Value Added


An Aggressive Approach to Overcoming Market Mayhem

Steven Goldberg

Until Europe fixes its "Club Med" debt problems, expect continued volatility in stocks worldwide. A star fund manager reveals alternative plays for proactive investors who see an eventual end to the current crisis.



When I want insight on which way the stock market will head next, I often turn to a first-class bond manager. Most stock managers pay scant attention to the big picture. By contrast, bond managers live and die by the accuracy of their economic calls. Unfortunately, what I’m hearing now isn’t good news.

Kathleen Gaffney, co-manager of Loomis Sayles Bond (symbol LSBDX) since 1997, is one of the best. Dan Fuss, one of her co-managers, launched the fund, a member of the Kiplinger 25, in 1991 and has been investing in bonds for more than 50 years.

Gaffney and Fuss predict continued volatility in stocks and other risky assets until the crisis is resolved. And they don’t see that happening soon. “The problem isn’t just Greece,” says Gaffney. “It’s all of the PIIGS,” referring to the indebted, slow-growing countries of Portugal, Ireland, Italy, Greece and Spain. “The euro zone isn’t functioning as it should. You have to restructure debt so the PIIGS can pay it off.”

Restructuring means that the mainly European banks that extended too much credit to the PIIGS (or Club Med countries, as I prefer to call them) will have to take a haircut. That entails trimming interest rates on existing bonds and loans, reducing the amounts owed, or lengthening repayment periods -- or perhaps some combination of all three actions. France and, particularly, Germany are dead set against such measures. In addition, Gaffney says, most of the Club Med governments will have to make more unpopular spending cuts, which, as we’ve seen in Greece, could lead to social unrest.

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Gaffney sees no end to the crisis until these steps are taken. She says Europe has no choice. “There has to be some arrangement.”

She draws an analogy with the U.S. subprime crisis. The euro zone, in concert with the International Monetary Fund, put together a package of nearly $1 trillion aimed at resolving Greece’s woes. The bailout addressed Greece’s immediate liquidity crisis but not the bigger problem that it simply can’t afford to pay off all its loans on time. Similarly, the U.S. Federal Reserve gave J.P. Morgan a $29-billion loan in March 2008 to acquire failing Bear Stearns.

But the U.S. financial crisis only worsened until late 2008, when the government put together the $700-billion Troubled Asset Relief Program (TARP) to bail out banks and took other measures to ensure that large banks wouldn’t fail. Even then, stocks didn’t hit bottom until March 2009.

The Club Med crisis is nowhere near as dangerous as the subprime crisis was. Banks and other financial institutions in Europe haven’t yet regained enough nerve to build frightening levels of leverage (borrowed money) into their balance sheets. “You won’t see the downdrafts that you saw then” in stocks, Gaffney says. “There’s a lot less leverage in the markets.”

What Loomis Sayles Bond likes now

While you’re waiting, you should consider putting some money into Loomis Sayles Bond. Over the past 15 years through May 31, it returned an annualized 9.2%, compared with 6.0% annualized for the average multisector bond fund. The fund was clobbered in 2008’s meltdown, plunging 22%, but it rebounded 37% in 2009. It’s my favorite high-risk bond fund.

Anticipating a resolution of Europe’s crisis, the fund’s managers have positioned it as aggressively as ever. About 30% of its assets are in foreign bonds. Gaffney favors bonds in “commodity currencies” -- those of Australia, Canada and New Zealand. The first two nations have abundant supplies of natural resources, and New Zealand is a big exporter of agricultural products. Commodities and the commodity currencies have plummeted with the crisis, but Gaffney anticipates a rebound. “The Canadian dollar at $1.07 is a buy.” The fund also owns a lot of emerging-markets currencies.

About one-third of the fund is in high-yielding junk bonds. Issuers of junk bonds run a high risk of defaulting. As with commodities, these bonds should rebound once Europe takes steps to resolve its Club Med problems. The rest of the fund is in investment-grade corporate bonds.

The crisis, Gaffney believes, has pushed back the Federal Reserve’s timetable for raising interest rates. She predicts that it will be the middle or end of next year before the Fed raises the federal funds rate from its current level of essentially zero.

Once the crisis is over, she thinks emerging markets will continue to power growth for the rest of the world. Growth in the developed world will stay sluggish, with a possibility that Europe will fall into another recession -- the dreaded double-dip downturn.

Gaffney is optimistic about stocks for the longer term, but it’s too early to load up on them. “It’s not a time to sell,” she says. “It will be painful in the short run to own equities, but I wouldn’t sell now.” If you have cash on sidelines, “I’d wait for an opportunity to buy.” If Gaffney is right, given Europe’s lack of resolve in dealing with its problems, it could be a while before that opportunity arrives.

Steven T. Goldberg (bio) is an investment adviser.



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