Inflation Lurks

Because "you can intimidate everybody," Carville said in the interview, still in a combative mood after spearheading Bill Clinton's presidential campaign in 1992.

Today, the bond market is just as intimidating as ever. Not only for it's sheer complexity, but also because of the massive amounts of currency tied up in U.S. Treasury bonds, which the government uses to fund its record budget deficits.

Bonds are also a good way to judge the state of the economy, and expectations of the future. When the economy is stalling and the stock market is tanking, bonds do well as investors rush to safety, as happened in 2001 and 2002. When the economy is chugging along, bond yields, which move inversely to price, decline as investors flock to stocks and other riskier, higher-growth-potential securities.

To get a take on the state of the bond market today, SmartMoney.com recently spoke with Tom Atteberry, co-fund manager of the FPA New Income fund (FPINX), which fund tracker Morningstar calls "one of the best bond funds money can buy." Atteberry's strategy on bonds has been increasingly defensive in 2004, he says; the fund has increased its cash position to 44% from 30% earlier in the year. We asked Atteberry how inflation is affecting bonds, whether consumer spending will decline and what he thinks about the troubles at Fannie Mae (FNM) and Freddie Mac (FRE).

SmartMoney.com: In FPA New Income's semiannual report, from March, you say you've taken a more defensive posture on the bond market this year. Is that still your position?

Tom Atteberry: Yes, very much so. We're even more defensive than we were then. If you look at inflation since 1926 forward, you have a median inflation level of 2.9%. If you look at the periods of time when inflation was very low, let's say less than 2% — the Depression, a couple times in the 1950s and four years in the early 1960s, and 1986 — all the dates you're looking at for inflation tend to be quite a long time ago. In a further look at inflation, you realize that most of the time the vast majority of the numbers are between 2% and 4.99%. That's the central tendency. So why shouldn't we expect the inflation range to be between 2% and 5%? If I look at that, and look long-term, what's the real rate that I get for a 10-year Treasury, if I look at the last 50 years? The real rate — which is the yield minus inflation — is 2.7%. So by taking 2.7% and 3% as a median inflation level, you see that a fair value in a 3% inflation level is a 5.70% yield on the 10-year bond. And we're sitting at just over 4% today.

So if you believe that you're going to have that kind of inflation, if you believe a 4% 10-year yield is appropriate, you're thinking that inflation is going be sub-2%, and we have a hard time thinking that that's going to occur.

SM: You think bond yields haven't priced in inflation enough?

TA: Take a look at the CPI data from August. It's a list of those items composed of the CPI that year-over-year were up more than 3%. Motor fuel; education; water; sewer and trash collection; fuel, oil, gas and electricity; medical care services; lodging; miscellaneous personal services; and food. The main point is that, with the exception of lodging away from home, these are basic services that consumers need. I don't necessarily have to travel, but I have to do the others. They're also very periodic — people are going to spend on most of these every month. Now look at all the items that are down any amount. Personal computers; used cars and trucks; telephone services; public transportation; new vehicles; household furnishings and operations; apparel and footwear; and personal-care products. We don't buy personal computers, used cars or new vehicles every month. They're discretionary. So inflation is going up on the things that we need and buy every month.

SM: Consumer debt and consumer net worth are at all-time highs. What does that tell you about the state of the economy?

TA: It tells us a couple of things. The consumer is doing very well. His net worth has increased. There's a school of thought that says the consumer has taken on all this debt and that unless rates stay low, there's going to be a problem for the consumer to service all that debt, and I'm saying no, no, no. We don't think that's the case at all. Mortgage debt from 1995 through 2004 has compounded at a rate of 9%. It has gone from $3 trillion to $7 trillion. Cash savings have gone up at a compounded rate of 8% from 2 1/2 trillion to $5 trillion. So the same time the consumer was taking on debt, he was increasing his cash savings. So he's got liquidity to handle the debt. That also tells us that the consumer is probably in fairly good shape and fairly optimistic about the future and is in shape to weather the inflation problem we have with oil and gas.

SM: According to recent studies, real wages haven't grown over the past few years compared with inflation. Are you factoring in wage growth when you talk about consumer spending power?

TA: Two things to that. Look at real wages in a slightly different sense. What is the consumer putting in his pocket? If you look at what the consumer was putting in his pocket in growth from say 1995 through 2000, and then 2000 through 2003, what you see is that wage growth has slowed. But real income into people's pockets has increased because tax policy has changed. The numbers indicating what people are putting in their pockets increased by the same percentage between 1995 and 2000 and 2000 to 2004. What changed was where it came from. From 1995 to 2000, it was wage driven, and from 2000 to 2004 it was tax driven. But the amount of money in people's pockets has been growing at relatively the same rate.

SM: Critics of the tax cuts say they were focused too much on high-income individuals to stimulate the economy most efficiently.

TA: But more people at the lower end pay less in taxes. There are fewer people paying taxes today than there were. They lowered everybody's tax rate. So everybody's tax rate went down, and everybody's tax bill went down. Some people fell off the tax rolls completely. The argument that the wealthy are impacted more, yes in a dollar amount they would be because they're making more money. In our opinion, you want the high end to come down in some degree. That's the business owner. If I put more money in the business owner's pocket, they'll use that money to expand their business. If they expand their business, they hire people.

SM: Let's talk about real estate. Some economists are saying it's a massive bubble in certain local markets and that trillions could be lost when it pops.

TA: If you look at the last five years, and you look at assets of the consumer, you see real estate going from $10.6 trillion to $20.8 trillion. But his home mortgage debt only goes from $3.2 to $7 trillion. So the asset, the real estate, has risen much higher than the debt. I think it's very safe to assume that if we raise interest rates from here that housing prices won't accelerate at the same rate they've been accelerating. Does it go flat or drop a little? It could drop a little, but it's not going to impair someone given the fact that there's $20 trillion in real-estate value supporting $7 trillion in real-estate debt. Another thing that explains the rise in real-estate prices is that 69% of households own a home. That's the highest level ever in this country. So the demand for real estate has been there. Does that demand continue? It's going to moderate some. So demand moderates and interest rates go up, and those things are probably going to force housing-price appreciation down. But there's more than enough built-up equity value in real estate to handle the debt that's out there.

SM: Do you see the shakeup at Fannie Mae as having any immediate macro impact on the housing market?

TA: I look at Fannie Mae, Freddie Mac and Ginnie Mae, the three major public/private entities, and they have a mission to provide liquidity to the mortgage market so that the availability of mortgages for consumers who want to borrow to buy a house is there. Banks are not going to lend for a 30-year fixed mortgage. It doesn't work in a banking environment. They're willing to underwrite that mortgage, but they want to sell it to somebody. That's what Fannie, Freddie and Ginnie are there for, to take that risk. I don't see that changing. Do I see the cost of them funding that purchase getting more expensive? That's possible. But I don't see their mission statement or their ability to provide that mission changing.

SM: What's the big picture on the bond market today?

TA: Valuation in bonds. Treasurys and high yields are overvalued by a tremendous amount, in our opinion. If you think you've got somewhere between 2% and 3 1/2% inflation, why wouldn't you expect as an investor at least a median real return on a long-term Treasury, which means that you should have a 10-year that's somewhere between 5 1/2% and 6%. Investors who think 4% is an appropriate handle for a 10-year Treasury must be thinking we're going to get extremely low inflation, and that doesn't seem to be in the cards.