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Corporate bonds are moderately attractive

Over the past four years, corporate bonds have delivered total returns that rival those of equities. The S&P 500 has generated a total return of 77%; high-yield bonds (using HYG as proxy) have enjoyed a total return of 101%, for an annualized return of 19%; and investment grade bonds (using LQD as a proxy) have delivered a total return of 55%, or 11.6% annualized. The drivers of this spectacular performance were falling yields and lower-than-expected default rates. 

The chart above shows just how much yields on corporate bonds have declined since late 2008. In retrospect, the late 2008 surge in junk bond yields was a once-in-a-lifetime opportunity for investors willing to take the securities off of the hands of the many investors who were forced to sell at super-depressed levels. Towering yields at the time implied a massive wave of corporate defaults which never materialized, thanks to the recovery—however tepid it has been—and to the Federal Reserve's super-accommodative monetary policy stance.

So: is this the end of the greatest corporate bond rally in history? The chart shows that corporate bond yields are as low as they have ever been, so that is a sign that caution is warranted.

Digging deeper, swap spreads and credit default spreads, shown in the two charts above, suggest that there is still some room for improvement. The level of corporate bond yields is at an all-time low, but corporate bond spreads are still relatively wide. Furthermore, the significant decline in swap spreads suggests that corporate yields and spreads can decline further. If the economy keeps growing at a slow pace, short-term rates remain incredibly low, and monetary policy remains super-accommodative, investors will be all but compelled to continue buying corporate bonds for their still-attractive yields. For example, HYG has an indicated yield today of over 6%, while LQD's yield is almost 4%.

The case for corporate bonds would be bolstered fundamentally by continued improvement in the economy and relatively low default rates. A growing economy and easy money are a perfect recipe for improving corporate cash flows, and that is music to corporate bond investors' ears.

Still, with yields this low, investors should realize that there is a very small cushion against downside risk. If another recession hits, default rates would likely rise in that in turn would erode returns even if interest rates remained very low. If the economy were to strengthen unexpectedly, the Fed would be forced to tighten policy, and that could push corporate bond yields higher, which would also erode returns. It's probably time to start taking some—but not all—of your outsized corporate bond risk off the table, beginning with the investment grade sector.

Full disclosure: I am long HYG at the time of this writing.

Washington needs to control spending, not raise tax rates

Federal government finances have been terribly unbalanced for the past four years, but the good news is that things are looking better, even as we approach the dreaded "fiscal cliff." The budget deficit peaked at $1.47 trillion in December 2009, equivalent to 10.5% of GDP. As of last month, the 12-month deficit had fallen to $1.1 trillion, or about 7% of GDP. That's welcome progress, and it has come about thanks to very slow growth in federal spending and a decent recovery in tax revenues spurred almost entirely by a growing economy.

As the chart above shows, the Great Recession was responsible for a 22% plunge (about $575 billion) in tax revenues. Since 2009, however, revenues have risen 22%, or about $455 billion. From the beginning of the Great Recession through today, federal spending has increased about $800 billion, while tax revenues are down only $120 billion. By far the largest factor driving the budget deficit, therefore, has been the surge in spending. Fortunately, that surge has not continued, but neither has it reversed, whereas the decline in revenues has reversed almost entirely.

As the chart above shows, individual tax receipts are up about $305 billion from the recession lows, accounting for two-thirds of the increase in total revenues. Corporate profits taxes have doubled over the same period, adding $120 billion to total revenues. All of this without any increase in tax rates.

The big message here is that federal revenues are highly sensitive to the health of the economy. They have risen strongly since the recovery began, despite the payroll tax holiday instituted almost two years ago, and revenues are likely to continue to increase as the economy continues to grow. It is spending that is still out of line. If Congress can control the growth of spending going forward, then the budget mess we're in will be resolved without the need for higher taxes on anyone. This is a very important point, since higher tax rates could jeopardize the health of the economy, and that in turn would slow or even reverse the ongoing gains in tax revenue. Balancing the budget only requires that we restrain the growth in spending; going forward, that will be especially important as concerns entitlement spending.

Things are bad, but not as bad as expected

The Eurozone is still in terrible shape, but Eurozone equity prices are up 27% from their June 1st lows. Eurozone equities, in fact, have risen more than twice as much as the S&P 500 over this same period. Are markets turning irrationally exuberant? Not by a long shot.

