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David Rosenberg

Why I'm still a bull on bonds Add to ...

There's a widespread belief that the U.S. economy is going to grow vigorously, that Europe will solve its problems, and that emerging markets will propel a global recovery in the year ahead.

I think all these notions are questionable. Let me explain what I see as the biggest threats to the sunny consensus for 2011.

Europe hits problems - again. Most investors have taken their eyes off the ball when it comes to the prospect of a deflationary shock coming from the other side of the Atlantic, but the continent's problems are far from over. The euro zone has to refinance a record $750-billion (U.S.) of debt in 2011. Portugal will probably follow Ireland and Greece on the road toward emergency funding.

Another European debt crisis would drive volatility higher and prod investors to seek safe havens against the storm. Now is the time to buy insurance against a possible market correction and to expect a reversal in the recent runup in bond yields. There is no better sign of what is to come than the litany of growth upgrades from the economics community. This is the hallmark of a market top.

Bad news out of emerging markets. Inflation is becoming more entrenched in emerging markets. Consumer price inflation in China jumped in November and the year-over-year rate is now at a 48-month high. Producer price inflation spiked to more than 6 per cent in November and stands at nearly 2 per cent even after removing the effects of higher food prices.

The surge in inflation comes right after the Chinese government raised reserve requirements for banks for the third time in the past month. It is becoming obvious that more aggressive action is going to be required. The concern that China is behind the curve in fighting inflation, and will have to clamp down on growth, is the most pronounced risk for commodity prices for the coming year.

A spike in U.S. Treasury yields. The fact that President Barack Obama was so quick to ink a deal on extending the Bush-era tax cuts without even a sketch of a medium-term fiscal plan to reduce the federal deficit has created a bit of a stir among some of the previously comatose bond vigilantes. They are concerned that the tax cuts may lead to higher deficits and more inflation down the road.

Such concerns may push up bond yields over the near term, although I don't believe that the move will be sustained. As we saw last year, if the yield on the 10-year U.S. Treasury note approaches 4 per cent, stock markets roll over.

Sharp increases in energy prices. The recent runup in energy prices is a drag on growth, as consumers and businesses must pay more to drive and transport goods.

The surge in the oil price toward $90 a barrel has already done damage. Gasoline prices at the pump are now more than $3 a gallon in 20 U.S. states, effectively draining $40-billion out of household cash flow. A good part of that Bush tax-cut extension is going to be siphoned into the gas tank.

U.S. state and local cutbacks. Much of the fiscal stimulus that Washington delivered over the past year went into the coffers of state governments and that source of assistance is now gone as the U.S. government clamps down on spending. State and local governments have reduced their work force by 250,000 people in the past year and more layoffs are likely as this crucial 13 per cent chunk of the U.S. economy moves further into downsizing mode.

U.S. home prices fall further. The Case-Shiller index of U.S. home prices is now down in the last three months and there is still roughly two years of unsold inventory overhanging the market if the "shadow" foreclosure backlog is included. Meanwhile, as we saw in the latest University of Michigan consumer sentiment survey, housing demand remains dormant. Mortgage applications remain near decade-low levels and part of this reflects lingering caution among private lenders who are still maintaining fairly stringent credit guidelines.

What does all this mean for investors? For the time being, the tide of bullishness will probably mean upward revisions to GDP estimates and earnings forecasts. Over the near term, it may not be a bad idea to lighten up on the bearishness.

Nonetheless, I do think that the U.S. economy will grow only about 2 per cent next year and that core inflation will continue to decline. I've been a long-term bull on bonds; I see no reason to change my viewpoint now.

 

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