Smart Money: Two Different Outlooks, Both Ugly

[La_Serpiente]

Mods: There is no link of this article online, so I typed it out.

This is from the magazine of the Wall Street Journal.
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Two Different Outlooks, Both Ugly

Bill Gross and Bob Rodriguez, two of the best bond managers in the business, have made successful careers out of accurately predicting economic trends. So what do their crystal balls tell them now?

Gross thinks the economy will stumble. Rodriguez disagrees. He thinks it's going to fall of the cliff.

Gross, who manages $350 billion in bonds assets for Pimco Funds in Newport Beach, Calif., is the world's biggest bond manager. he believes deficit spending and a declining dollar will slow economic growth. Investors will demand higher rates before lending money to cover the growing costs of the military and health care. "The Salad Days for bonds are over," he predicts.

To position his flagship portfolio, the $74 million Pimco Total Return fund for a downturn, Gross has reduced the duration -- a measure of risk that factors in average bond maturity, amount other things -- of his holdings. Expecting rates to rise, Gross has lowered his duration to 4.3 years, from 5.3 last spring, when rates were falling. If he's right, his portfolio should shield investors from the worst of the battering.

"My biggest fear this year has been no necessarily a recession or a weak economy, but a dollar rout, leading to a sale of U.S. Treasurys on the part of central banks or foreign institutions," Gross says. "that hasn't happened yet, but it's on the front burner for me." His portfolio consists largely of corporate issues and Treasury inflation-protected securities, or TIPS. he's taken profits on some of his junk bonds, which have rallied over the past 12 months.

Rodriguez, who's been bearish on bonds for the better part of two years, thinks Gross underestimates the threat of rising rates. In his fund, the $1.1 billion FPA New Income, duration is a minuscule 1.4 years. He says bonds are vastly overpriced, and sees an economic crisis right around the corner, as the government spends more and takes in less revenue. When that happens, bonds with long maturities will suffer most and issues that mature in a shorter time will hold their value better. The result is a portfolio that's lean on government bonds and heavy on cash.

"Interest rates in the 4 to 5 percent range aren't providing enough safety to compensate us for the risks we see in the system," he says. Rodriguez's short duration means that interest rates on the 10-year note would have to increase to 5 percent from the 4.23 in mid-November, for such a portfolio even to keep pace with the benchmark. "A substantial reduction in duration comes at a cost," says Gross, who doesn't expect such a big move. Rodriguez responds: "We'd rather give up opportunity returns , as opposed to real capital losses" if rates rise.

Of course, this is also a good approach if the economy improves, because in that case interest rates are also likely to rise, and the managers' defensive positions will serve them well. If that happens, Rodriguez is likely to do better than Gross, simply because his duration is shorter.

Through early November both managers were beating their peers. When bonds rallied early this past summer, the Gross portfolio got a pop. Then a sharp bond selloff hammered many government bond funds, but Rodriguez's fund gained 2.5 percentage points, and Gross's mildly defensive posture protected him somewhat. By early November, Gross's fund was up 3.9 percent for the year, compared with 3.4 percent for the typical intermediate-term bond fund. Rodriguez's was up 7 percent, beating nine out of 10 competitors.

So what should investors do? One options is to invest according to your outlook: Gross tends to beat competitors during bond rallies, and Rodriguez often trounces them in bear markets.