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©2009 Wilmington Trust Investment Management, LLC. All rights ...

  1. 1.     May 29, 2009 Adrian Cronje, Ph.D., CFA®, Chief Investment Strategist Wilmington Trust Investment Management Rex Macey, CFA, CIMA, CFP®, Chief Investment Officer Wilmington Trust Investment Management Fear of Economic Collapse Yields to Worries About Inflation and the Greenback Executive Summary • Recent increases in longer-term bond yields signals greater investor concern about inflation. • The U.S. dollar is under pressure to decline. • Rebalancing away from investment-grade corporate bonds to emerging equity markets helps hedge our more aggressive strategies against both these risks. Gregory Mankiw, who teaches economics at Harvard, recently wrote a piece for The New York Times (May 23) about whether the teaching of economics is changing (or not changing) in response to lessons learned from the financial crisis. That everyone missed this crisis is neither an indictment of economics, nor a cause for embarrassment, he suggested. We agree with his point that no one has a perfectly clear crystal ball. Medical experts cannot forecast the emergence of diseases like swine flu and they can’t be certain of the paths diseases will take. Some things are just hard to predict. What should come as no surprise is that surprises will happen. Figure 1: A Steeper Yield Curve In recent months, the yields of short-term U.S. Treasury securities have fallen and those of longer-term Treasuries have risen. We interpret the changes as a warning on future inflation. Source: Bloomberg ©2009 Wilmington Trust Investment Management, LLC.  All rights reserved. 
  2. 2.     What the teaching of economics over the last 30 years has underemphasized is the nature of a debt deleveraging cycle, and how it often muddies standard textbook relationships between economic and market variables. Take, for example, changes in the shape of the yield curve. There has been a dramatic steepening in the yield curve in recent days as short-term rates have remained steady, while long-term rates have increased sharply. That is often interpreted as a sign that investors expect imminent increases in short-term rates as the economy recovers. But in the last few months, the Federal Reserve has been explicitly targeting short-term rates, as well as implicitly targeting long-term rates by buying bonds across the maturity spectrum. Policymakers have made plain their desire to lower key borrowing costs, such as long-term fixed mortgage rates, to cushion the impact of deleveraging. That the yield curve has steepened so far and so fast this time is perhaps more reflective of growing concerns about both the increased supply of bonds from the U.S. Treasury, which needs to fund growing deficits, and future inflation. Sowing Inflation Seeds? The good news is that the yield curve steepening has not (yet) been accompanied by a sharply declining dollar, meaning that foreign demand for Treasury bonds has not evaporated. But how quickly will concern about inflation begin to feed on itself? In well-publicized recent remarks, the President of the Reserve Bank of Philadelphia, Charles Plosser, underscored this point, warning about the tendency among private sector economists to use flawed measures of below-potential economic output to predict that inflation will be moderate for many years. The extraordinary efforts to avoid another Great Depression may seed the next great bout of inflation. The questions arise: how much more will the Federal Reserve expand its balance sheet in order to prevent the riot in the bond markets from derailing the stabilization of the economy? Can it continue to do so without undermining its inflation fighting credibility? Will the Federal Reserve be able to engineer an orderly withdrawal of its unprecedented stimulus? Will it raise the federal funds target first, or sell long- term bonds, or both at the same time? Regardless, the management of interest-rate exposures in fixed income portfolios will be critical in the next few months. A New Move for Aggressive Investors Inflation and U.S. dollar risks have been high on the agenda of our Investment Strategy Team for some time. While we have always recommended high strategic allocations to international stocks and real assets (inflation-linked bonds and commodity- and real estate-related securities) to hedge against any nasty surprises, we have taken additional steps in recent months. Having already shifted to a purer inflation- hedging posture by emphasizing commodity-related securities and inflation-linked bonds over real estate- related securities, we took another step last week—in our two most aggressive strategies, Maximum Appreciation and Appreciation—by reducing our tactical overweight to investment-grade corporate bonds and increasing our stake in emerging equity markets. (A 5% allocation to investment-grade corporate bonds remains in our less aggressive strategies.) This decision reflected movement in our model comparing developed international and emerging equity markets; the model has moved from a preference for developed international over emerging markets to a neutral stance. Crucially, the shift from investment-grade corporate bonds into emerging markets mitigates the risk of higher inflation and U.S. dollar depreciation arising from the build-up of U.S. public debt from aggressive ©2009 Wilmington Trust Investment Management, LLC.  All rights reserved. 
  3. 3.     government intervention to alleviate the credit crisis. One of the reasons for the shift into investment- grade corporate bonds was to offset higher market risk. Market volatility has moderated, but it is still likely to exceed its long-term historical average. The risks arising from threats to our financial system have diminished and have now been replaced by the risk of higher inflation and U.S. dollar devaluation. Emerging markets have high exposure to commodities. They also trade in currencies that are likely to appreciate against the U.S. dollar due to high local savings rates. This recommendation also reflects a substantial narrowing in recent months of investment-grade corporate yield spreads—the incremental yields that they offer over U.S. Treasuries with comparable maturities. The current yield of Barclays Capital Investment-Grade Corporate Bond Index fell from 8.37% on December 1, 2008 (the effective date of our initial recommendation to invest 5% in investment- grade corporates) to 6.65% as of May 18 (the day before we suggested that aggressive investors move more heavily into the emerging markets). The yield of 5-year U.S. Treasury notes rose from 1.71% to 2.10% on those same dates. In all, investment-grade corporate bond yield spreads have fallen by more than 200 basis points since we initially recommended the asset class, increasing the returns and lowering the volatility of our strategies. We continue to advise all of our clients to invest 5% of their portfolios in high-yield corporate bonds, because, unlike high-quality bonds, the yields of speculative-grade bonds have not yet compressed to levels near their long-term average. Watching Profits Speaking of high-yield bonds, the announcement that a tentative agreement had been reached with General Motors bondholders is another step toward an orderly Chapter 11 bankruptcy proceeding. We expect the automaker will have an opportunity to restructure its debt, improve its brand, address the retirement costs of its employees, and reduce the number of excess dealerships. As we observe the pendulum swing from the laissez-faire policies of the Reagan years (he fired striking air traffic controllers in 1981) to the side of intervention (the U.S. and Canadian governments will own over 70% of GM), we’ll keep an eye on issues that can significantly impact short- and long-term profits. High on the list is protectionism. More broadly speaking, we have to consider whether creative destruction will be allowed to run its course. The essence of capitalism is competition that leads to evolution and change. Companies must be flexible. We may be inclined to adjust our expectations for the long-term growth in corporate profits, which may affect our strategic allocations. Investment Products: Not FDIC Insured | No Bank Guarantee | May Lose Value Disclosure The information in Market Notes has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Wilmington Trust that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. There is no assurance that any investment strategy will be successful. ©2009 Wilmington Trust Investment Management, LLC.  All rights reserved. 
  4. 4.     Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by Wilmington Trust or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Some investment products may be available only to certain “qualified investors”—that is, investors who meet certain income and/or investable assets thresholds. Past performance is no guarantee of future results. Investing involves risk and you may incur a profit or a loss. CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. Third-party marks and brands are the property of their respective owners. ©2009 Wilmington Trust Investment Management, LLC.  All rights reserved.