Markets & Finance

Time to Think Treasuries


Economic forecasting is a hazardous art, even in our era of hyperfast computers and copious quantitative data. Still, it seems that the degree of uncertainty over the economy's trajectory is unusually deep at the moment. And that's why I think now is a good time to load up on U.S. Treasuries.

Before I get to the case for Treasuries, let's examine the outlook. Last week, the Federal Reserve took a break from its two-year monetary-tightening campaign (see BusinessWeek.com, 8/8/06, "The Fed Shows Its Dovish Side"). Fed Chairman Ben Bernanke convinced all but one of his colleagues that it was time to hit the pause button and take stock. It was a reasonable stance to take, and the Fed had broadly hinted a pause was in the works.

Yet the reaction on Wall Street has been vehement—and all over the map. Here are the more popular responses: 1) The Fed made a terrible mistake. Now inflation is going to take off. 2) The Fed tightened too much. The economy is sinking into recession. 3) Hah! We've got the worst of both worlds—rising inflation and slowing growth. And 4) Ben Bernanke is one of the best economists around. He knows what he's doing, inflation is moderating and so is the economy.

And, to make it more confusing, all these highly divergent responses are supported with reams of data (see BusinessWeek.com, 8/8/06, "The Pause that Perplexes").

Adding to the aura of economic uncertainty is the wild card of terrorism. A plot to blow up transatlantic flights was foiled, but it's a safe bet that other nightmare acts of wanton violence are in the planning (see BusinessWeek.com, 8/10/06, "Fear in the Air: Terror and the Airlines"). Iraq is lurching into civil war, and the turmoil in Afghanistan is getting worse. While welcome, the cease-fire agreement between the Israelis and Hezbollah is fragile and could easily fall apart.

TOUGH CALL TO MAKE. Taken altogether, my sense is that the economy is at a major turning point. Problem is, in which direction? Is the economy going to get better or worse? The track record of economists is miserable when it comes to predicting major turns in the business cycle. And by their very nature, acts of terror are unpredictable. That's why it makes sense for investors to take out an insurance policy against financial calamity. Peter Bernstein, a longtime financial adviser and market historian, recently argued that U.S. Treasuries are a smart hedge against the possibility that something goes badly wrong. I think he's spot on.

Yes, gold is the classic hedge against disaster. And fixed-income securities have long been the Rodney Dangerfield of the finance world—they get no respect. But gold is too expensive these days to act as a hedge for the average individual investor. In sharp contrast, Treasuries are cheap to buy and to sell. "The long-end is a hedge against deflation," writes Bernstein in his newsletter, Economics and Portfolio Strategy. "The short-term is a hedge against inflation, because you get a higher rate of interest every time you roll them over." Bernstein points out that investors earned a real rate of return on their Treasury bills even during the worst inflationary outbreaks of the '70s and '80s.

Loading up on bonds isn't a bet that the sector is poised to rally or fall in value. For instance, William Gross, the bond market guru at Pimco, believes the U.S. economy is slowing and that the bond market is at a tipping point. He thinks we could even sink into recession. Inflation is a receding worry. Another great bull market in bonds is about to appear.

I think he makes a persuasive case, but it isn't an opinion widely shared by much of Wall Street. Instead, many commentators are convinced that inflation is a real problem and that the Fed will resume its monetary-tightening campaign soon. They're recommending steering clear of fixed-income securities since rising inflation rates are toxic to bond market values.

COVERING THE BASES. The beauty of a hedge created out of U.S. Treasuries, of all maturities, is that it works whether inflation takes off or the economy swings down. Again, you're buying an insurance policy, not speculating on future market moves.

That said, constructing a large hedge from U.S. Treasuries doesn't mean abandoning the equity markets. Far from it. For one thing, it seems to me that equities should remain the core of any long-term portfolio. U.S. companies are highly competitive in the global economy. Companies are flush with cash, earnings are strong, and innovation is flourishing. And, with long-term interest rates around 5%, stocks seem attractive.

What's more, I've always liked the answer longtime money manager Theodore Aronson gave several years ago to a question about investing in equities over the long haul: "If you can envision real gross domestic product in the U.S. being higher 50 years from now than it is today, I'd say you should own a lot of stocks, and they should probably be the majority of your portfolio," he said in an interview published in the professional journal Investment Policy. Or as Bernstein puts it in his newsletter, the core of a portfolio should be based on optimistic assumptions that the world economy will continue to grow over time. "The unknown future is not necessarily bad just because we do not know what it is."


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