Bonding with the Bond (Rosenberg)

Let’s contemplate that for a minute — core inflation is basically at zero, and very possibly turns negative. Over the past decade, we have seen the long bond yield average 240 basis points above the core (and headline) inflation rate. This means a long bond yield of 2.3%, and a 10-year note yield of 1.9%. This is the future. Just think of what these rates will end up doing to the housing market. At the margin, it will help absorb the de facto 26 months of excess inventory and finally put a floor under residential real estate prices.

As for the equity market, the news, unfortunately, is not good. The S&P 500 has broken below the key line of support for the past five months of 1,040, and since technicals do account for something, especially in a market where the technicals have been dominant for over a year, a move to 880 on an interim basis seems likely. We recently had the pleasure of spending quality time with the likes of Bob Farrell and Louise Yamada and both believed — as do I — that a retest of the March 2009 lows cannot be ruled out.

We cannot be emphatic enough about what happened today over and beyond the close below 1,040 on the S&P 500. The market closed near its low for the day and at the low for both the month (-5.4%) and the quarter (-12%). At the same time, Treasury yields out the curve also closed at their lows for the month and the quarter. This is a powerful exclamation mark regarding the rising risks of a double-dip and deflationary outcome. Judging by the most recent data on market sentiment and the Commitment of Traders report, most institutional investors are still not positioned for these growing probabilities. The prospect of a major capitulation in the third quarter, which would reinforce the second quarter trend in bond yields and equity valuation, would seem to be rather high at this point.

If that is the case, it begs the question what it is we are supposed to be bullish about? Especially since zero policy rates leaves cash as little more than a tactical asset. The answer is, from an investment stance, SIRP (Safety and Income at a Reasonable Price). High-quality bonds with duration. Capital preservation strategies with low correlation to the equity market, such as classic long-short hedge fund exposures. And, hedges against recurring bouts of global financial, economic and geopolitical instability, which means a core holding of precious metals in the portfolio. Strong balance sheets, positive net free cash flow yield, earnings stability, non-cyclical sectors and dividend growth and yield are all the characteristics that should be screened for in any equity market investments.
To reiterate, there are still needles in the haystack for equity investors in a deflationary environment.

TABLE 1: INVESTMENT STRATEGY IN A DEFLATIONARY ENVIRONMENT

1. Focus on safe yield: High-quality corporates (non- cyclical, high cash reserves, minimal refinancing needs). Corporate balance sheets are in very good shape.

2. Equities: focus on reliable dividend growth/yield; preferred shares (“income” orientation). Starbucks just caught on to the importance of paying out a dividend.

3. Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios — balance sheet quality is even more important than usual. Avoid highly leveraged companies.

4. Even hard assets that provide an income stream work well in a deflationary environment (ie, oil and gas royalties, REITs, etc…).

5. Focus on sectors or companies with these micro characteristics: low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, health care — these sectors are also unloved and under owned by institutional portfolio managers).

6. Alternative assets: allocate significant portion of asset mix to strategies that are not reliant on rising equity markets and where volatility can be used to advantage.

Read the rest of the report here. (A free, but worthwhile registration is required.)

Copyright (c) Gluskin Sheff

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