There’s a debate in economics these days as to whether inflation or deflation will drive the future of the U.S. economy. On one side, experts point to a confluence of trends — a weak economic recovery, high unemployment and overcapacity — driving down wages and prices. On the other, some economists maintain that inflation, as a result of the vast expansion of the money supply, is the bigger risk.
For money managers, the challenge is to prepare portfolios for both scenarios.
The U.S. Federal Reserve Bank has boosted excess reserves in the banking system from about $2 million before the financial crisis to $1.2 trillion at the February 2010 peak. Many economists believe that inflation will reignite as soon as the money sitting on bank and corporate balance sheets begins to circulate. “The real question is when we cross the divide,” says Ronald Muhlenkamp, manager of the nearly $1 billion Muhlenkamp Fund.
Not any time soon, says Anthony Crescenzi, a market strategist and portfolio manager at fixed-income giant Pacific Investment Management Co. Crescenzi’s forecast for near-term disinflation is keeping Pimco’s allocation to Treasury Inflation-Protected Securities relatively low. In their place, he’s emphasizing high-quality senior corporate bonds with high underlying recovery rates. “These issuers generally have hard assets, such as gas pipelines and metals manufacturing facilities, which can be sold in the event of default,” he explains. His firm also believes it can enhance returns by moving money into foreign government bonds, targeting Brazil, Egypt and some North African countries with strong economic growth.
Peter Palfrey, co-manager of Loomis, Sayles & Co.’s $364 million Core Plus Bond Fund, takes a similar view. Loomis Sayles is forecasting disinflation — a moderation or slowing of inflation — but not outright deflation. Palfrey believes the best strategy is to have excess yield in the portfolios. His fund currently yields about 4.5 percent, compared with a 2.65 percent yield on the Barclays Capital U.S. Aggregate Bond index, its benchmark.
He’s been able to achieve the incremental yield by shifting assets out of U.S. government securities, which he says have become too expensive after all the government support during the crisis. He’s rechanneled the bulk of the proceeds into high-yield and investment-grade corporate bonds.
“Corporations have done a very good job of reducing expenses while keeping top-line revenues stable,” Palfrey notes.
He is finding additional yield in structured products such as asset-backed and commercial-mortgage-backed bonds and foreign bonds. The fund’s largest foreign allocations are to the countries poised to do best in the eventual global recovery, including Canada, Mexico and New Zealand, which hold relatively strong fiscal positions and show promising growth.
Muhlenkamp, for his part, is playing the markets cautiously. “Interest rates are as low as they can go,” he says. His concerns about the risk of near-term deflation and longer-term inflation have caused him to build up cash reserves to 30 percent of assets. Remaining assets are invested in the stocks of companies expected to benefit from enterprise spending. Consumers are overleveraged, but “corporate balance sheets are in pretty good shape,” he says.
In the face of economic headwinds, the focus should be on bottom-up securities selection, says Vanguard Group’s Joseph Davis. The no-load mutual fund giant is forecasting a muted, U-shaped recovery with high-quality earnings in both equity and fixed-income portfolios. “In a tepid recovery,” says Davis, “the difference between the top and bottom performers is going to be wide.”
