Giving Thanks and Looking Ahead

It's been a tough year. With the events of Sept. 11, a weak economy, job losses and another down year for stocks, it's understandable to be unhappy. Even people I know who have done tremendously well this year on investments don't seem to be having any fun.

Yet as Thanksgiving approaches, everyone should be able to find at least something to be thankful for, even if it's simply being alive. If you're an investor, it probably means you're still in the game. After two difficult years, that's something to be thankful for.

If you've been able to stay afloat, you probably have a disciplined approach to investing with an eye to the future, much like many successful institutional investors. Pros usually return from the Thanksgiving respite focused on identifying next year's major trends and trying to align their portfolios to capitalize on them.

I've outlined here what I foresee as some of next year's major issues in the bond market, which in turn could affect the economy and equity markets.

Stock-Bond-Cash Relationship

I've written about the importance of having a mix of stocks, bonds and cash that fits your outlook and risk profile. Although you should constantly evaluate your mix, now is an especially good time, with year-end tax planning right around the corner.

Unless a radical shift happens in the next month, this will be the second consecutive year that bonds have outperformed stocks. This doesn't happen often, and it's historically been followed by a reversal in outcomes.

That doesn't mean that I think bonds are unattractive; I think they offer value compared with short-term rates and expected inflation levels. Last week's stunning selloff makes bonds more attractive to me, not only because yields are higher but also because the rise in bond yields makes it harder for the economy to accelerate next year.

There's no perfect allocation mix; it's an individual decision. A little thought can produce a blend that works for you.

Money-Market Flows

A huge fixed-income story this year has been the tremendous inflow of money into money-market funds and the disruption that has caused in the rest of the bond market. Next year we may see a reversal.

I've been frustrated with analysts who've been calling for this money to flow out of money funds all year; that call didn't make mathematical sense.

Now, with the two-year Treasury 90 basis points above the Federal Reserve's target for the fed funds rate, it's starting to make sense for banks to borrow in the fed funds market and take positions in the two-year. But because money funds lag behind market rates, it doesn't yet make sense for other institutions to abandon funds for riskier instruments. Considering current trends, it may make sense starting in midwinter, though that could change according to market movements.

Corporate-Bond Yields

The behavior of corporate-bond yields will probably have a big impact on the economy's performance next year. I've noted the similarities between the current environment and the 1990-1992 period; the charts below update some comparisons of the two eras.

The red line covers the period from September 1989 to September 1992, encompassing the 12 months leading up to September 1990's peak in industrial production (a handy, though simple, way to date turns in the economy) and the following two years. The blue line represents the current environment, starting in September 1999, through the September 2000 economic peak, up to the most recent data point.

Production has fallen further and for a longer time than it did in 1990.

Industrial Production Year-to-Year % Change

Source: Federal Reserve Board St. Louis

Oil prices have behaved similarly, though both the increase and decrease of this cycle have been more gradual.

Oil Prices West Texas Intermediate, $/bbl

Source: Federal Reserve Board St. Louis

If current energy prices hold, the consumer price index could drop to the 1% range over the next year. Investors can expect inflation to average 2% or less over the long term, measured by the break-even spread on Treasury Inflation-Protected Securities, or TIPs,. If so, bonds are attractive, especially when you consider that their yields haven't changed much this year despite the improved outlook for inflation.

As in the early '90s, short-term rates have eased tremendously. In the last cycle, the Fed brought overnight rates down by 500 basis points. This year the Fed has reduced them by 450 basis points.

Federal Funds Rate

Source: Federal Reserve Board St. Louis

Both cycles have also had a lot of fiscal stimulus. Recent tax cuts and additional spending will help shift the net budget around $200 billion from what was expected at the start of the year. From January 1990 to April 1992, the budget deficit soared from $150 billion to $332 billion.

Yet despite the fiscal and monetary stimulus, the start of the last expansion was one of the slowest on record. Why? A major reason could be because long-term bond yields didn't follow short rates down the way they usually do.

Corporate Bond Yields Moody's Baa Index

Source: Federal Reserve Board St. Louis

In both periods, professional bond managers worried that the economy or inflation were about to come roaring back. It took time for bond yields to come down in the last cycle; I think it will also take time for yields to come down (perhaps as a result of outflows from money funds) in this cycle. The longer that bond yields stay up, the harder it'll be for the economy to accelerate -- and thus the more attractive bonds will be.

After last week's selloff, most bond yields (Treasury, mortgage and corporate) with 10-year maturities and longer are now higher than they were Sept. 10. This means the cost of capital for companies remains high, and this will also put a damper on the refinancing boom that began last month.

The good news is that year-end pressures in the bond market don't appear to be intensifying. Corporate spreads in both the investment-grade and high-yield sectors have come in a bit in the past few weeks.

Given that this tightening is occurring at a seasonally difficult time of year, it offers hope that corporate-bond yields have room to fall next year. If so, that could spur the economy and give support to equities.