July ’07 Bonds The U.S. economy is a movable bubble, the latest being private equity borrowing on terms equivalent to the worst sub-prime mortgage lending practices. Fortunately, this one seems to have been nipped in the bud before an equal amount of damage could be done. But the sub-prime debacle is casting a long shadow, at least through 2008, and the worst may not have been seen. There are many forces which will combine to increase domestic interest rates. They are needed to counter a sinking dollar exchange rate, to fight an inflation rate rather higher than the misleading “core” rate, to rein in rampant liquidity leading to unwise capital allocation, and to stimulate the abysmal rate of personal saving. It should be worthwhile to make it just too expensive to risk becoming head over heels in debt. This works reasonably well with corporations and the public, but we haven’t yet found a way to make it work with the U.S. Congress.
Equities Equity markets make new highs almost daily. At the same time, money market funds have record assets. The usual see-saw relationship between these two asset pools is in abeyance. What gives? We think a large part of the explanation is a surge of buying by foreigners applying their higher dollar purchasing power to U. S. equities rather than Treasury bonds, the asset which has turned out, after all, not to be riskless for them. In a way, this amounts to a dog chasing its tail. Less demand for Treasuries will lower bond prices, raising interest rates, producing a negative effect on equity values, which may cause indiscriminate selling by both foreign and domestic investors, leaving little to show for the exercise. Either way, the offshore buyer loses. Foreign involvement in U.S. equity investment, both buying and selling, has traditionally been as ill-timed as the activity in mutual funds by Main Street USA. The U.S. represents only about 40% of world equity market value. The largest capital pools outside the U.S. should be taking more notice. In general, better values with less currency risk exist without our borders, an opinion even domestic investors are beginning to embrace.
The current earnings season is bringing at best lukewarm results. Even meeting or exceeding estimates is accompanied by less than encouraging guidance for the immediate future. And the dreaded September-October period of traditionally weak markets lies just ahead. The old saw “Sell in May and go away” failed to be prescient this year. We would not bet on the next three months delivering market returns at variance with normal. Energy, infrastructure, certain areas of health care and defense are sectors which should be able to cope. Financials and consumer spending sectors have less appeal. The huge amount of derivative risk present in the economy is apt to swamp generally well-upholstered corporate balance sheets if an unknown comes out of left field. The markets have enjoyed a long period of subdued volatility. This is very likely to change over the next year. Good for some stocks, not so good for others.
William Wright