What are professional money managers thinking these days? A new poll by Russell Investments offers an answer. Among the highlights:
• 67% of managers are now bullish on corporate bonds
• 61% are bullish on high-yield bonds
In both cases, the percentages are a bit higher compared with the previous poll from last December. “In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasuries that are at historic levels,” Erik Ristuben, Russell’s chief investment officer, says in the accompanying press release. Expectations for junk bonds are also higher from late last year.
U.S. equities, on the other hand, have fallen in the eyes of managers. Value and small-cap equities suffer the most in terms of the current outlook, according to the Russell survey. Here’s an overview of how the changes in expectations for the various asset classes stack up:

Jeffrey Lacker, president of the Richmond Fed, is a voting member of the FOMC and a card-carrying hawk on matters of inflation. So when he warns that monetary policy faces new hurdles, our ears perk up. As we’ve been discussing, minting money is easy.;taking it away is something else. The hazards on the latter have rarely been higher at this juncture. At a talk a few days back at the College of Charleston, Lacker summarized the approaching task on soaking up the massive liquidity that’s now in the system, albeit much of it sitting idle for the moment:
“Whether it has an inflationary impact or not depends on our skill at the Federal Reserve in withdrawing the stimulus in a timely way when the economy begins to recover. That is a very delicate, very hard policy…The economy when it recovers is spotty…Inevitably, we face this dilemma. Do we keep policy easy and stimulative because of the sectors that are lagging behind in this recovery or do we get ahead of the curve…it is going to be a tough call.”

Today’s update on personal income and spending reminds that the attack on the consumer rolls on.
As our chart below suggests, the recession is bearing down on Joe Sixpack and the pressure isn’t likely to ebb for some time. Disposable personal income was flat to slightly down last month on an annualized seasonally adjusted basis. Personal consumption expenditures fared a bit better, posting a roughly 0.2% rise in February, but that looks like statistical noise and a reaction to the sharp pullback from previous months. Given the sober outlook for the labor market, there’s little hope that we’ll see much improvement for spending or income any time soon. As the crowd comes to terms with the economic backdrop, we’re likely to see ongoing retrenchment in the late, great consumption binge.

But for the moment there’s another threat to watch: inflation. Yes, we’ve been talking about deflation these past few months, and based on the numbers published late last year it looked like the potential for a deflationary spiral was quite real. But it was only a true threat if the Federal Reserve dithered and let deflation take root. As we’ve discussed, the Fed did no such thing and instead has acted aggressively in combating the threat by flooding the system with liquidity. Given the economic context, a fair amount of the liquidity is sitting idle—i.e., the classic problem of pushing on a string, as they say. Indeed, quite a bit of the newly minted liquidity has been redeployed into nonproductive areas, i.e., safe havens, which is why short-term Treasury bill yields remain at roughly zero, if not slightly negative. When the liquidity starts to come out of hibernation, the potential for inflation will rise.

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The first order of business in repairing the economy is reestablishing a stable rate of inflation, ideally a small dose just above zero. There’s inherent danger in targeting higher inflation, but it’s a necessary evil at the moment, and there are signs that the effort is working.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries. The spread is considered the market’s inflation forecast. Although no one should confuse this outlook with perfection, it does reflect market sentiment to a degree and it’s also monitored by the folks at the Federal Reserve, among countless other statistics.
As our chart below shows, this spread continues to exhibit an upside bias, and in the current climate that’s encouraging. As of last night’s close, the Treasury market is forecasting a 1.3% inflation rate for the next 10 years—up from virtually zero late last year. Certainly the extreme lows of last November and December appear to be history, at least for the moment. That’s heartening because it suggests that the market’s modestly encouraged that deflation’s threat is passing.

Insuring that deflation doesn’t take root has and remains the priority for stabilizing the economy and laying the foundation for recovery, as we’ve been discussing in recent months, including here and here. The good news is that progress in this battle continues to accumulate, and the above chart is but one example.

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In the long run, equilibrium prevails, supply matches demand and something close to pure efficiency in market pricing reigns. In the short run, on the other hand, stuff happens.
The idea that Mr. Market wins eventually crosses our mind as we consider the massive government intervention of late. There are some who are expecting something for nothing as the Federal Reserve, the Treasury and other state entities step into the vortex of market turmoil. In fact, there’s a cost to everything, and that includes the intervention du jour.
The rationale for intervening is compelling at the moment, but no one should think it won’t come at a price. The question is: What price?

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The March rally in the stock market has people talking, and asking questions, such as: Was that a bottom?
For the moment, the answer is “yes.” Deciding if the answer holds is debatable. We’re skeptical largely because the rally this month has drawn power primarily from a new round of hope that Washington’s various experiments to right the economy will finally hit pay dirt. Perhaps, but it’s not the stuff that powers sustainable rallies, much less secular bull markets. We’re closer to that point than we were 3 months ago, of course. But uncertainty still dominates.
The latest chatter may put a floor on equity prices, and for the moment that’s what we’re looking for, although it’ll only be obvious in hindsight. Clearly, the government is integral in the healing process. But expecting the latest press release from the Treasury or the Fed to unleash something more substantial than a bounce is probably expecting too much at this point.
Nonetheless, it’s tempting to look at the trend in recent weeks and draw an optimistic conclusion. As the chart below shows, March has been kind to owners of equity. After taking another drubbing in February, investors were primed for anything that even remotely looked like good news.

