April 19, 2011
More support for a bond rally
Texas-based Hoisington Investment Management supervises over $4 billion in fixed-income assets. In their most recent commentary, the firm’s principals, Van Hoisington and Lacy Hunt, were sharply critical of the Fed’s quantitative easing policy. They argued that it encouraged speculation, slowed economic growth and “eviscerated” the standard of living for the average American family.
On their last point, Hoisington and Hunt cited the “misery index,” which combines the unemployment and inflation rates. This metric was less than 7% prior to the financial crisis. Since the Fed announced QE2 in the second quarter of last year, it has risen from 9.1% to an estimated 14% in the current quarter.
“The Bernanke Fed provides fresh confirmation that trying to substitute higher inflation for lower unemployment harms the economy,” they wrote.
Hoisington and Hunt concurred with Gundlach, arguing that the end of QE2 will bring about lower interest rates. It will not restore the Fed’s balance sheet to a “reasonable size,” they said, but it will reinforce the actions of the other major central banks (the ECB, the People’s Bank of China, and the Bank of England), which have all commenced raising interest rates.
“The global upturn in inflation will reverse, thereby placing the global economy on a more stable footing,” they wrote.
Hoisington and Hunt advised investors to move gradually into Treasury securities, although they warned (as did Gundlach) that the economy would slow in the second half of this year. Deflation will be the dominant theme, creating a favorable environment for holders of long-dated Treasury bonds. “Positioning for an inflation boom will prove to be disappointing,” they said.
The likelihood of QE3
What if Gundlach, Hoisington and Hunt are correct and the economy slows appreciably in the second half of this year? Tighter Fed policy, rising interest rates and higher commodity prices could combine to bring about that outcome.
In an email exchange, Gundlach wrote that slower growth could also be a consequence of “a well-intentioned attempt to rein in the out-of-control budget deficit through tax hikes and spending cuts. “
If so, then pressure will build for another round of quantitative easing.
“When a debt-logged economy experiences even a moderate growth slowdown, the deflation winds begin to blow,” Gundlach wrote. “When that happens, the population will be screaming for QE3, and so they will get it.”
For active managers like Gundlach, the challenge will be to anticipate the Fed’s moves, assess market sentiment and correctly position their portfolios on the yield curve – a challenge that Gundlach has more than met over the last decade.
In light of Gundlach’s advice, however, a long-term buy-and-hold investor should simply position his or her portfolio for inflation.
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