A Moderate Recovery Is in the Works

These days, I know plenty of economic bears and bulls. The bears say we're just at the beginning of an economic downturn, and the events of Sept. 11 will only magnify the problem of the tech bubble's demise. The bulls say that though September's events caused a sharp downdraft, we're now primed for a strong recovery.

Me? I think the economy was struggling before September, and it was given a sharp push down. When a recovery starts, probably sometime in the first half of next year, we'll most likely see a fairly slow and modest advance unless we get some help in the form of lower corporate bond yields.

A Chilling September

Before September, it felt like we were in a recession, though the economy had so far escaped the technical definition. I felt any recovery would be modest and reminiscent of the sluggish expansion of 1991, largely because of the similarities between the two periods in the fixed-income markets.

As a result of the 1990 recession, the Fed lowered short-term rates by 500 basis points during a period of massive federal budget stimulus. (Does this sound familiar?) Yet bond yields remained stubbornly high, and that high cost of capital helped lead to one of the slowest starts to an expansion on record. That contrasts with 1998, when both short- and long-term rates fell in tandem, helping to bring on several years of supercharged growth.

After Sept. 11, I noted a lot of crosscurrents, but the economic outlook would rely in part on two big factors: our response to terrorism and domestic travel patterns.

Hopefully, the fall of Kabul is a precursor to even better things in the war on terrorism. As for domestic air travel, it looks to have bottomed out, because the initial 30% decline has since improved to a 20% decline. Hopefully, that gap can narrow to 10%.

Because air travel and the spending that accompanies it account for about 10% of gross domestic product, a 10% drop in air travel over the next year could imply a 1% hit to GDP. Some of that would be offset by local trips made by alternate means of transportation, so a rough impact on GDP from travel would seem to be a loss of 0.5% to 1%.

How several other positives and negatives play out will determine whether the economy can surmount this dent from travel.

Impact on Bonds

For me, the biggest positive is the decline in oil prices. It's difficult to have enduring, strong growth with high inflation, because bond investors panic and send the cost of capital skyrocketing. If oil remains where it is, the consumer price index could trend down to 1% or so over the next year. Many of my friends in the bond market worry that the economy will rebound and push inflation higher after it bottoms. However, they've been worrying about that all year, so if they keep bond yields high and the economy slow, that fear may begin to recede.

If so, then intermediate- and long-term bonds look like great values. If something sends oil prices back up, bonds would become an instant sell among fund managers. I think corporate bond yields are high enough to provide a decent return over inflation, even if consumer prices creep up to the 2% to 3% range in the next few years.

Consumer spending fell off sharply after the attacks but has recently shown signs of life. Lower short-term rates can help sales at General Motors (GM), Ford (F) and DaimlerChrysler (DCX), and their 0% financing offers have helped sales. Given these companies' cost structures and that their cost of capital has escalated drastically in recent months, these sales aren't particularly profitable. However, they show that consumers are willing to spend at certain price levels.

The demand for safety among bond investors has helped to pull mortgage rates down along with the 10-year Treasury, and that's also supporting consumer spending through increased refinancing activity. However, I think mortgage-backed bonds are overvalued, so I think some risk exists for a continued refinancing boom. If the battle in Afghanistan continues to progress, bond investors could be ready to take more risks and end up selling mortgage-backeds (pushing their yields higher and making refinancing less attractive) and gravitating to higher-yielding corporates.

The fairly high bond-yield levels relative to expected inflation are a major reason I don't feel the economy will get significantly worse. Should the pace of layoffs increase and the economy threaten to slow further, bond yields have plenty of room to fall and support the economy. While short rates have fallen 450 basis points since the Fed began easing in January, the 10-year Treasury yield has fallen by only about 100 basis points, and corporates by just 30 to 40 basis points.

Short- and Long-Term Yields

Source: Federal Reserve Board

With a brighter outlook for inflation, the cost of capital to companies has actually risen this year, which is why capital spending and the economy may have a hard time accelerating. It's also why I'm overweight in corporate bonds. I've never seen the corporate market so sick, especially factoring in the combination of spreads vs. Treasuries, expected inflation and the lack of liquidity in the market. It seems to be discounting a very nasty credit cycle. If things turn out better than what the market is discounting, that could lead to outsize gains for corporates -- and lend support to equity valuations.

If year-end pressures intensify, I'm prepared to add, in gradual slices, to my corporate holdings over the next month and a half.

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