In today’s markets, investors’ zeal for yield and disregard for risk favors the junkiest of the junk.
This “risk on” environment must be incorporated in any investment strategy. I remain cautious, nonetheless, because of what I call the grand disconnect between investors’ focus on the immense liquidity created by central banks and weak and weakening global economies. When this disconnection becomes unsustainable, probably after a significant shock, my strategy will shift to “risk off,” as I will discuss in tomorrow’s column.
For now, let’s look at the themes I believe will work in the current “risk on” investment environment.
Why Treasury bonds?
-- Because I foresee slow economic growth at best;
-- Because the Federal Reserve is determined to further reduce long-term interest rates;
-- Because deflation looms;
-- Because long Treasury bonds are attractive to pension funds and life insurers that want to match their long-term liabilities with assets of similar maturity;
-- Because Treasuries are the haven from trouble in the euro area and elsewhere;
-- Because China’s attempts to cool its economy and stoke weak exports may precipitate a hard landing;
-- Because the Fed and other central banks and foreign governments continue to buy huge quantities of Treasuries;
-- And because Treasuries have worked for me for 31 years, and the 30-year long bond has been one of my most profitable investments.
I have never bought Treasuries for their yield. I only care that it is going down. I value Treasuries for the same reason that most of today’s stockholders want equities: appreciation.
I predict a further decline in the 30-year Treasury bond yield to 2 percent from 3.2 percent now, though not before the grand disconnect ends. That further rate decline would produce a 30 percent total return in one year on a 30-year coupon Treasury, including interest, and 44.9 percent on a zero-coupon bond.
I also expect the 10-year Treasury note yield to drop to 1 percent from about 2 percent, though the total return would only be 10.4 percent, largely due to its shorter maturity. It would be 11.2 percent on a 10-year zero-coupon note.
High-Quality Income-Producing Securities:
After the bloodbath for almost all securities in 2008, many individual and institutional investors prefer predictable cash payouts now to pie-in-the-sky capital gains in the future. Treasury bonds are still attractive for appreciation, but with questionable gains available elsewhere, investors will probably continue to seek meaningful interest and dividend payments.
The rise of municipal bonds last year, with a total return of 6.5 percent, may benefit from the further decline in Treasury yields. Investment-grade corporate bonds gained 11.8 percent in total return in 2012 and also remain attractive for yield and appreciation. Debt service isn’t a problem for most since nonfinancial corporations are replete with cash. This also limits the need to issue more debt.
Companies that pay substantial, predictable and increasing dividends are back in style, and their stocks rose in 2012.
In the aftermath of the Enron Corp. and Arthur Andersen scandals, the financial crisis and the gigantic writedowns that made reported earnings questionable in many cases, a company paying meaningful dividends is assuring investors that it is generating real earnings and real cash flow. Furthermore, a significant dividend payer will almost certainly continue to be managed in a prudent and stable manner.
Last year, my firm’s index of companies involved in premium beer and liquors, perfumes, luxury clothing, jewelry, home products and handbags was up about 18 percent. Consumers, especially when they are hard-pressed as many are now, tend to buy the very best of what they can afford, even if it’s within a low-priced category. Manufacturers and retailers that can adapt to the demand for small luxuries will continue to be winners. Some are adopting the small-luxury model, offering essentially the same products at lower prices by cutting their manufacturing costs.
Consumer Staples and Food:
Items such as laundry detergent, bread and toothpaste are essentials that are purchased in good times and bad. Their producers’ equities will remain attractive. The Standard & Poor’s Consumer Staples Sector Index was up 10.8 percent last year, after a 14 percent gain in 2011.
Among retailers of consumer staples, the winners may continue to be discounters, such as Family Dollar Stores Inc. U.S. used-merchandise stores have been thriving. Producers of national brands will need to continue to adapt to weak consumer incomes and high unemployment by emphasizing cheaper “value” products.
