Cover Story: Commentary
THESE ARE THE GOOD OLD DAYS FOR BONDS
History does not repeat itself. But it rhymes.
It seems that hardly a day goes by without a money manager or an economist issuing a dire warning about bonds. For a generation seared by memories of high inflation and abysmal bond markets in the 1970s and early 1980s, inflation always lies just around the bend. Recent signs that the economy is gathering strength only reinforce the belief that robust growth will soon ramp up inflationary pressures. With interest rates now bouncing off their 20-year lows, the next big move in rates can only be upward.
So what should the investor do? Avoid bonds and put the money into stocks, advise many economists. After all, stocks outperformed bonds by a heady, inflation-adjusted six percentage points from 1946 to 1992. And for most of those years, inflationary pressures were on the increase. Little wonder that many forecasters, reared on the notion of an inflation-prone U.S. economy, discount the sharply lower inflation rates of the past several years and predict higher prices.
DEJA VU. Yet economists often underestimate how long a powerful downward price trend lasts, once it is in motion. Since 1857, periods of commodity price declines have averaged 22 years in the U.S., says Steven Nagourney of Lehman Brothers Inc. Certainly, disinflation, including large pockets of actual price declines, has become a force in the U.S. economy. Disinflation has been propelled mostly by the gale-force winds of international competition and by tightfisted central bankers, starting in the early 1980s. Today, the producer price index is fast approaching zero, and even previously immune sectors of the economy, such as the drug industry, are fiercely joining the discounting game. Disinflation, like inflation before it, has taken on a life of its own. And since inflation dominates bond returns, fixed-income investors able to ride out the market's inevitable swings could enjoy far better long-run returns than the post-World War II experience suggests.
Indeed, the world economy today looks somewhat similar to the final 30 years of the 19th century. True, instead of an international gold standard, currencies now float, and computerized trading was unimaginable back then. But like today, the period from 1870 to 1900 was a time of surging international trade, vast global capital flows, and widespread immigration, says David D. Hale, chief economist at Kemper Securities Inc. World output soared, and dramatic strides were made in factory production and technological innovation. America's industrial barons and their financiers put together steel and electrical-power combines, just as media tycoons and their investment bankers are creating multimedia empires today.
Perhaps most striking, during the last three decades of that century, the unprecedented expansion in world trade and investment pushed down global commodity and manufacturing prices. And U.S. interest rates fell. For instance, during the last quarter of the 19th century, the rate that was paid to depositors at savings banks was cut from 6% to 3.5%, and railroad bond yields fell from 5.45% to 3.13%.
As for the financial markets in that era, stocks outperformed bonds, but not by much. After adjusting for inflation, stocks returned 8.5% annually, and bonds 6.57%, over the 30-year period, says Jeremy J. Siegel, finance professor at the Wharton School.
Capital-market theory and investor experience alike say that over the long run, stocks will outperform bonds. Stocks, after all, are riskier investments. If you have any doubts, just recall the 1987 stock-market crash. But stocks will beat bonds by thinner margins when inflation is constrained and lenders are confident of earning decent real returns. "If inflation expectations continue to melt, even a two- to three-percentage-point difference between stock and bond returns may be too high," says Peter L. Bernstein, a New York economic consultant.
Of course, bond yields and inflation rates will spike up periodically. Those swings may be costly for anyone who must sell bonds at that time. But for those with longer-term horizons, bonds could well prove to be a sterling investment in the 1990s.Christopher Farrell