4 investing guidelines from bond expert Dan Fuss

Source: MARKETWATCH

Longtime fund manager looks to peace, people, politics and prosperity

By Robert Powell, MarketWatch

Last Update: 12:01 AM ET May 10, 2012

BOSTON (MarketWatch)When Dan Fuss speaks, its impossible not to listen. Fuss, with 53 years of experience, has been managing money longer than many mutual-fund managers have been alive.

This week, the 78-year old vice chairman of Loomis, Sayles & Company predicted that interest rates will indeed rise, and that investors ought to be especially careful when selecting securities in light of that prospect.

We are in the foothills of a period of time where interest rates will start to go up, Fuss said in a speech at Financial Advisor magazines third annual retirement conference in Florida this week.

This is not the end of the world, but its very different since the last week of September of 1981, when interest rates stopped going up and started going down, he said.

When rates might start heading higher is anyones guess. But Fuss, who is also the manager of the Loomis Sayles Bond Fund , is of the opinion that interest rates wont start rising until after the stated unemployment rate falls under 7% and continues to fall over at least two quarters. (The current unemployment rate is 8.1%; the last time the unemployment rate was under 7% was November 2008, when it was 6.8%.)

Given his outlook for interest rates, Fuss suggested that investors might consider substituting specific risk for market risk. The way to do that is to move from U.S. government bonds toward corporate securities, including stocks and bonds.

But not just any stocks and bonds.

According to Fuss, consider the corporate securities of those firms that have strong market share and where share is growing incrementally. Those are the companies that will survive as the cost of money goes up, Fuss said. Incremental gains in market share are critical in this environment, he said.

Fuss came to this conclusion by looking at four factors: peace, people, politics and prosperity, the latter of which is shorthand for economy.

1. Peace

If you dont have peace, you really dont have any basis to invest money, said Fuss, who served in the U.S. Navy from 1955 to 1958 and held the rank of lieutenant. If we were sitting in the middle of a war zone, we would not be having this discussion.

For most of human history, to one degree or another, peace has not been present, he said. But luckily, in our lifetimes, peace has been mostly or at least substantially present, he said.

Today, Fuss examines defense spending as a percent of GDP as one measure of the investing environment. In the 1930s, for instance, it was just a few percent. Over time, it has spiked and declined. Currently depending on what you include, its just shy of 4% and the forecast is for that percent of GDP to drift gradually down toward the mid-3% range, perhaps lower.

Theres a lot of strong evidence behind that [forecast] as long as the assumptions underlying this are correct, said Fuss.

But Fuss said he thinks forecasters are underestimating two costs. One is the cost of maintaining and replacing ships, airplanes and the like. That could add about one-fourth to three-eighths of one percentage point. Then theres the personnel cost.

What is not recognized is that the people coming back from extended and numerous deployments are coming back with the type of injury that we havent encountered to this degree before, said Fuss.

First of all there are the physical injuries, he said. People are surviving injuries that they would not have survived in the Vietnam War era. And then there is the [mental and psychological] trauma. And its not really forecast well.

This could add at least one-half of one percentage point to the military-spending-as-a-percent-of-GDP number.

The point, he said, is this: What will the U.S. Treasury borrowing requirement be going forward? What percent of our national activity, what percent of GDP, is U.S. Treasury going to have to raise in the capital markets as opposed to the normal sources of all us chipping in?

When Fuss looks at the forward forecasts, he believes that we could be off by as much as one percentage point, and perhaps a bit more.

2. People

As for the people part of the equation, Fuss noted that the worker-to-retiree ratio is falling and that doesnt bode well for the economy. You young people are supporting more and more of us old people, he said. And this is a real problem.

According to a Congressional Budget Office report in August 2011, there were 42 workers per retiree in 1940; 16 per retiree in 1950; 2.8 in 2010; and its projected to be just two-to-one within 40 years.

The idea of using the political process to square revenue with spending is hopeful, but its not going to work, he said. The only thing that works is to increase the percentage of the population age 16 and older in the workforce, as happened in the second half of the 1990s. That would drive revenues to the U.S. Treasury, Fuss said.

Could it happen again? According to Fuss, its happening in some parts of the world, such as Japan, where the effective retirement age is now 69, and it could happen here in the U.S. where, according to a recent Gallup poll, the expected retirement age is now 67. Read that Gallup report.

Its going to be very difficult getting our federal budget under control unless we can get a lot more of old people back in the workforce, Fuss said.

3. Politics

Politics is a key issue as we approach the election, but its also the key issue when we look at whats going on in Congress apart from the election, Fuss said. We have to come together if we are going to solve this, and I dont think we are, he said. The division is pretty broad.

What does that mean for the economy? Any of us can have a near-term guess on the economy, he said. My guess is a little bit higher than the accepted guesses out there.

On a short-term basis, he said, its a tricky time to forecast GDP, because most of the information is adjusted on a seasonal basis. But in general, he said, the economy looks OK.

4. Prosperity and the economy

Youd be right to ask why interest rates arent already rising, given the level of borrowing by the U.S. Treasury. But rates arent rising now for supply-and-demand reasons. The U.S. Treasury is supplying a ton of opportunities to the market, Fuss said. However, the supply of funds coming into the market is tremendous.

According to Fuss, demand is coming from at least two sources. The supply is coming from a net increase in outstanding U.S. Treasury debt. If you take the second year on outnotes and bondsyou discover that all of the net increase is being acquired by our own central bank and the central banks of other countries.

Our own central bank is philanthropists, he joked. They even tell you in advance, they will tell you the time, the day and roughly how much they are going to buy. It is no trick at all to be a Treasury trader these days.

The Federal Reserve is, of course, also selling U.S. Treasurys via Operation Twist. They are selling at the short end of the yield curve and buying at the long end, Fuss said.

Foreign central banks are helping the cause as well. Those banks, he said, are buying U.S.-dollar denominated bonds, much of it being U.S. Treasurys.

This seems like a really good thing, he said. Why cant we keep this thing going? he asked. Its been working so far. But you might say, Something about this doesnt quite ring true. Well, thats true. But were skating along.

In this country, for instance, he said, We have a lot of underutilized, unutilized resources. Were not anywhere near full capacity in virtually anything.

The political and monetary answers here are unknown. The theories abound, said Fuss.

Lastly, Fuss suggested its possible the U.S. dollar might fall in value given the current state of affairs.

Thats certainly the lesson of history, he said. However, thats not what happened in Japan over the last few decades. That country is similar to the U.S. in some ways and its currency has been strong.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets at RJPIII.

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