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Pay heed, investors: The lenders are worried

It is sometimes said that bond managers get paid to worry. If that's true, they are earning their money.

As has often been the case over the past two years, bond prices and bond strategists are pointing to fears that stocks aren't acknowledging. That's saying something, given that stocks have not exactly been soaring so far in 2010.

Bonds market watchers are exhibiting an increasingly severe case of nerves about the ability of the world economy to continue its rebound in the absence of stimulus. At the same time, the bond market is balking at funding any more stimulus for many countries, and the hope of growing out of debt for the countries with the worst balance sheets is getting fainter. Stocks, meanwhile, while not roaring ahead, are holding on to last year's huge gains.

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All this comes as the Group of 20 leaders prepare to meet in Toronto at week's end to try again to hash out just how and when to withdraw stimulus. Many investors are already headed out for the summer, and bored with such summitry in any case. But this bears watching.

It's a tough balance for the politicians to strike. U.S. President Barack Obama wants to stick it out with more stimulus; European politicians would probably love to oblige, but don't have the money. Canada's position is that advanced countries need to start agreeing to "credible plans" to cut deficits.

The stakes are high, not only for stock investors who are hoping for another year of solid returns, but also for a world economy that some analysts say may not be able to limp along without more government aid.

"The music's going to stop with the removal of stimulus," argues Simon Ballard, chief credit strategist at Royal Bank of Canada's securities unit.


Mr. Ballard believes that "equity geeks," as he likes to call them, "are still smoking something when they talk about the outlook for equities," which is predicated on continued strong economic growth starting at last to drive a big pickup in revenue growth.

In his view, there's not much of a growth prospect for the top line once governments pull back. Consumers are going to be constrained in large parts of the world where governments are raising taxes and cutting jobs. In that environment, the only thing keeping profits on the rise is cost cutting and margin expansion, which can only go so far.

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There are indications that the U.S. economy is not nearly as strong as it was a few months ago, and is struggling to build on the initial post-recession pop in growth. The labour market remains weak, retail sales experienced a surprising setback in May and manufacturing numbers are wishy-washy.

"The strength of the U.S. economy has been a pillar of support during this EU crisis and the system is not ready for this to roll over yet," Jim Reid, a Deutsche Bank credit strategist, said in his note to investors last Friday. "Data will start to regain centre stage over the next couple of weeks as we trying to assess whether this is a small blip or the start of a worrying trend."

That might explain why Mr. Obama, who has a front-row seat on the U.S. economy, is pleading with other governments to keep the stimulus pedal to the metal. He urged his peers last week to "reaffirm our unity of purpose to provide the policy support necessary to keep economic growth strong," and to "be prepared to respond again as quickly and as forcefully as needed to avert a slowdown in economic activity."

Easier said than done. Lenders are beginning to balk at handing over the money needed for countries to keep spending on stimulus, Bill Gross, head of Pacific Investment Management Co., argued in his latest investment outlook. In many countries that are now forced to cut deficits to rein in debts, Mr. Gross says the risk is that "recession becomes the fait accompli."

"Sovereign debtor nations are now saying all the right things and in some cases enacting legislation that promises to halt growing debt burdens," he says. Still, he adds, "credit and equity market vigilantes are wondering if in many cases sovereigns haven't already gone too far and that the only way out might be via default or the more politely used phrase of 'restructuring.' "

The upshot is that investors must get used to a new normal of returns of around 4 to 6 per cent a year, Mr. Gross argues. That's a far cry from what stock investors have been talking about and dreaming of.

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"Investors must respect this rather tortuous journey in the months and years ahead for what it is: A de-leveraging process based upon too much debt and too little growth to service it."

The bond market may have it wrong, but Mr. Gross, as the manager of the world's biggest bond fund, is one of the largest lenders of them all. His firm manages more than $1-trillion of assets. If he's worried, in a world built on the confidence of lenders, it pays to take note.

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