From the July 2011 issue of Research Magazine • Subscribe!

Morningstar Confab Puts Focus on TIPs, Munis, Commodities & Ratings

(Chicago) PIMCO Co-Chief Investment Officer Bill Gross painted a gloomy picture of U.S. investment prospects during his opening keynote address at the Morningstar Investment Conference in Chicago on June 8. The high-profile bond portfolio manager encouraged the audience of financial advisors to seek investment opportunities outside the Treasury market and away from dollar-based markets more generally. Gross noted that real, or inflation-adjusted, interest rates, as indicated by pricing in the five-year market for Treasury Inflation Protected Securities (TIPS), have fallen from about 4% in October 2008 to minus 0.5 percent today.

Such negative rates benefit debtors, including the U.S. government, but amount to “picking the pockets” of investors and savers, he emphasized. The drop in interest rates has put a damper on the prospects for U.S. stocks as well as bonds, he added, since equity prices cannot be expected to benefit from further drops in rates. “If real interest rates cannot go much lower, stocks are on their own. The bird is out of the nest,” Gross said.

“Get out of [negative] real interest rate space, and find something more attractive,” he suggested. In particular, Gross cited Brazil, Mexico, Canada and Germany as countries meriting investor interest. Brazil, Gross acknowledged, has currency risk and country risk reflecting a history that includes defaults on government debt. However, he noted that real interest rates in Brazil have lately been 6 percent and higher.

Gross denounced the high levels of U.S. government debt as a form of “financial repression” that damages the ability of investors to benefit from their assets. He contrasted this with policies in Canada, which he said “has a much cleaner balance sheet,” and in Germany, noted for its fiscal conservatism. “You don’t have to go too far afield in terms of developing countries to find less repressive countries than the U.S.,” he said. He did, however, suggest that some U.S. companies remain attractive investments because they offer high dividends and extensive exposure to foreign markets. He cited Coca-Cola, Johnson & Johnson and Procter & Gamble as examples.

Gross likened the predicament of investors whose assets gradually erode because of negative real interest rates to that of the proverbial frog sitting in a pot that’s gradually heated until it boils. He amplified on the amphibian theme by citing a frog that escapes from a pitcher of milk by energetically churning its legs to find an alternative situation. “Don’t be a frog,” said Gross. “And if you are a frog, be one in a pitcher of butter.”

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Recent gloom about a possible wave of municipal bond defaults got a dismissive response from a panel of muni bond portfolio managers at Morningstar on June 10. “The predictions of widespread defaults that are going to decimate municipal bond portfolios are completely preposterous,” said panelist Michael G. Brooks, senior portfolio manager at AllianceBernstein, as the discussion opened. The panelists were Brooks; John Cummings, head of the municipal bond desk at Pimco; and Lyle Fitterer, head of the tax-exempt fixed income team at Wells Capital Management. Moderating the discussion was Miriam Sjoblom of Morningstar.

Public anxiety about the muni market was stoked last December by a “60 Minutes” segment in which high-profile financial analyst Meredith Whitney predicted “significant” muni defaults and “hundreds of billions” in losses for investors. That prediction brought a “collective gasp,” recalled moderator Sjoblom. The reaction of the June 10 panel, however, was more of a collective yawn. “Sensationalism [about massive defaults is] doing a disservice to investors by putting fear in their minds,” said Fitterer, who added that such fears also have created some opportunities to buy munis cheaply. “Default is a tiny risk because issuers do not want to be shut out of the credit market,” said Brooks. The AllianceBernstein manager pointed out that municipalities, unlike corporations, do not have options of “moving to Barbados” and therefore must plan on maintaining an ability to borrow in the future.

Pimco’s Cummings assessed munis as a relative bright spot in his firm’s outlook on bond markets. “We think that municipal bonds are attractive relative to other U.S. fixed income assets for a U.S. taxpayer,” he said, noting that munis “do not protect you from a drop in the dollar and they do not protect you from an increase in inflation, but they do protect you from an increase in tax rates.”  “Clearly tax rates are going to be higher in the future than they are now,” said Brooks, adding that munis will remain attractive for tax purposes barring a development — which he thinks unlikely — such as Republican presidential hopeful Tim Pawlenty’s proposal to eliminate taxes on interest and capital gains.

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Experts on commodity markets touted divergent investment strategies in a panel discussion on June 9. The panelists largely agreed, however, on the underlying economics of tight supply and growing demand across a range of commodities. The panelists were Bob Greer of Pimco, MacKenzie Davis of RS Investments, and Geoff Jay of Janus. The discussion, held in a room packed to capacity with hundreds of attendees, was moderated by John Rekenthaler of Morningstar.

Pimco’s Greer touted using commodity futures for diversification, emphasizing that historically they have provided “negative correlations in many cases from stocks and bonds” along with “greater inflation protection.” Davis, however, countered that “correlations have risen” and “the negative correlation of equities and commodities has not held up in recent years.” The RS Investments fund manager argued that “futures work well to protect you against supply shocks,” but “increasingly commodities are driven by changes in demand.” His strategy focuses on investing in the stocks of natural resources companies. Jay, an energy equity research analyst at Janus, emphasized his firm’s approach of “bottom up stock picking,” or focusing on the merits of individual companies.

To some degree, the panelists viewed their divergent strategies as complementary. Greer acknowledged that “oil equities have a place in a portfolio.” Still, he stated that “if you want exposure to the price of oil, it’s preferable to strip away the equity beta that comes with energy stocks,” such as the risk of an offshore platform explosion as occurred to BP’s Deepwater Horizon in the Gulf of Mexico last year. Asked about oil prices, Jay predicted that they would be higher in a 24-36 month timeframe. He noted that “OPEC spare capacity is very low.”

Greer argued that “we are stretching our capacity in many commodities,” and noted that global demand for commodities will continue to rise as China and other emerging economies develop. “As you increase per capita income in an emerging economy, you will increase demand for commodities,” he said. Davis noted that supply in the copper market is “quite tight,” and suggested it may become tighter if the new president of Peru, Ollanta Humala, follows through on a proposal to tax copper companies. Pointing out another commodity niche in which supply is tight, Davis said there is a rising need for workers to handle production jobs in the oil sand fields of Canada. It is possible, he said, to make an income well into the six figures doing such work without benefit of a college education.

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Also at the conference, Don Phillips, Morningstar’s president of research, announced a new “forward-looking” analyst rating system on June 9. According to Phillips, the new system will be based on analysts’ convictions about a fund’s ability to outperform its peer group and relevant benchmarks on a risk-adjusted basis. The company plans to launch the new ratings and research reports in the fourth quarter.

“While the star system has traditionally been a grade that the fund and the manager receive based on past performance, the new system will be more of more of an ‘aptitude test,’ and based on how the analyst perceives any investments, news or management changes will affect performance,” Phillips said.  “The new ratings will not replace the star ratings, and the existing star methodology will not change.”

Morningstar will not charge fund firms to be rated, and its decision to rate and report on a specific fund is made solely by the analyst team based on factors such as investor interest and asset size. In the United States, the new ratings and research reports will replace the company’s “Analyst Picks and Pans.”

The new ratings will be assigned as follows — AAA, AA, A, Neutral or Negative. In addition, Morningstar plans to adjust its methodology for its stewardship grades in the United States.

Additional reporting by John Sullivan of Investment Advisor magazine. 

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