Market update — Increased economic optimism with a perspective on Chrysler and the evolving bond market

William F. (Ted) Truscott, Chief Investment Officer
May 5, 2009

The U.S. economy seems to have stopped getting worse, which has been enough to create some optimism in financial markets for the first time in a long time. An old phrase suggests that things cannot get better until they stop getting worse and since investors focus on change at the margin, the mere sign that there could be an end to the relentless stream of bad news sent stock and bond markets soaring in April.

The non-treasury portion of the bond market continues to lead the pack with returns ranging from 3% for U.S. corporate bonds to in excess of 17% for high-yield bonds. Municipal (or tax-exempt) bonds have had returns of 7 to 12%. This is welcome news as we do not see a sustained stock market rally occurring until the bond market improves to the point where credit markets are considered fully functional. Rising bond prices, narrower spreads and positive returns suggest the many financial rescue plans that have been put in place are beginning to work.

Positive year-to-date returns in many portions of the bond market and a strong April in the stock market have reinforced our 70% probability that government and monetary stimulus will work. We continue to believe that the economy will rebound in the later portion of the second half of this year. We call this our "reflation" scenario and the most prominent risk in this scenario is the emergence of an unwelcome bout of inflation in two years' time.

Importantly, a successful economic rebound will ward off the threat of deflation, the phenomenon of falling prices. A continuous fall in prices would be an unwelcome event as corporate revenue and workers' wages decline rapidly and any indebtedness becomes increasingly difficult to service. The result would be a significantly greater number of business failures than currently forecasted and a marked increase in personal bankruptcies. Of even greater concern is that central banks are unfamiliar with fighting deflation and most deflation-fighting theories are the stuff of text books and have not been proven in recent years. We assign only a 30% probability to a deflationary outcome and yet we must be alert to the fact that scenario remains a possibility.

Chrysler

We must be ever-mindful of the effects and nuances of rapidly changing market conditions and economic policies that are by their nature a double-edged sword. Today's victory can become tomorrow's problem with often unforeseen consequences. Take, for instance, the recent entry of Chrysler into bankruptcy. President Obama has made no secret of his distaste for the lenders (mutual funds, banks and hedge funds) that refused to succumb to a debt exchange offer that would yield them only pennies on the dollar.

Beyond our concern at the President's high-profile involvement in Chrysler, this issue could be a watershed development in finance. The Obama camp points to union and other stakeholder sacrifices and is demanding the same of senior secured lenders. Equality of treatment seems to be the principle as opposed to well established legal principles and practice. It is no surprise, therefore, that the senior secured debt holders who have mortgages and other first priority claims on Chrysler property, inventory and plants point to the protections that the rule of law gives them in a bankruptcy. For better or worse, the law is clear that contractual claims evidenced by perfected liens (such as a mortgage) are first in order of preference for repayment. Unsecured creditors, which can include employees, come last and receive much less, if anything.

Here's an analogy to make this concept simpler. Assume Tim is the owner of a mortgage on a home. The owner of the home, Chris, decides he cannot pay Tim back and declares bankruptcy. Tim then seeks to take possession of the house to recover the debt he is owed, while Chris also owes money to the phone company and the gas company. In the case of Chris's personal bankruptcy, Tim's claims as a secured mortgage holder come before those of say the gas or phone companies, under the law. What was proposed in the Chrysler situation is equivalent to the phone and gas companies' rights being equal to the mortgage holder's, despite their lack of a secured claim on any of the assets.

The entire process is further complicated because the government owns big stakes in some of the very banks who loaned money to Chrysler. As if this was not enough, a major mutual fund manager that owned Chrysler debt in its mutual funds sided with pushing Chrysler into bankruptcy. The manager felt a Chrysler bankruptcy would result in a higher recovery for debt holders and in doing so was fulfilling its fiduciary duty to the fund shareholders. Those mutual fund shareholders may be the very people that some politicians and pundits have derided in the press as "speculators" and "vultures."