And more of it appears to be coming in today’s news cycle. The latest from the Treasury is yet another freshly hatched plan to subsidize private purchases of the toxic securities that are weighing on the banking industry’s balance sheets. The size of the plan is a tidy $1 trillion, which is to say it’s sizable. Asian markets responded positively to the news and as we write the U.S. stock index futures are up ahead of the opening bell on Wall Street. It’s not over till it’s over, but with just over a week to go, it’s looking as if the S&P 500 may post a modest gain for this month…maybe.

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Economic research published since the late-1980s tells us that watching the Treasury’s yield curve is a productive exercise for analyzing the outlook for the business cycle and interest rates. In 2006, for example, the New York Fed offered a primer on why the yield curve is useful as a forward-looking indicator. As it turned out, the yield curve was set to invert at the time, offering an advance warning that the economy was headed for trouble. Few heeded the warning, thanks largely to a bull market in virtually everything. The recent past, once again, has a habit of clouding the crowd’s ability to look ahead.
Normally, the Treasury yield curve is upward sloping: yields rise along with bond maturities. When the curve inverts—short rates above long rates—that’s often a sign of trouble brewing. For some thoughts on why that’s so, we recently talked with Bob Dieli, an economist who runs RDLB Inc, an economic consultancy that publishes research at NoSpinForecast.com.
On the new episode of the Inside View podcast, Dieli explains why the yield curve is a critical measure of current and future economic and financial trends…

Today’s report on consumer price inflation (CPI) for February confirms yesterday’s news on wholesale prices for last month: deflation is on the run. For the moment, anyway.
That’s good news, but if it’s true, then monetary policy becomes increasingly tricky in the months ahead. We say if it’s true because it’s hard to make definitive conclusions on just a few months of data. At the moment, the case for arguing that deflation has been banished rests on January and February numbers. Deciding if that’s a trend with legs remains speculative, albeit less so than in the past several months. Only once it’s clear that the economy is past its worst point in the current downturn will it be obvious that deflation is no longer a threat. Where and when that point lies, alas, isn’t yet obvious, at least to this obsever.
Meanwhile, the Labor Department reports this morning that consumer prices rose 0.4% last month on a seasonally adjusted basis. That’s up from January’s 0.3% and both numbers stand in sharp contrast to the previous three months (Oct through Dec), when CPI dropped sharply.

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Is the Fed’s liquidity attack winning the war on deflation? This morning’s update on wholesale prices, new housing starts and new building permits offers a few reasons for answering with a tenuous “yes.” Maybe. Even if that’s true, we’re a long way from a “recovery” that’s worthy of the name. But perhaps the blood will run a little slower; perhaps it’ll stop flowing altogether. Stranger things have happened.
First let’s take a look at prices. The Producer Price Index (PPI) for February rose a modest 0.1%, the Bureau of Labor Statistics reports. That follows January’s roaring 0.8% jump. And not a moment too soon, in the wake of large back-to-back monthly declines last year in PPI from August through December. A similar run of deflation has weighed on consumer prices as well.
Is it safe to declare the deflation risk over? No, not yet, but it’s not too soon to start thinking about the light at the end of the tunnel, dim though it’s likely to be for the time being. We’ve been arguing for some time that the first priority for the economy is nipping deflation in the bud. Without that, broader progress on 1) stopping the bleeding; and 2) laying the groundwork for recovery isn’t possible.

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What if the apocalypse is delayed once again? What if the depression turns out to be a nasty recession? We don’t have the definitive answers, but we know how to ask the questions and consider the odds.
When the last investor has sold, when the appetite for risk has completely vanished, the markets will bottom and the cycle will turn in earnest. Deciding in advance when that moment arrives is an inescapably speculative venture, and investors with weak constitutions will want to avert their eyes, and portfolios. For everyone else, it’s time to go to work.
That starts by recognizing that waiting for a clear confirmation that the turning point is here is likely to miss the big gains that typically come in the early weeks and months of the eventual rebound. Navigating those two extremes is a big fat slice of risk. Finding a reasonable balance, which differs for every investor, is the core of the investment challenge at the moment.
The generic solution is to keep the risk allocation of the portfolio fully invested, through thick and thin, boom and bust, while keeping a stash of cash. Of course, that doesn’t feel so good when the bust actually arrives. Looking at long-term numbers is easy; weathering the day-to-day pain of a bear market, especially one as deep and devastating as this one, is sheer torture for all but the most disciplined of investors.

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