by Bob Van Wetter

 

During what was a busy and news-filled quarter, the S&P 500 was up 15.93% including dividends. For the year, the S&P 500 is up 3.16%. The rise in global stock prices since early March has been a welcome development indeed and a tangible sign that economic activity is on the mend following the big banking and credit freeze last fall.  Many leading economic indicators such as building permits and consumer confidence have leveled off and in some cases have begun to trend higher. Positive trend reversals often feed on themselves, creating a positive feedback loop that increases confidence and begets more positive economic data points. One example is corporate debt whose pricing has improved and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity capital in recent months. Coincidentally, and thanks to extraordinary liquidity measures by the government, market fears of bank insolvency have faded and the prices of bank stocks have risen dramatically off their lows.

 

With the S&P 500 having gained some 40% since the lows were put in more than 18 weeks ago, the now famous 'green shoots' - early signs of an economic recovery - had better start yielding some fruit in the form of positive earnings and job growth soon or all bets will be off for a continuation of this spectacular rally. Thus far, many supply and demand or technical characteristics of this move off of the March lows bear no resemblance to bull market beginnings of the past. While hopeful signs are in evidence (see charts for a few examples), we are left to wonder whether conditions are right for a sustainable recovery that is replete with job creation, profit growth and higher home prices.

 

 

With all of the talk about inflation in the news lately, we thought it would be helpful to summarize our fixed income strategy for a potential inflationary cycle. While many of the traditional ingredients for inflation are present in the economy, investors cannot be certain that inflation is the only possible outcome. Thus, our fixed income portfolios are generally structured to address three probable outcomes from this crisis: 1) high inflation, 2) no significant inflation, and 3) future declines in rates.

 

1.     High Inflation. If we enter a period of sustained high inflation, our bond portfolios are generally structured with bonds maturing every few years.  This allows us to invest the proceeds from maturing bonds at higher interest rates as inflation rises.  While the total interest paid in the portfolio would lag at the start of the inflationary cycle, as new bonds are purchased at higher rates, your interest payments will increase. Then, when inflation falls in the future, your total bond interest would likely exceed current interest rates because the bonds bought during the peak of the inflationary cycle are still providing higher interest payments through their maturity dates. This way, we can ride up and down the interest rate cycles, without attempting to select one particular outcome for interest rates and inflation.

2.     No Significant Inflation.  It's possible we may not see high inflation.  If the economy stagnates or slips into another recession, interest rates may remain low.  Thus, we want to be investing today to capture a fair amount of interest on high quality bonds. If investors are waiting for inflation by holding large amounts of cash, they forfeit a great deal of current interest.  For example, interest payments on government money markets funds are currently below 0.50%, and interest payments on high-quality intermediate term bonds are at about 4.5%. This is a difference of about $4,000 in interest for every $100,000 of bond investments.   So waiting in short term holdings for inflation would be very costly from a current income perspective. 

 

3.     Rates Decline. While it seems highly unlikely, there is the possibility that interest rates in the bond market decline over the next few years.  This may occur if we enter a longer period of deflationary pressure on things like real estate and wages.  This is similar to the situation that occurred in Japan. That's why we currently hold some bonds that will mature several years from now. For instance, if interest rates declined next year, and we have a bond that matures 6 years from now, we will continue to collect the higher interest payment for the next 6 years.

 

Also, I invite you to check out my latest blog post for CBS MoneyWatch.  You can find it here.