Mutual fund shareholders are not speculators but most are certainly taxpayers. A conflict of interest is thus established at the individual level that is not easy to reconcile because taxpayer and debt holder may be the same person. Which is better for America? Is it a mutual fund shareholder earning a return on investment that may generate tax revenue in the future? Or is it better to preserve jobs by striking a deal that may limit taxpayer exposure to the auto industry even if the mutual fund shareholder loses money and bankruptcy law is altered? The situation with banks and auto makers is delicate and there are no easy answers.

There is another unforeseen consequence of treating secured and unsecured creditors equally lurking beneath the surface. Suppose in the future that the government does prevail in forcing debt holders to a position of equality versus other more junior creditors? In the world of finance, investors will then consider any loan to a company associated with the U.S. government as a higher risk. Higher risk requires higher reward and the price of debt will rise for those companies, which in the long run is not a favorable outcome.

Bond market opportunities continue to evolve

We continue to prefer the bond market over the stock market as has been the case since last November, as we believe there are still decent returns to be earned for the risks incurred. We continue to favor high-grade corporate bonds, high-yield bonds, high-quality mortgages and municipal bonds. That said, prices have improved dramatically and we need to begin focusing on trimming or exiting positions in sectors that have performed particularly well. This is particularly evident in the floating rate loan space where fixed income senior portfolio manager, Lynn Hopton, tells me prices in some categories have moved above fair value. While the Chrysler bankruptcy has already been reflected in loan prices, Lynn has pointed out that the trouble in the auto industry is bound to affect suppliers and that additional distress in the auto sector could also be on its way. As we have noted in past updates, investors need to be more nimble in this rapidly changing environment where asset prices can move from being undervalued to overvalued in a short period of time.

The story of Nick and "CD" Herb

Back in the 1980s and 1990s, I knew two older gentlemen named Nick and Herb. Both had served their country in the armed forces during World War II and had successful careers thereafter. They were enjoying a well deserved retirement by the time we met in the mid 1980s. Unfortunately both are no longer with us. Nick loved the stock market and followed the investment world closely while Herb was much more conservative and had little taste for the ups and down of stocks and bonds. Herb pursued an investment strategy based only on certificates of deposit (CDs), which offered good yields with the protection of FDIC insurance. Nick and I used to sit on the tailgate of his station wagon in the summer enjoying a cold one and giving Herb a hard time about his CDs. He soon became known as "CD" Herb. We had a few laughs at Herb's expense in those days but I suspect that Herb might be the one having a few chuckles today.

Here's what I took away from this unique pairing. Each man had a certain risk tolerance and pursued a strategy that was right for him. Neither envied the other and their basic strategies did not change. Nick may have loved his stocks but he made sure that there was enough cash available for emergencies. Herb, of course, had to worry less about his liquidity given his investment strategy but may have missed potential opportunities to increase his long-term returns and outpace inflation when markets were performing well.

They both stuck with what was right for them and had a plan based on their specific expectations for the future. One man was more conservative than the other but that did not mean that one was more right than the other. Financial planning and investing is just that. Understanding your goals, risk tolerance and time horizon are critical. While Herb and Nick did not have to adjust their strategies much, that might not have held true in today's rapidly changing environment. Both men were wise enough and old enough to know that times change and sometimes a new perspective is warranted.

Here are two actions to consider as you work through the difficult investing environment that exists today.

• Have a plan but remain nimble — focus on investments that are appropriately designed to help you reach your long-term objectives, while remaining open to new ideas and opportunities. These opportunities are evolving much quicker during this downturn than they have at any time in the past. Investors must remain nimble and take action when necessary, while at the same time being ready for additional change.
• Stay invested and invest systematically — stay invested in the markets, as missing just a few days can drastically alter your long-term returns. Although volatility will continue and the timing of the recovery is uncertain, dollar-cost averaging and tactical asset allocation are necessary tools in helping you manage through this new economic reality.

My example of Herb and Nick highlights the fact that no two investors are the same. Make sure you take the time to think through your investment plan and act on the opportunities as they present themselves. I am fond of saying there are opportunities in every market and right now is no exception. Stay connected by meeting with your advisor and discussing the strategies that will help you reach your financial goals.