A neglected asset class?

In an exchange with Aaron Edelheit on his blog earlier this week (in the comment thread of this post of his, "Why are you sitting in cash?"), I pointed out that, even if one were bearish on the U.S. dollar, it might not make sense to diversify out of it now if one believes that the stock market is overvalued. That's because, if history is a guide, the dollar will rally (at least temporarily) when the stock market corrects. At that point, after the dollar rally, it might make more sense to diversify into non dollar-denominated assets.

Richard Bernstein made a similar point in his column in yesterday's Financial Times ("Lessons of investing are ignored"), noting the negative correlation of U.S. Treasuries to stocks and other asset classes:

Investors should be trying to emulate their Chinese and Japanese overweight positions in Treasuries. Instead, Wall Street is striving to get the Chinese and Japanese to “diversify” like everyone else. In my opinion, the Chinese and Japanese should ignore the advice and stick with their Treasuries.

[...]

Treasuries are today’s “alternative” asset class. Treasuries’ returns continue to be negatively correlated to equities, yet they remain widely underowned because investors consider them overly risky.

Update: Yahoo! Finance's current headline: "Stocks fall for 3rd day as dollar strengthens".

The Latest Warning from China about the U.S. Dollar and Debt

From an op/ed column by Professor Yu Qiao of the School of Public Policy and Management, Tsinghua University, Beijing, in the Financial Times this week ("Asia is the victim if the bond bubble bursts"):

Most of Mr Obama’s stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America’s over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve’s move to inject money into credit markets, contains self-destructive seeds. The US risks ending the dollar’s role as the reserve currency, especially considering there is already $10,000bn (€7,535bn, £7,009bn) in US Treasury debt, and much more in liabilities from the costs of social security, healthcare and financial institution bail-outs.

The provision of stable, reliable and viable dollars may be subordinated to short-term US interests, posing a risk to global monetary stability. In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. This is depicted in a Chinese proverb: “Drinking poisonous liquid to quench thirst”.

Professor Yu proposes an interesting alternative in his op/ed: essentially, for China and other Asian holders of our debt to work with the U.S. government to convert some of these holdings into preferred minority stakes in equities and infrastructure projects, since "equity claims on sound corporations and infrastructure projects are at less risk from a currency default".

Dealing with Deflation and Ameliorating a Recession, Part I

A number of columns have been written recently about dealing with the threat of deflation, including this one by Nouriel Roubini in today's Financial Times, "How to avoid the horrors of deflation". In that column, Roubini writes approvingly of the Fed's programs to purchase commercial paper, mortgage-backed paper and similar programs to increase liquidity and drive down borrowing costs for businesses and consumers.

With the bond market willing to lend the U.S. government funds at such low rates (e.g., 10-year Treasury yields at ~2.7%), why not take maximum advantage of that to stabilize asset prices and support aggregate demand? One fear is that, eventually, this orgy of borrowing will lead to a surge in inflation and interest rates when economic growth recovers, but it would seem that one way to ameliorate this would be to focus on buying assets rather than increasing outright spending.

For example, with many states facing budget shortfalls, instead of just giving money to the states, why not have the federal government buy a special class of 10-year municipal bonds from the states? The rate could be set at 50bps or 100bps over the U.S. government's current borrowing costs, which would still be a huge discount over the states' current borrowing costs in the municipal bond market. According to Bloomberg, yields on 10-year general obligation municipal bonds currently average 4.2%, so if these special municipal bonds sold to the federal government had a coupon rate 50bps higher than current 10-year Treasury yields (2.7%), they would still yield a full 100bps less than current 10-year municipal bond yields¹. The proceeds from these special municipal bonds sold to the federal government would enable the states to make payroll, fund already-scheduled local infrastructure projects, and -- if the federal government purchased a large enough order of these bonds (say, an amount equal to double each state's current budget shortfall) -- to call some of their callable municipal bonds, thus lowering their overall interest expenses and taking further pressure off state budgets.

According to the the Center on Budget and Policy Priorities, estimated shortfalls in state budgets for fiscal '09 total about $80 billion, so it would cost the federal government about $160 billion to buy an amount of special municipal bonds equal to double the states' estimated '09 budget shortfalls. Since these bonds would represent assets for the U.S. government, and the U.S. government would recoup its investment (with interest) in ten years, that ought to temper concerns about this expenditure's long-term impact on inflation and interest rates and assuage the Treasury market.


¹The coupon rates on the municipal bonds are of course what the states are actually paying in interest costs, but I'm using Bloomberg's yields as a proxy, for simplicity's sake.

AP: Stocks Surge on Report of Entity for Bad Debt

AP: "Stocks surge on report of entity for bad debt". Excerpt:

A report that Treasury Secretary Henry Paulson is considering the formation of an entity like the Resolution Trust Corp. that was set up during the savings and loan crisis of the late 1980s and early 1990s left investors ebullient.

Excellent news, if it turns out to be true. I floated a somewhat similar idea in a recent post

Bill Gross's Open Letter to Barack Obama

In his July Investment Outlook, the manager of the world's largest bond fund offers some advice and predictions to the man he thinks will be the next president: "Dear President Obama".

I don't agree with all the politics there, but that's immaterial. What's of interest, from an investing perspective, is Bill Gross's prediction that an additional $500 billion in government spending will be needed to stimulate the economy; that this will lead to our first $1 trillion deficit, rising inflation, and rising bond yields over the next 4-8 years. "Your term will not go down in history as investor friendly.", Gross writes.

If the views of Jim Rogers and Vitaliy Katsenelson on U.S. stock market over the next several years didn't give you pause, perhaps Bill Gross's predictions will. Those who follow traditional financial planners' suggestions about asset allocation (e.g., keeping a large percentage of one's portfolio in domestic stock and bond index funds) may come to regret it.