As I argued in my previous post, with all the bad news and pessimism that's out there, it doesn't make sense to think that markets are even slightly optimistic at current levels. What's happening is that valuations have been so deeply depressed that the market is essentially priced to the expectation of another deep recession—but a recession keeps failing to show up. So even modest growth of 2% or so with continued high unemployment ends up being better than the market expected, and that forces the price of risk assets higher.

Here's a recap of the evidence of pessimistic market sentiment:

Sovereign yields in all developed economies are at extremely low levels. Plus, they are converging with the extremely low yields that have marked Japan's long economic slump. In a sense, the market is saying that the Eurozone and the U.S. economies are destined to suffer the same fate as Japan: prolonged, very weak growth.

Real yields on inflation-indexed bonds are negative. Negative real yields are a strong sign that markets expect very weak growth in the years to come. As the chart above suggests, negative real yields on TIPS are pointing to years of zero growth in the U.S.

PE ratios are below average, even though corporate profits are at record-high levels. This can only mean that the market believes that profits cannot maintain current levels and are almost sure to decline significantly in the years to come.

Earnings yields on equities are substantially higher than corporate bond yields. It's rare for the market to allow earnings yields that are substantially higher than the yield on corporate bonds. Investors are apparently willing to sacrifice a significant amount of earnings yields on stocks in exchange for a much lower yield on corporate bonds, since bonds are senior in the capital structure and thus more secure. In normal environments, equity investors are willing to accept lower earnings yields because they expect future capital gains to more than make up for those low yields. It's also a strong sign of pessimism that investors have stashed $6.6 trillion in bank savings deposits paying almost nothing, when stocks are earning 7%. That huge gap is a good measure of the market's extreme risk aversion today.

Stocks are edging higher because the market is becoming slightly less pessimistic.

Small business optimism plunges

The November report of the National Federation of Independent Business was downright gloomy. I'm feeling gloomy as well, since it's very hard to get optimistic about the future, even if Congress somehow manages to find a compromise to avoid going over the "fiscal cliff." No matter what happens in the next several weeks, it's rational to expect tax burdens, regulatory burdens, and healthcare costs to rise over the next year or so. Entitlement programs, from food stamps to disability to social security and medicare, are going to be consuming an impossible share of our national income within my lifetime unless drastic changes are implemented soon. Yet very few in Washington seem to want to do anything about this, our biggest national problem.

The chart above shows the overall results of the latest survey of small businesses: the Small Business Optimism Index. It fell significantly in November, and is about as weak as it has ever been.

This is a big deal, since small businesses are critically important to the health of the U.S. economy. The Small Business Administration has the relevant stats:

Small businesses make up:
     99.7 percent of U.S. employer firms,
     64 percent of net new private-sector jobs,
     49.2 percent of private-sector employment,
     42.9 percent of private-sector payroll,
     46 percent of private-sector output,
     43 percent of high-tech employment,
     98 percent of firms exporting goods, and
     33 percent of exporting value.

The weakest part of the survey is shown above. As the NFIB reports, "The net percent of owners expecting better business conditions in six months fell 37 points to a net negative 35 percent." This is worse even than in depths of the 2008-2009 Great Recession. Small business owners overwhelming expect business conditions to deteriorate next year.

As the chart above shows, only 5% of small business owners plan to increase hiring. This is up from the Great Recession low, but still substantially below normal levels.

This sums it up:
Something bad happened in November—and based on the NFIB survey data, it wasn’t merely Hurricane Sandy. The storm had a significant impact on the economy, no doubt, but it is very clear that a stunning number of owners who expect worse business conditions in six months had far more to do with the decline in small-business confidence. Nearly half of owners are now certain that things will be worse next year than they are now. Washington does not have the needs of small business in mind. Between the looming ‘fiscal cliff,’ the promise of higher healthcare costs and the endless onslaught of new regulations, owners have found themselves in a state of pessimism.

The only good thing that can be said about all this gloom and doom is that the stock market is undoubtedly suffused with similar gloomy sentiments. Markets are braced for lots of bad news, so if the future turns out to be even slightly less bad than expected, risk asset prices can rise.