BondsOnline Advisor

How to Play the Economic Recovery

by Stephen Taub

So, now that it is becoming increasingly apparent that a pretty decent economic recovery is underway, what should fixed-income investors do?

Tough question, given that the bond market is not behaving like it typically does during the early stages of an economic rebound. Rates are supposed to be taking off and the Fed is supposed to be raising short-term rates.

But, this isn?t happening. Although rates have jumped up since June, they have retreated somewhat from their summer peak. And the Fed is signaling that it probably won?t lift its short-term benchmark from its 45-year low until well into 2004. This is because employment and capacity utilization still haven?t picked up.

?Today, inflation does not appear to be a threat unless the economy rebounds with more vigor than economists believe it to be capable of accomplishing,? notes Smith Barney Citigroup in a recent report to clients.

So, how should investors play the 2003 economic recovery? One thing most pundits agree is that you no longer need to fear deflation. On the other hand, they believe inflation also is not much of a concern, although they are closely watching the labor and pricing fronts for signs of improvement.

Indeed, SmithBarney recently told its clients in a report, ?The futures market currently anticipates a rate hike as early as the first half of 2004.? Merrill Lynch agrees, pointing out, ?The fixed-income market traditionally sniffs inflation early, and it seems to have caught the scent.?

Merrill?s Steven Narker, director of research, private client, recently pointed out that Tom Sowanick, Merrill?s chief global fixed-income strategist, expects the yield on the 10-year Treasury to move toward 5.5% during the next year, and thinks the entire yield curve will rise and flatten in the months ahead. ?Fixed-income investors could find that shorter-term issues are the place to be when the overall level of interest rates rises,? Narker wrote. ?That?s because those maturities are less subject to price risk than long-dated issues.?

But, this is more of a defensive strategy. Merrill fixed income strategist Martin Mauro stresses that short-term rates, including those on money-market funds, are unlikely to rise meaningfully through next year. On the other hand, intermediate- and long-term rates may be pushed higher by the weakening dollar, the widening federal budget deficit and a gradually improving economy.

In fact, Mauro warns that since foreigners own about 40% of the US Treasury market, they may begin to require higher yields to compensate for their expected currency losses. ?We therefore recommend that investors de-emphasize longer-term issues, especially in the taxable market,? he adds.

Rather, investors who want to take advantage of the weakening dollar should consider selected foreign bonds. ?We also recommend the euro block, where we expect a 10% currency appreciation versus the dollar through next year and only a modest rise in yields,? Mauro adds.

And with the economy in general improving, he also thinks now is a good time to take on more credit risk. ?As long as the economy grows modestly, as we expect, spreads are unlikely to widen meaningfully, and they could even narrow further,? he explains. So, he has raised his allocation to high-yield issues for taxable accounts from 6% to 8%. But, he recommends these purchases be made through mutual funds.

Smith Barney agrees that lower quality bonds, such as Triple-B and junk, will probably outperform higher quality issues. But, it warns investors to be wary of reaching for yield in deteriorating industries, such as autos.

In general, Smith Barney recently increased the proportion of bonds in what it calls its ?tactical model portfolio? from 30% to 35%, and reduced the proportion of cash from 15% to 10%. ?This shift still reflects a modest underweight in bonds and a modest overweight in cash, relative to our benchmark asset allocation,? it added. ?Nevertheless, it reflects our view that any further near-term increase in intermediate and long-term interest rates is likely to be limited by low short-term rates and a benign inflationary picture.?

Smith Barney figures the most likely scenario is that rates rise gradually and the Fed Funds rate remains anchored at 1% for at least 12 months.

As a result, it recommends fixed-income investors not retain excess cash on the assumption that interest rates will rise significantly. Instead, it suggests extending beyond the very short end to what it calls the "belly" of the yield curve.

?In our view, purchases in intermediate maturities would enable income-oriented investors to capture the best combination of yield and relative price stability in both the taxable and tax-exempt markets,? it added. ?We continue to suggest shortening the duration of bond portfolios that are concentrated in long maturities to minimize potential interest rate volatility.?
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.