A VOTE FOR BONDS OVER U.S. STOCKS / BARRON´S INTERVIEW ( RECOMMENDED READING )

Monday, September 14, 2009

INTERVIEW

A Vote for Bonds Over U.S. Stocks

David Rosenberg, Chief Economist and Strategist, Gluskin Sheff & Associates

By LAWRENCE C. STRAUSS

AN INTERVIEW WITH DAVID ROSENBERG: The former Merrill Lynch economist sees an economic revival that's more like a series of lower-case Ws.

DAVID ROSENBERG, WHO LEFT MERRILL LYNCH IN May after many years to become chief economist and strategist at asset manager Gluskin Sheff & Associates in Toronto, doesn't consider himself bearish, just realistic. The 48-year-old Ottawa native maintains that the U.S. has too much debt, and that it will take years to repair the nation's public and private balance sheets. In the meantime, he says, the economic recovery will be listless, despite the $787 billion federal stimulus package, which he likens to "patching up a leaking boat."

Rosenberg isn't entirely gloomy, however, finding opportunity in bonds -- even though spreads between the yields on corporates and U.S. securities have narrowed. During his years at Merrill, Rosenberg earned plaudits for his prescience, in part because he picked up signs of a deteriorating economy before many others did. He has a similar role at Gluskin Sheff, which oversees $4 billion. Barron's caught up with him recently to learn more about his outlook for the economy and the markets.

Barron's: Now that you work in Toronto instead of New York, has your view of the world changed?
Rosenberg: The actual location of my work has exactly zero bearing on what my fundamental view is. Wherever you reside, the differences between Canada and the U.S. are basically twofold:

First, Canadian banks never endured near the same default experiences as was the case south of the border. The primary reason for that is because the words "down payment" were never stricken from the mortgage-market lexicon, as they were in the States. So not only did no Canadian bank cut its dividend, but no Canadian bank had to go cap in hand to the government for its survival.

Second, the Canadian economy and the stock market have about three times the exposure to the commodity sector that the U.S. does. If you see Asia as being in a secular-growth phase, that means that the Canadian stock market is in for a period of secular outperformance, compared to the United States. The really big difference between working in Toronto versus New York is that I'm not getting stuck in midtown traffic between meetings any more.

What's your outlook for corporate profits?

In terms of operating earnings for the Standard & Poor's 500, I think it will average $50 this year and probably around $60 next year. If the question is: "Has the profit outlook improved, benchmarked against earlier this year?" it has, no question about it.

I believe we've hit bottom in the profit cycle. That is borne out in the NIPA [National Income and Product Accounts] data, which revealed that both sequentially and seasonally adjusted corporate profits managed to rebound for two quarters in a row, even if profits are still down almost 20% over the past year. If there is a silver lining in the profit data, it's been this aggressive cost-cutting. Of course, the cost-cutting is a reason why aggregate demand has been so weak and why so many companies are still missing their revenue targets. But the cost-cutting, coupled with 6% productivity growth if the data are accurate, is simply astounding. These are the primary drivers behind the profit turnaround.

We have never seen this before -- that is, a situation where profits are on the rise with such a deep decline in revenue. However, the operative word is "sustainability." The market is basically priced for 40% EPS [earnings-per-share] growth over the coming year, but that's a little too much. It isn't a case of whether profits are rebounding. The question is the magnitude of the rebound.

What's your forecast for U.S. gross-domestic-product growth?

It's going to be down roughly 2.5% this year. Next year, it is going to be fractionally positive, probably around 1% to 2%. Are we past the recession? We may well be, but it is going to be a listless recovery.

What's your read on 10-year Treasuries, which last week yielded around 3.5% -- down from about 4% in June?

I'm generally cautious on the outlook for the equity markets. At the same time, I believe there is going to be room for inflation expectations to come down. What really drives inflation are wages, credit and rents, and all three are going down at the same time.

Rents, which comprise a 30% chunk of the CPI [consumer-price index], are deflating for the first time in 17 years, and this is what is going to dominate the deflation in the CPI for the foreseeable future. Inflation expectations have room to come down. As I see it, 10-year Treasury-note yields have locked into the 2% to 4% range, and the prospects that we head toward the middle of that range, or even lower, in the next several months are very high. That's against a backdrop of declining inflation expectations and an economy that probably will disappoint in its growth goals.

Plenty of people argue that deflation isn't a big worry. But wouldn't it be a major impediment to a recovery?

In some sense, it already is. Because of the deflation and the widespread excess capacity, both in the labor market and the product market, the only way that corporate profits are rebounding is through aggressive cost-cutting. These measures ultimately come at a cost of lower employment or fewer hours worked, and that feeds right into a listless consumer spending environment that's only really propped up periodically through the generosity of Uncle Sam.

It is one thing to have deflation when it comes from an innovation that sparks productivity. But when you get deflation that is principally driven by deficient demand, that's different altogether.

Is there any chance of a V-shaped economic recovery?

