Pay attention to the bad news. Consumer Confidence sank to 46, the lowest since 1983. Bank loans are at a 60-year low. Home prices are quite soft and sales are slow. In short, reality is beginning to chip away at the consensus view of a V-shaped economic recovery.
The prevailing rule of thumb is that deflation, not inflation, is the dreaded external reality. Our markets could be dominated by the concept.
"Long expansions of credit are followed by long contractions of credit," writes Robert Kessler, founder of Kessler Investment Advisors in Denver, Colo. Deleveraging, a requirement from an aging population, is only just beginning.
"The ultimate problem is a glut of debt, not savings," says Kessler. "Raising rates to slow things down when we have seen no evidence of speeding up, would be catastrophic to the economy," he wrote last month. Kessler chastises pundits like David Malpass and Brian Wesbury (a Forbes contributor) as having "a complete misunderstanding of the cycle."
Malpass and Wesbury have been recommending that the Fed raise interest rates to curb inflation expectations. Tough stuff. Kessler has studied Japan in the last two decades and the U.S. in the '30s and '40s; credit cycle contraction pushes inflation and government bond yields lower. The possibility of default, foreclosure, bankruptcy means new loans become scarce. This is what the statistics are saying.
On a TV show with Kessler last weekend, David Darst, asset allocation guru at Morgan Stanley, predicted "the end of Treasuries" and reported that Morgan Stanley has its lowest allocation to government securities in recent history at only 7%. The firm believes the 10-year rate, now 3.8% will be 5.5% by year-end.
We have to thank Kessler for the the historical insight that long rallies in the stock market, as we have had since March 2009, often turn around and reach new lows while interest rates also decline as well. Think Japan where the 10-year note hasn't closed over 2% in the past 10 years.
"When households become more interested in deleveraging and saving than borrowing, the economy grinds to a halt," writes Kessler. "It's not time for a Fed exit strategy; its time for an entrance strategy, he says with sarcasm during a telephone interview.
So what investment strategy does Kessler recommend? He sees the 10-year Treasury yielding 3.7% as one of the great buys in history. The worst-case scenario is you only get the 3.7% interest for 10 years. The best-case scenario is that the yield will fall to 2%--or lower. At 2% you would make an annualized return of 32.55% from the carry on income and capital appreciation. If you borrow and do this, you'll make even more.
Investors can even borrow money cheaply to buy these bonds and, if right, capture the spread between their cost of money and the absolute promise Uncle Sam to pay the coupon; this is called the Carry Trade, which is being used in major way by the banks to restore their profitability. It means you can invest like JP Morgan Chase, if only in a more modest way.
Kessler is a sophisticated investment manager who handles assets on behalf of Goldman Sachs with cumulative portfolio returns of 25.1% unaudited since inception in 2006, a lot better than any stock index.
"Knowing that asset prices have just barely risen from troughs, we expect credit problems to continue to emerge from unknowable places at unknowable times," he says. "Credit problems will exist until the underlying assets return to loan-initiation levels." That could be a long time coming. No V here.
