Bond Managers Like Stocks

The end of the tightening cycle has fixed-income types bullish.
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The year 2006 is off to a roaring start for stocks. And with fed funds futures predicting only one more rate hike from the

Federal Reserve

-- maybe two at most -- even fixed-income managers are saying this could be the year for stocks.

"Even though I've spent most of my career in bonds, I'm thinking that over the next year to two years equities should outperform bonds," says Jerry Webman, director of fixed income at OppenheimerFunds.

That's because like so many economists and money managers, Webman believes that the fed funds rate will top out at 4.75%.

"It's important to look at what you know matters to the Fed chairman ... and they've told us over and over again that it's core inflation and that they'll sleep soundly with anything below 2%," says Mitch Stapley, who oversees $14 billion as chief fixed-income officer for Fifth Third Funds.

He says the core personal consumption expenditures index, or PCE, the Fed's chosen inflation measure, is at 1.8%, so it makes sense for the tightening cycle to end with the Federal Open Market Committee's March meeting.

The housing market and the economy are slowing, but not contracting, just as Alan Greenspan has said they should, even while employment growth stays solid, Stapley says.

"Add all those things together and I see a bunch of Fed governors sitting pretty pleased ... with a slowdown in growth that markets and institutions have time to adjust to," he says.

If this is indeed the course the central bank takes, equities historically rally before the second-to-last rate hike as traders anticipate the end of a tightening cycle, says Bob MacIntosh, co-head of muni bond funds at Eaton Vance.

Moreover, foreign investors appear to be growing more bullish on U.S. stocks and may be looking beyond the Treasury market in order to reap higher returns.

The Greenspan years of low interest rates unleashed a slew of dollars around the world. Following the dot.com bust and the wave of scandals that hit Wall Street in 2000, foreign central banks plowed that money back into the safe haven of the Treasury market.

But Webman says foreign investors are buying stocks again at levels approaching the $400 billion made in 1999, and trending higher. Gross purchases dropped off to $200 billion in 2001.

He says that given how flat valuations have been, now might be a good time to bid on growth rather than value.

"It's time to look for a three- to five-year time horizon for earnings growth potential, rather than search for bargains," says Webman. "And there are also fewer and fewer bargains right now."

While it's tough to make a case that investment grade fixed income will do very well in 2006, Jim Hopkins, fixed-income strategist for all of State Street Global Advisors, says not to panic if foreign investors buy more stocks because there will always be foreign bond buyers.

"Our rates are higher, relatively speaking, than rates in the major economies of the EU and Japan ... and I would maintain that our credit is better," Hopkins says.

Pension reform in Europe, and to some extend in the U.S., is also forcing companies to buy longer-dated, relatively safe, U.S. Treasuries in order to shore up shaky pension plans.

"The trend for 2006 would seem to be higher rates for the early part of the year and widening credit spreads," Hopkins says.

Whether the Fed gives the equity market what it wants, 2006 is a high-risk year and should be played accordingly, says Michael Cheah a portfolio manager at AIG Sun America Asset Management and the former chief representative with the Monetary Authority of Singapore.

This year marks a major transition at the Fed; Greenspan's departure as Fed chief, the likely end to rate hikes and even the beginning of fed funds rate cuts by 2007.

"With all the uncertainty, people will start second guessing. And that could drive positions very quickly," says Cheah.

"I'll stay close to the benchmark and trade opportunistically within a rolling, one-month view based on employment data," he says, adding that employment figures will set the pace for stocks.

But short-term, tactical asset location doesn't sit well with OppenheimerFunds' Webman, who says that how you allocate should depend on when you need the money and how much money you need, not on guessing the near-term future of stocks, bonds or currency.

"In the short term, it is hard for any of us to outsmart the sum wisdom of everybody else," he says. "And even if there is short-term volatility in interest rates, if you don't need the money for 10 years it doesn't matter as much."

For the excited equity buyers among us, a final caveat:

Conventional wisdom calls for stocks to rally once the FOMC stops raising rates. But this could be a situation where traders should buy in anticipation and sell on the event, writes Richard Suttmeier, chief market strategist for Joseph Stevens & Co., and a contributor to

TheStreet.com

.

If the economy slows too much, corporate profits would come under pressure, which would stymie huge returns.

And there are plenty of rational reasons why central bankers would keep a foot on the brake, Suttmeier adds, citing housing bubbles, the budget and trade deficits, skyrocketing gold prices and spiking fuel costs.

"If for some reason they go to 5.75% on the fed funds rate, it's a whole different ballgame," agrees Fifth Third Funds' Stapley. "You'd see a sharper slowdown in the economy led by a sharper downturn in the housing market and a much more painful impact on the consumer."

The 30-year Treasury bond would likely rally in such a scenario, "and there would be a nice inversion in the curve," Stapley predicts. "But the only people who would enjoy that would be fixed-income investors hanging out on the long end."