The odds are pretty close to zero. The case for the V-shaped recovery lies in a view predicated on the history of post-World War II cycles: the deeper the economic downturn, the more robust is the economic rebound. But in these previous cycles, the V-shaped recoveries were all in the context of a secular expansion in credit. What most analysts, economists and strategists are grappling with is what it really means to have had a 25-year secular credit expansion come to an end.

There's no question that we are going to get periodic spasms -- cash for clunkers, cash for clothing, housing subsidies for first-time buyers, etc. All of these things will give you a sugar high for a given quarter. But if you look at what happens after you burst a credit and asset bubble as deep as we did in this cycle, there is no V-shaped recovery. What you get is a series of lower-case Ws attached to each other.

Why are you more bullish on bonds than stocks?

The equity market is de facto priced for 4% real GDP growth. The corporate-bond market is priced for 2% real GDP growth.

So in terms of asset mix, it's pretty clear that you have more downside protection in corporate bonds right now than you have in equities. And if you can tolerate the risk, you can pick up a 12% coupon in the high-yield market. But if you are a more cautious investor, you have an array of solid investment-grade securities in the A-rated universe where you can pick up a 6% yield. With a negative 2% inflation backdrop, that equates to an 8% real yield -- a very juicy rate of return. In the equity market, you have a 4% earnings yield plus a 2% dividend yield, and you are in a riskier part of the capital structure. Corporate bonds are priced for the sort of recovery I have in my forecast.

How should investors allocate their holdings?

When you look at the household balance sheet -- and this is the largest balance sheet in the world -- 25% of it is in equities. Even today, 30% is in real estate, 12% is in cash, and less than 7% is in fixed income. The remainder is mostly in life-insurance policies and pension funds. But fixed income is the part of the asset pie that will expand the most over the next five to 10 years.

When you look at the labor market, the 55-and-up age group is the only one that has posted any job growth in the past year. They aren't coming back into the workforce because they want to. They are doing it because they have to. They need the income to make up for the record amount of lost net worth that they endured. From a life-expectancy table, they can see if they made it to 52, they are probably going to make it to 82. They aren't going to make up for all that lost wealth, but there is this growing realization that the boomers are going to have to prepare for retirement the old-fashioned way -- by putting more of their income into the coffee can, as opposed to buying more coffee cans.

Where do you see opportunities in fixed income?

It doesn't just mean Treasuries, which obviously are low-yielding and completely safe. But it also means a shift toward other forms of fixed income -- the municipal market, the corporate-bond market or even the equity market in terms of dividend yield and reliable dividend growth.

Yet we are going to see more reliance on income orientation and capital preservation, as opposed to strictly capital appreciation. The operative theme is safety in income at a reasonable price.
What do you need to see for the economy to be on solid ground for a sustainable recovery?

At the risk of sounding glib and dire, we have to go back to the concept of what mean-reversion really means. And when you come through a 25-year secular credit expansion, regressing to the mean isn't going to take months or a quarter. It will take years to bring levels of outstanding credit into realignment with the country's debt-servicing capacity. We are really in this deleveraging process. It is inescapable.

The government, including the Federal Reserve, is going to do its utmost to ensure that the process is as smooth as possible -- not unlike how the Japanese government did everything it possibly could in terms of fiscal stimulus. But this isn't about being bearish, it's not about being bullish, it's about being realistic that we are just simply carrying too much debt at practically every level of society. This process of deleveraging is going to require much lower GDP-growth rates in the future.

Do people ever tell you that you are too bearish?

All the time. This has become such a what-have-you-done-for-me lately investment climate that people tend to forget that, at the lows in March, people were wondering what they were doing in the equity market. And then 50% and five months later, people are wondering how they were not in the equity market. All this experience has taught me how volatile the markets are and how, in a short period, sentiments can go to such extreme levels. Inevitably, the fundamentals will determine the direction of the trendline, and everything else is just noise around that trendline.

It's crucial to understand that secular bull and bear markets move in 18-year cycles, and to understand that today, we are really only halfway into the secular bear market. Then you know how you can service your clients. In a secular bear, market rallies are to be rented, not owned. But in a secular bull market, corrections are opportunities to build your long-term positions at better prices, as was the case with the crash of October 1987.

What's your parting advice to investors?

We are in a post-bubble credit-collapse environment, and what is critical is capital preservation and income. Asset mix is extremely important. We at Gluskin Sheff have a cautious view toward U.S. equities. We're more positive on Canadian equities, given that the banks are stable and the commodity market is in a bull phase. We've been big fans of corporate bonds, though, admittedly, a good part of the low-hanging fruit is behind us. But they will be relative outperformers.

The rally in the U.S. equity market has been so pronounced that it is no longer just pricing in the end of the recession. It is pricing in two years of recovery. At this stage, there is a little too much risk. If the S&P 500 were to correct back to around 840 or 850, versus 1025 recently, I would be much more interested.

Thanks, David.

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