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2005 Economic Outlook

Around this time every year we try to identify the economic trends that will help determine the fate of the markets during the year ahead and suggest particular areas in the fixed income arena that will help to add value to our clients' portfolios. The results of our efforts follow.

2005 appears to be a year where global growth will slow on the back of a cooling U.S. recovery and Europe and Japan will not be able to pick up the slack. Increased labor costs and a weaker dollar will create inflationary pressure, but the headwind of worldwide production overcapacity will help mitigate this effect. We expect yields on 10-year Treasuries to range between 4% and 4.25%, while keeping an eye on the possibility of a .25% breakout on the high side of that estimate.

Some key aspects of our outlook are:

Slowing U.S. Growth – Slack in the U.S. economy is narrowing but growth will be constrained by the removal of accommodative monetary and fiscal policy as the Fed tightens interest rates and the benefits of fiscal stimulus decrease. The housing cycle will moderate, causing not only a slowing in the industry, but also slowing consumption of homeowners as they are no longer able to put their home's equity into play in the economy. Lack of pent-up consumer demand and heavy consumer debt burden will also put the brakes on this very important engine of global growth. Companies in the U.S. and Japan have ample liquidity to boost investment after repairing their balance sheets over the last several years, but a lack of confidence about growth and lingering excess capacity will subdue the animal spirits of corporate executives.

Foreign Financing of U.S. Consumption – With its low savings rate, the U.S. must rely on foreign lenders, mainly Asian central banks, to finance its consumption and the trade deficit that accompanies it. The chart below shows the erosion in the U.S. trade balance over the last four years and the critical role Asian economies play in providing low cost “vendor financing” to the U.S.

In the short run, this game will go on, since it mutes appreciation of the Chinese and Japanese currencies versus the dollar and sustains export-led growth in those countries. There is reason to doubt, however, that China and Japan will continue to provide such financing on agreeable terms over the long run. In fact, purchases of U.S. bonds by Asian buyers may already be near their peaks. Some marginal decline in purchases may occur in 2005 in conjunction with an upward adjustment of China 's currency. The result would be upward pressure on U.S. rates and further weakening of the dollar. The extent to which the U.S. dollar has declined against the euro and yen over the last four years is depicted in the chart below:

Europe and Japan Will Lag – Europe will not add much to global growth. The European Central Bank has been reluctant to cut rates to stimulate domestic demand; exports are vulnerable to a strong euro; and business and consumer confidence remain weak. Japan 's contribution to growth will also lag that of the U.S. Japan 's export-led recovery will be constrained as China moves to cool down its economy to curtail its own inflationary pressures.

Emerging Markets Add Stability – After painful currency and financial crises in the late 1990s, many EM economies opted for reform and restructuring. The results have been impressive: an increasing share of global GDP, accumulation of record currency reserves and growing trade surpluses.

So what does all this mean for the bond market and stable value investors?

Defensiveness and value are the keywords in this environment where interest rates are low and core bond sectors have continued to richen. Tactical flexibility will be critical in this setting, such as shifting between U.S. and non-U.S. bonds or between market sub-sectors within the U.S.

Duration – Duration targets should be kept modestly below benchmark. This strategy should include gaining less interest rate exposure in the U.S. and taking more interest rate risk in Europe. The reason is simply that a strong currency and slow growth will temper inflation and interest rate risk in Europe compared to the U.S.

Retain Underweight of Core U.S. Sectors – Investors stretching for extra “carry,” or yield in excess of currently low short-term borrowing costs, have bid up values of mortgages and corporate bonds to frothy levels. While security selection in mortgages and corporates offers some opportunity to add value, these sectors overall represent an unfavorable trade-off between risk and reward.

Out-of-Index Allocations – Putting all debates about the wisdom of going beyond core sectors within stable value funds aside, the balance of risk and reward is currently more appealing outside the core sectors. Real return bonds should outperform nominal bonds in an environment where the Fed will keep real yields low to stimulate the economy. Longer-term municipal bonds offer attractive yields versus Treasuries in comparison with their historical relationship and present less credit risk than corporates. Emerging market bonds still offer value, as credit upgrades should continue in light of growing trade surpluses and increasing currency reserves in many of these economies.

In summary, with cautious positioning stable value funds should be able to maintain their yield advantage over money market funds as the Fed's “measured” pace of interest rate increases slows and leaves money market fund yields below 3%, while restrained inflationary pressures prevent a rapid rise in rates farther out on the yield curve where stable value funds earn their living. As a rising tide lifts all boats, gently rising interest rates will lift stable value fund yields and help this critical savings vehicle retain its well-deserved luster.

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