The U.S. currency should strengthen as other nations, notably Japan, competitively devaluate. The new Japanese government has made it clear that it wants a weaker yen. It is pushing the Bank of Japan to flood the country with money and turn chronic deflation into 2 percent annual inflation.
Health-Care Providers and Medical-Office Buildings:
Health care is a huge part of the economy, accounting for 17.9 percent of gross domestic product in 2011, and growing.
Major pharmaceutical and biotechnology stocks are attractive. So, too, are companies that promote cost containment, such as pharmacy-benefits managers, diagnostic-testing labs and diagnostic-equipment makers, outfits that provide home health-care services and supplies and outpatient services and clinics. This includes manufacturers of noninvasive diagnostic and surgical equipment, companies that provide health-care information and services on and off the Internet, and companies involved in physician and hospital-management information systems, as well as market-research services. A plus is that many health-care-related companies pay meaningful dividends.
I also favor investments in medical-office buildings, including related outpatient facilities such as those for ambulatory care, surgery centers, ambulatory surgical, outpatient cancer and wellness centers. Last year, demand for such real estate was forecast to expand 19 percent by 2019, with 11 percent of that demand expected to be generated by changes from the recent health-care law and the rest as a result of population growth. In addition, physicians are increasingly moving from small practices to hospital campuses and satellite facilities. About 53 percent now work for hospitals. Medical-office-building values are much less volatile than those of other commercial and residential real estate. This market won’t be afflicted by persistent excess capacity, which hinders new construction, as is the case with residential real estate, malls and office buildings.
Rental apartments will continue to benefit from the separation that Americans are beginning to make between their homes and their investments. The two functions used to be combined in the form of owner-occupied houses in the days when owners believed house prices would never fall.
Empty-nesters in the suburbs will probably unload their money pits and move into rental apartments. Young couples may decide that because houses are no longer a great investment, there’s no reason to buy big, expensive ones as soon as possible. So they will stay in rental apartments longer.
Furthermore, rental demand and rent rates are increasing because of tight lending standards for homebuyers, continuing high unemployment and job risks. Real-estate investment trusts containing rental apartments are probably fully priced, though direct ownership of rental apartments is still probably attractive, with overbuilding still some years off.
Last year, the AMEX Computer Technology Index rose 10 percent. I predict further growth this year in such productivity enhancers as business pressure to cut costs persists.
In this slow growth and deflationary environment, increased profit through price and volume increases is difficult, if not impossible, for many companies. That means the appetite for cost-cutting zeal will remain intact. Labor cost-cutting has been under way in recent years, though it has limits. As a result, anything -- high-tech, low-tech, no-tech -- that helps reduce costs and promote productivity will be in demand.
North American Energy:
Conventional North American energy will benefit from the national resolve to reduce imports from unreliable foreign sources. Winners include natural-gas producers, pipelines, oil sands, energy services, oil producers, nuclear energy and shale oil and gas. At the same time, I remain skeptical of ethanol, biofuels, wind, solar, geothermal, electric vehicles and other renewable energy because of their heavy dependence on government subsidies.
The Dow Jones U.S. Select Oil and Gas Exploration Production Index rose 5 percent in 2012, and natural-gas prices fell a little during the course of the year.
Hydraulic fracturing and horizontal-drilling techniques are opening vast energy sources in North America that are close to consumers and in politically safe areas. After years of searching for oil in the Middle East and Africa, major oil producers are returning their attention to North America. Exploiting these more expensive sources of energy requires continued high prices for oil and rising prices for natural gas.
Commodities Remain Unattractive:
Commodity prices have been falling since early 2011. Apparently, slow global growth and mounting inventories, especially in China, are overcoming investor zeal for these assets.
In 2013, industrial-commodity prices should be further depressed by continuing global economic weakness and rising inventories. High grain prices may be vulnerable if the unusual global weather patterns of 2012 return to normal and farmers respond to high prices with record plantings.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five-part series. Read Part 1, Part 2, Part 3 and Part 5.)
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