Morningstar Advisor - April/May 2009 - 46

Morningstar Conversation 20% today. But this recognition was a good sign in March and April 2008. Where the market got it wrong was that people said, “Hey, it’s an all-clear signal now that this high default rate is reconciled into market thinking.” To me, that’s an intellectual argument, and intellectual arguments run into trouble when emotions start to come into play. It’s one thing to say the market’s reconciled to a bad outcome because it’s assuming a 30% default rate. But remittance reports in March 2008 were saying that about 6% or 8% of these mortgages were in trouble. So 30% looks like it has what I call the “comfort cushion.” You take comfort in the fact that rates are at 6% or 8%. You say, “It can double, it can triple, and my 30% number that I’m thinking about intellectually will still protect me.” My point at the time was that once those default rates got above 20%, the fear factor would take over the intellectual comfort factor and the market would crack to the downside. Indeed, that happened pretty dramatically in the second half of last year. Today, the corporate credit market is in exactly that same position. Some of these rating agencies have gotten themselves reconciled to the idea that default rates would be—I think one of the rating agencies said that the 12-month default rate would be 14%. Yeah, that sounds much higher than what people were using, and yeah, that sounds like there’s some cushion built into it, but right now, that’s the intellectual argument because the default rate is running at 4%. It’s exactly the same comfort cushion the Alt-A nonagency market had one year ago: 4% to 14% and 8% to 30% are almost identical ratios. People might feel better that there’s this higher number being bandied about, but they take too much comfort in the fact that there’s this cushion. That cushion is for sure going away, and when it does, people will freak out and those prices will go down. Rodriguez: I’d only add one other item in here to what Jeffrey’s talking about. Yes, there’s a deleveraging on the corporate side, but there is a massive releveraging on the governmental side. My work shows that at the end of this year, we’ll have debt/GDP ratios north of 80%, and in 2010, they’ll be north of 90% to 95%, just with the massive Treasury issuance that is coming. an inflation problem for sure. The other way it could play out is in a massive societal default. You try to prop up all the private institutions with the risk transference going to the government, and ultimately, the government has to default. So you have an inflationary outcome and you have a societal default outcome, and both decimate the value of dollar-based financial assets. Watching for potential inflation is worth doing. One of my favorite things to watch is industrial commodity prices. If they were showing any signs of life whatsoever, then maybe you’d have to start worrying about inflation appearing. For the time being, commodity prices are absolutely in the basement. There doesn’t seem to be any telltales right now for the coming inflation problem, if that’s the way this is going to resolve itself. But you have to keep a very close eye on that. For the time being, the deflation trade and related low Treasury interest rates do look wanting, but that is the part of the market that has worked the best during the credit crisis. Although Treasury rates retraced a lot of their big rally of the fourth quarter during the first six weeks of 2009, my view is that Treasury rates are probably going to be headed down in the near term and not up. Rodriguez: I’ve been doing a lot of thinking on The $64 question is how is that going to be financed. I don’t think a lot of my contemporaries out there have really given a lot of thought about how this all plays out, other than that there’s going to be a considerable amount of printing of money by the Federal Reserve. In the short run, they can manipulate the market as they’ve been attempting to do on the mortgage market, as well as on the commercial paper market and a host of other areas. In the long run, the underlying fundamentals will play out, and that’s why I wrote in last year’s shareholder letter that it’s not years one and two that concern me, it’s years three through 10. Jones: Both of you have argued that the government’s actions will likely result in higher long-term interest rates and, very importantly, in higher levels of inflation. How are you trying to manage in an environment where governmental action is disrupting what you might call natural market dynamics? Gundlach: Certainly, you have to pay very close attention to market-based indicators that are less manipulated, to try to figure out what the inflation risk really is. Bob’s right that the financing implications for all these government programs are enormous, and it’s a real issue as to how that’s going to resolve itself. In my view, there’s really only two ways it can resolve itself. One is a massive inflation rate due to tremendous printing of money. In a sense, you change the rules and you’re not really borrowing the money anymore; you’re just printing limitless amounts of it. That would be this whole issue of Treasury debt issuance. I started writing about it last fall in the shareholder letter. I came out with a number that incremental Treasury issuance in the next year would be in the neighborhood of $2.5 trillion to $3 trillion. The fourth-quarter annualized rate of Treasury debt issues was $677 billion, or an annualized rate of $2.7 trillion. This was before [Treasury secretary Tim] Geithner came out with what I would call his outline without detail of spending upward of $2 trillion to address the issue. 46 Morningstar Advisor April/May 2009

Morningstar Advisor - April/May 2009

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