revision in the level of real GDP in Q1 2010, a point that Yanick Desnoyers, Assistant Chief Economist at the National Bank, addressed in his comment on the report:

The U.S. economy increased 2.4% in the second quarter, slightly below market expectations. Q2 delivered slower GDP growth compared to Q1 but with a marked acceleration in real domestic demand from 1.3% to 4.1%. We prefer to see a weaker GDP growth due to a rise in imports with strong domestic demand than a weaker GDP growth due to a weaker domestic demand.

That said, what was more striking in today’s report was the BEA’s annual revisions to the National Income and Product Accounts. The level of real GDP in the first quarter of 2010 was revised down by $100 billion. From a component perspective, consumption registered the largest revisions in dollar terms with a decrease of $134 billion. Accordingly, U.S. consumption is not in an expansion mode as originally reported but rather still in the recovery stance.

There are mainly two consequences with the BEA’s revisions. First, it means that the savings rate probably was higher than first thought and job creation is more than ever needed to sustain consumption growth (conversely it means that the U.S. consumer is deleveraging more quickly than expected). Secondly, the U.S. output gap is deeper in excess supply territory than before the BEA’s revision.

Bottom line: The Fed is on the sidelines for a longer period of time.

The output gap is deeper than we previously thought, but there is another reason why the Fed will remain on the sidelines for longer than we think: it wants to see asset reflation translate into mild inflation and avoid a protracted deflationary scenario at all cost.

Importantly, Fed policy remains geared entirely towards banks, allowing them to continue borrowing on the cheap to invest in risk assets all around the world as they shore up their balance sheets. This is why I remain bullish on stocks.

But what about bonds? I recently wrote a comment asking whether or not we're on the cusp of a global bond hiccup. My point was that global growth will put upward pressure on bond yields, and I thought the US economy was in better shape than what most analysts thought.

Obviously today's downward revisions in US GDP will continue anchoring down long-term inflation expectations. Some strategists think that Treasuries are still a buy:

Treasury yields fell Friday, with the 2-year note hitting a record low 0.55%, after the government said U.S. GDP grew a weaker-than-expected 2.4% in the second quarter.

Get used to both more weak economic data and lower Treasury yields says, Yves Lamoureux, investment advisor at Macquarie Private Wealth.

"If you're looking at leading [economic] indicators, they are pointing down," he says. "There's no doubt the next quarter and the one following are going to be disappointing." (On Friday, the ECRI said its weekly leading index rose to 121.1 for the week ended July 23 from 120.6 the prior week; but the index's growth rate fell for an eighth-straight week.)

With the economy slowing, the "secular bull market" in Treasuries should continue, Lamoureux says, predicting 30-year bond yields will fall as low as the average of comparable debt in Japan and Germany, which is currently 2.575%.

Furthermore, he argues the high rates of the 1970s and 1980s were the "black swan" resulting from the Fed's mismanagement of the money supply. Excluding that period, Treasury yields have mainly been in the 2-4% range since the 1900s; Lamoureux calls that the "natural equilibrium" for yields, while expressing faith the Fed has learned its lesson of the 1970s.

"I believe the Fed won't make the same kind of mistake again," he says. "From a long-term perspective, inflation is coming down. You will not get a big inflation shock."

Lamoureux's reasons for why Treasuries are still a good buy (and not in a bubble) also include:

Financial deflation: While the price of many goods and services continue to rise, Lamoureux estimates there has been a 2-4% annual contraction in the money supply since 2008. In other words, deleveraging is overcoming the expansion of the Fed's balance sheet.

Diversification: Treasuries are "the only asset class that compensates you" if stocks go down, he says, calling U.S. debt the "last diversifier left."

You can watch the interview with Mr. Lamoureux below. His views on financial deflation are echoed in Hoisington Investment Management's Q2 economic letter.

Also, his point on diversification is important because in a low interest rate environment, asset classes tend to be a lot more correlated than investors think. With so much pension money flowing into hedge funds, real estate, private equity, commodities, and infrastructure, this should worry us.

If a protracted period of deflation does materialize, it will ravage private markets. The Fed will do whatever it takes to avoid such an outcome.

Bottom line: We might be in for a long period where both bonds and stocks trade in a range. Better pick your spots carefully.

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