Equities and Many Bonds Face a Rocky Road

07/15/2010 12:00 pm EST

Focus: MARKETS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, says investors in stocks, Treasuries, and municipal bonds face big challenges ahead.

Income investors can once again take solace in the fact that their investment approach continues to outperform equities. Equities of all persuasion saw mid-year losses after a first-quarter surge.

What accounts for the second-quarter downturn? Various theories are being put forward. One is that corporations are pulling profits forward into 2010 to avoid the higher taxes coming in 2011. Another possible reason for the decline is the fear of a double-dip recession starting early next year.

This is supported in part by expiration of the federal economic stimulus (yes, even bad stimulus has some effect on the economy) and uncertainty arising from the financial reform legislation now pending in Congress and the actual fallout from the health care legislation.

Finally, there is the expectation that corporate earnings and competitive position internationally will be negatively affected by the higher corporate tax rates in 2011.

At mid-year, we see ten year Treasuries below 3% and 30-year Treasuries below 4%. What would possess an asset manager to buy 30-year Treasuries with a locked in yield of 4% when the outlook for inflation over the next few years promises to make this a losing proposition, if not a disastrous one?

Considerable media attention has been given to the municipal bond market in recent weeks. We see yields on ten-year AAA munis going from 3.91% at year end 2008 to 3.25% at year end 2009 to 3.13% at mid-year 2010. Much of this decline is due to the high demand for tax-free munis by individual investors in high-tax states, as well as generally, given the pending tax rate rises in 2011.

The decline in muni yields is also influenced by the continued perception that munis are safe because they have always been so. [But] municipalities have rarely faced the kind of budget pressures they are experiencing today because of the revenue declines resulting from the recession.

Added to this is the retirement of government employed baby boomers, whose pension liabilities have gone mostly unfunded. This is an increase in current expenditures which is not discretionary and growing rapidly. It promises to create a budget crisis at the city and county level, since these entities now face a cash expense they can no longer ignore.

Despite the fact that Congress seems to be playing a losing hand, they seem unlikely to change course before the November elections. Should the Democrats lose control of the House of Representatives, we can expect a major market rally, since a stalemated Congress would be a welcome relief for the markets.

This may be short-lived, however, since a lame-duck Congress may well try to finish their agenda before leaving office (think carbon tax or a VAT). In short, equities don’t look promising between now and November and don’t look all that great for next year. A healthy position in cash and gold still looks like a safe bet.

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