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Fiscal Irony

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ITALIAN ECONOMIC REFORMS
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Equity markets worldwide are gyrating due to ongoing uncertainty in Europe. On Wednesday, the yield on 10-year Italian bonds soared to a new euro-era high of 7.25 percent. Many economists view the 7 percent level as a critical threshold, beyond which Italy's debt service costs will become crippling. This development is so unsettling because Italy accounts for nearly one quarter of all euro-zone public debt, according to the Wall Street Journal. The Italians are heavily dependent on the capital markets as they will need to refinance over 300 billion Euros in debt next year in addition to funding an estimated 25 billion euro deficit (also according to the WSJ). If rates remain this high or go even higher, it will become prohibitively expensive for Italy to fund its government. This is especially true given the rising expectations for a European recession, which will lead to lower tax revenue across the euro zone.

Nobody is quite sure how the European drama will unfold. Some are speculating that the European Central Bank will have to become more active in purchasing Italian debt so that yields remain at manageable levels. To date, the ECB has been reluctant to get too aggressive. The central bank says that its function is to maintain price stability, not act as the lender of last resort for over indebted member nations. As time goes on, we suspect the ECB's attitude may change. In any event, it is worth examining the factors that have led to surging yields on European (specifically Italian) debt while our cost of borrowing in the U.S. continues to fall.

There's a fairly obvious negative correlation between bond yields on U.S. and Italian government debt for most of the past three years. This negative correlation intensified in 2011 as yields on Italian debt have soared from about 4.8 percent at the beginning of the year to nearly 7.25 percent today. Over that same time frame, yields on U.S. debt have plummeted from about 3.3 percent at the beginning of 2011 to less than 2.0 percent today. What are the factors driving this wide discrepancy in bond performance this year?

For Italy and the other PIIGS nations, the answer is fairly obvious. Soaring debt levels have caused investors to lose confidence in these countries' ability to repay their obligations. At inception of the European monetary union, member countries had agreed to maintain annual deficits at 3 percent of Gross Domestic Product while keeping debt under 60 percent of GDP. Clearly, nobody was enforcing these rules. Profligate spending across several member countries has caused debt levels to far exceed GDP, while efforts to reign in spending ("austerity" measures) are hindering economic growth and exacerbating the problem. This vicious cycle has caused bond investors to cut and run in an effort to limit their losses.

In the U.S., the action in the bond market is more difficult to explain. Yields have fallen dramatically this year despite several developments that normally would cause bond investors to flee and yields to soar. Consider the following:

• The U.S. government is expected to run its third consecutive $1 trillion+ deficit in 2011, with its debt-to-GDP ratio soaring to nearly 70 percent from 36 percent in 2007
• Standard & Poor's lowered its credit rating on U.S. sovereign debt from AAA
• The budget crisis threatened to shut down the government, while the deficit super-committee is clearly having trouble coming up with $1.2 trillion in mandated cuts
• Inflation has risen measurably, as measured by a variety of metrics

If you had been given all these developments at the beginning of the year, would you have been a buyer of bonds? I think most people would respond in the negative, so there are clearly other factors driving investors into the safety of U.S. Treasuries. The first is, somewhat ironically, their safety. Given the turmoil in Europe, investors have flocked to the safest security in the world. This has occurred even though real yields (yields adjusted for inflation) are very close to negative. Investors would rather ensure the return of their principal than put some of it at risk in the quest for a higher return.

The second factor is the U.S. dollar's status as reserve currency. Foreign central banks continue to park their surplus funds into the safety of U.S. dollars and U.S. Treasuries. Although the Chinese and other countries with large reserves have talked about diversifying away from the dollar, this simply is not feasible. There is no other market as large, deep and liquid as that for U.S. Treasuries. You hear stories about the Chinese buying more gold or other assets in an effort to diversify, but the reality is that this can only be a very small part of their investments.

Third, the Federal Reserve is still a very big factor in driving interest rates. Even though QE1 and QE2 are history, the central bank stands ready to buy more Treasuries in huge quantities, and everybody knows it. Given the fragile state of the economy and housing market, along with the possible negative fallout from the European crisis, many economists believe that additional action from the Fed is right around the corner. We don't necessarily disagree.

And finally, bonds prices are supported by the expectation for weak economic growth or even the potential for another U.S. recession in the near future. Typically, bond yields fall during times of weak or negative economic growth. Inflation is generally not a problem and the central bank is likely to remain supportive with monetary policy for longer. Therefore, until expectations for a more robust recovery are more widespread, bond yields are likely to stay low.

We continue to believe that stocks in high-quality, blue-chip multinational companies with strong dividend yields offer superior relative value in this environment.