Bob Carlson

Sometimes it seems the only people who favor another round of Quantitative Easing are the Fed members and a few diehard Keynesian economists.

This week Bill Gross of PIMCO weighed in with a much-discussed monthly commentary. Gross’s take is that the economy is in a liquidity trap,  meaning individuals and businesses aren’t going to borrow money no matter how low interest rates fall and how much money is available. They already have too much debt and have no confidence that the economy and markets will grow enough to make borrowing profitable.  He thinks QE 2 will make things worse by raising inflation expectations and interest rates along wiht it.

Gross’s investment recommendations are similar to those we’ve made this year and last. Look for what he calls “safe credits,” such as high-grade corporate bonds and mortgages purchased at discounts. Also, invest in assets backed by strong currencies that will appreciate against the dollar.

John Hussman of the Hussman Fund  also is against QE 2, and strongly so. Hussman thinks there will be short-term effects most investors view as positive: low interest rates, rising stock prices, and rising commodity prices. But these will be temporary and lead to problems. Here are key excerpts:

One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data, and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970′s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers).

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Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5-10 year total returns below 5% annually). The Fed is not helping the economy – it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

I suspect any benefits of QE 2 already are reflected in the investment markets, and that as with QE 1 the effects on the economy won’t be enough to stimulate sustained economic growth.

Merrill Lynch once was considered Middle America’s broker and one of the most profitable firms on Wall Street. All that ended rather quickly in the financial crisis. Investors wonder exactly what happened. We know the firm ended with billions of dollars of bad mortgages on its books, but how did a brokerage firm evolve to the point that it was holding these bad assets? One explanation in a recent article in Vanity Fair is Goldman Sachs envy. An excerpt:

The man who wanted to change all that was E. Stanley O’Neal. Having joined the firm as a junk-bond trader in 1986, he had risen to become C.E.O. by 2002—just before Goldman began its magical run. Proud, prickly, intolerant of dissent, and quick to take offense at perceived slights, O’Neal had never worked as a stock broker and had no particular affection for the business that had long been Merrill’s heart and soul. His burning ambition was to transform its Mother Merrill culture, which he viewed (correctly) as bloated and soft—“not adequate to the times,” he once told a colleague—and he wanted to put new emphasis on trading. Most of all, O’Neal pushed Merrill to take more risks and bigger risks—Goldman Sachs—like risks. After all, wasn’t that how one made Goldman Sachs—like profits?

Read the full article to hear the sad story.

We’ve been saying for some time that policymakers are avoiding the real structural problems in the economy. They are choosing short-term policies to keep the economy moving, hoping the real problems will be worked out in the meantime or the short-term growth will become sustainable long-term growth. We are skeptical either of these scenarios will happen. We’re not alone. Economist Joseph Stiglitz, a Nobel Prize winner, has a good summary of the situation. He rightly points out that another round of Quantitative Easing (QE 2) won’t help the economy, because it is small businesses that are having the problems. Lower interest rates and even more liquidity in the economy won’t help them. But QE 2 is likely to lead to a lower dollar and a bond bubble. So the Fed is again attempting to resolve one crisis by causing another one. There’s little positive potential from QE 2 and significant potential problems. The entire article is worth your review.

There aren’t many investment analysts who were right far more than wrong over the past five years. Oneof them isBill Gross of PIMCO. Another pair are Lacy Hunt and Van Hoisington of Hoisington. You probably don’t know as much about the Hoisington pair as about Gross, but their record in bond investing is comparable to Gross’s. They’re kept a lower profile and focused on helping institutional investors, such as pension funds.

I mention these three because of their recent commentaries for investors.

Gross notes that we are in an extended period of below average returns and below average economic growth. He sees the Federal Reserve and congressional policies as continuing low interest rates and high deficits. Washington is hoping this will lead to above-average economic growth, most of which will be due to inflation. But Gross says it won’t be clear for a few years whether this reflation policy will work. In the meantime we’re stuck with an economy much like the present. The most likely consequence of these policies, he says, will be a declining dollar and lower standard of living.

Hoisington and Lacy maintain that more Quantitative Easing will fail and shouldn’t be tried. They have no doubt that more deflation or disinflation is in the cards because:

“1) the U.S. conomic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government’s spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. ”

Hoisington and Lacy have been invested primarily in long-term treasury bonds for several years and continue to recommend them.

A fair amount of our recommended portfolios are in mortgages and mortgage-related securities. In the last few weeks a number of lenders and mortgage servicing companies announced complete or partial moratoria on foreclosures. You’ve seen the reports that the processing of foreclosures has been as sloppy and unprofessional as the issuing of the mortgages in the first place. How will this affect mortgage investors?

Jeff Gundlach of DoubleLine Total Return bond issued a summary of his view. His conclusion is the investments in his funds won’t be affected much by the moratoria.

One of my recommended mutual funds, DoubleLine Total Return Bond, changed its allocation recently. The portfolio was about half weighted to treasury bonds starting in the spring, when interest rates rose briefly. Recently, manager Jeff Gundlach trimmed his treasury bond holdings because of what he calls “market divergences.”

Here’s how Gundlach explained things in a recent interview with Advisor Perspectives, a web site for financial advisors:

Now the two-year Treasury has gone down again in yield, and it has actually gone to a new low.  It went lower than that 75 basis point or so level seen in late 2008, and now it’s down to about 50 basis points.  The five-year Treasury went almost all the way back down to where it was at what I call the orthodox low it made in December 2008, but it didn’t actually match that low, and certainly didn’t break through it.  Basically it met it.  The 10-year Treasury didn’t even get really that close to its low in late 2008.  It got to about 2.4%, and the 30-year Treasury only got down to about 350 basis points, almost a full hundred basis points away from its low.

That’s a classic divergence where part of the yield curve, the one that is controlled by the Fed, goes down to a new low, but other parts of the market don’t corroborate that type of activity.  The orthodox low in yields will ultimately prove to have come in late 2008.

Gundlach thinks we’re forming a low in interest rate, a process that could last into 2011. He doesn’t think the 10-year treasury will repeat its prior low, so there’s not much return potential left in treasury bonds. Gundlach says he’s not bearish on treasuries, that it could be nine months or more before rates rise and cause bond prices to fall. But he thinks the risk and reward of owning treasuries is not a good trade off and that you’ll miss out on opportunities in other investments.

In the full interview, Gundlach discusses high yield bonds, mortgages, and more.

Last month John Hancock announced substantial premium increases on existing policies, with increases averaging 40%. Hancock attributed the increases to unanticipated longer life expectancies and higher-than-anticipated claims. Hancock expects the increases to go in effect in January 2011. But at least some insurance analysts disagree. They say key states (Florida, California, New York) are not likely to approve the full increase. The result would be reduced earnings for Hancock and its parent company, Manulife. But the companies won’t be at risk.

Hancock increased individual policy rates two years ago but otherwise hasn’t increased rates on existing policies, say insurance industry sources.

The Hancock move is consistent with actions taken by other LTC insurers. Claims and life expectancies are higher than were priced into the policies. Some insurers are dropping out of the market.

More details here.