March 10, 2010Talk of President Obama’s new budget has faded. Investors for the moment face too many distractions from European credit problems and renewed doubts about the economic recovery. They will return to fiscal issues, however, and fairly soon, too. Projected deficits remain too large for too long into the future to avoid raising serious concerns about inflation, the dollar’s value, and the economy’s fundamental growth potential. When investors return to these questions, chances are markets will also see a return of the bond vigilantes that so roiled pricing some 15–20 years ago when Bill Clinton occupied the White House.
Almost forgotten now, the “vigilantes,” as they were called, held significant power in the early 1990s. Then, bond investors, with fresh memories of the severe inflation of the 1970s and 1980s and the Reagan budget deficits, showed an inordinate sensitivity to any red ink in federal finances. Their concerns over excessive government spending in 1994 pushed up bond yields by more than 300 basis points in the run-up to the midterm elections, helped alter the electoral landscape, and fundamentally changed policy. The vigilantes’ influence was so great that Clinton aid James Carville described their bond market as having an ability to “intimidate everybody.”
The Obama budget certainly invites a return to such vigilante behavior. In 2009, deficits soared. The recession cut into Washington’s tax revenues, to be sure, but the Troubled Asset Relief Program and the huge $787 billion stimulus also raised outlays by unprecedented amount. Red ink for the year as a whole ran at $1.4 trillion, more than three times the $459 billion of the previous year and, at 10% of gross domestic product, a burden unprecedented since the Second World War. Now, in an economic recovery, official White House estimates for the current fiscal year show even larger deficits of $1.6 trillion. Worse still, from an investment standpoint, the deficit estimates, even with an implausibly optimistic economic outlook, stay above $700 billion until 2013.
Adding further reason for investor uneasiness is the administration’s ambitious legislative calendar. Neither healthcare reform nor cap and trade nor special bank taxes are included in the administration’s estimates. Though the Congressional Budget Office concludes that all these actions would narrow the deficit, investors have their doubts about such “solutions.” On two out of three, the narrower deficit comes entirely from higher taxes, which only promise to raise costs throughout the economy, add to inflation, and hamper economic growth. On healthcare reform, narrower projected deficits rest on the dubious assumption that businesses will pay out any healthcare savings to workers and, consequently, raise income tax revenues. Meanwhile, gestures at spending restraint are little more than gestures.
Against such a backdrop, deficit concerns will almost surely multiply as the year progresses, especially on inflation, if the Federal Reserve continues to buy Treasuries directly. As occurred 15–20 years ago, fears of rising bond yields and falling bond prices will prompt traders and investors to move away from Treasuries, driving down prices and raising yields even before the Treasury debt burden reaches flood stage or any signs of inflation emerge. Since the White House cannot turn budget policy on a dime, the only way for team Obama to avoid such vigilantism is: 1) to end to this huge legislative uncertainty and 2) present a credible, balanced plan to contain the future flow of debt, one that includes realistic economic projections and genuine efforts to control spending. If Washington really wants to avoid the vigilantes, it will have to include some plan to control entitlements spending, which lies at the root of the huge deficits and which already exceeds half of the federal budget.
Though little in Washington to date points to an adequate response, the vigilantes have held off—less out of faith and hope than because of distractions. But such immediate distractions will dissipate as the economic recovery gains momentum and market participants become more secure about financial healing here and abroad. Investors then will consider the longer-term future. As they do, they will turn to budget issues, and an unresponsive White House will face renewed vigilantism.
Note: The value of an investment in bonds will change as interest rates fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. High yield securities, sometimes called junk bonds, carry risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. These factors can affect a bond’s performance. Any investment in bonds involves risks, such as credit risks, the risk of default on principal and/or interest payments, market fluctuations, or liquidity risks due to a limited secondary market. Bonds also may be subject to prepayment risk, interest-rate risk, and changes in prices. Bonds are not a suitable investment for all investors.
Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.
The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.
Investors should carefully consider the investment objectives, risks charges and expenses of the Lord Abbett funds. This and other important information is contained in a fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at (888) 522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.
Copyright © 2010 by Lord Abbett Distributor LLC. All rights reserved.
Website: www.lordabbett.com
NOT FDIC INSURED—NO BANK GUARANTEES—MAY LOSE VALUE
|
Most Popular Articles
