Baird Chief Investment Officer Stanek Addresses A Prolonged Slow Growth, Low Rate Environment

A “New Normal” of Heightened Risk and Volatility; Fed Can’t Go It Alone

MILWAUKEE, Oct. 14, 2011

In recent comments to investors, Chief Investment Officer Mary Ellen Stanek discussed the investment challenges of a prolonged slow growth and low rate environment and the investment opportunities her team is finding in this environment. She also provided her annual bond market outlook. Baird Advisors is the fixed income asset management unit of Baird, an employee-owned global capital markets, private equity, wealth and asset management firm. 

Last year at this time, we predicted a continued weak recovery and reiterated our belief that inflation and interest rates would stay lower longer than people expected. We also expected that we would remain in a heightened risk environment for some time with a very wide range of possible outcomes.

Recent market volatility in the third quarter was driven by a confluence of events including concern in the global financial system as the debt crisis unfolds in Europe, the dysfunction of our severely divided congress during the debt ceiling debate, the uncertainty as Congress kicked the can down the road to the Super-Committee, and ultimately the S&P downgrade in early August.

The negative impact of the U.S. sovereign rating downgrade was not specifically on the U.S. Treasury market, but on overall psychology and confidence in the financial markets and U.S. economy. The hit to confidence led to a spike in market volatility and generally less-liquid markets. It also exacerbated the slowdown in the economy by making both businesses and consumers more cautious in their hiring and spending decisions.

The global slowdown coupled with the sovereign debt issues in Europe and the U.S. have shaken the market’s confidence and reintroduced a high level of fear. In August we saw volatility spike to 48%, as measured by the VIX index, a measure of implied stock market volatility that is used as a “fear” gauge in the markets. As we have stated in our economic and market outlook for the last three years, we believe we are going to be in a heightened risk environment for some time. This may be the “new normal” for market risk and volatility.

High market volatility clearly has a negative impact on both business and individual confidence and behavior. Wild rides in the market create a negative feedback loop by negatively impacting confidence leading to more cautious behavior and further slowing of the economy. Interestingly, the two asset classes that fearful investors flocked to during this period were gold and U.S. Treasuries. The fact that both gold prices and bond prices have been rising together for the past two years tells us that we are in uncharted waters.

Treasury yields have been driven down sharply as a result, despite a consensus forecast of higher yields in 2011. Credit spreads for both investment grade and high yield were sharply wider in August and September reflecting a global re-pricing of risk. In fact, August was the third worst month (after October and November 2008) in terms of widening yield spreads. We believe these sharply wider spreads have provided attractive opportunities, especially in corporate bonds given the improved credit fundamentals for most issuers. Today, we are seeing Treasury yields at record lows while some investment grade corporate bonds yield close to 6%. Driven by strong profits, most corporate issuers have been able to de-lever balance sheets and increase liquidity. These improved credit fundamentals will likely allow these issuers to better weather an extended period of slow growth or even an economic downturn.

Turning to the municipal markets, most states are balancing their budgets by cutting back aid to local municipalities. Our approach continues to stress high quality, intermediate duration municipal bonds. We believe this is the best approach in the elevated risk environment that is likely to continue for some time.

Before we look ahead, I want to review our outlook we presented last year at this time. We correctly saw the slow recovery continuing in 2011 with significant constraints and fragile confidence that might be shaken by a European debt crisis and U.S. policy uncertainty. We also saw benign core inflation and wage increases, which we believed would give the Fed the needed flexibility to maintain extraordinary accommodative monetary policy thru 2011 and likely even longer. We were possibly too right on the fragile confidence and the slow-growth forecast.

Our outlook from here has a few key drivers. First, there is significant slack in the U.S. economy’s actual output versus its potential. This output gap has created significant unused economic capacity and high unemployment. Stubbornly high unemployment is the key factor holding down consumer confidence. Along with high unemployment, weak housing and stock markets have been a significant headwind to both confidence and spending.

Let’s look a little closer at employment. The number of full-time workers in the U.S. today, at approximately 131 million people, is the same as it was in January 2000. The current unemployment rate at 9.1% would be as much as 11% if the participation rate (employed or unemployed actively looking for a job) did not fall over the past three years as discouraged unemployed workers left the labor force. Looking more closely at how education impacts these numbers, those with lower education face significantly higher unemployment. The dramatic drop in residential and commercial construction jobs explains some of this huge disparity in unemployment rates. Further, the rise in long-term unemployment is disconcerting. The largest group of unemployed is those who have been out of work for more than six months. This is likely due in part to structural issues in the U.S. labor markets where skills of the unemployed are not matching up with the current needs of employers.

The extended period of high unemployment has made wage pressure in the U.S. economy virtually nonexistent. For higher inflation to truly take hold and stick, we believe it needs to get embedded in wages. We are clearly not at risk of this happening over the next couple of years. However, broader headline inflation flashed some warning signs earlier this year. Higher oil and food prices drove headline inflation to over 3.5% in the first half of 2011, but slower U.S. and global growth will likely reverse this trend. Core inflation, the Fed’s preferred measure because it excludes highly volatile food and energy prices, has also risen somewhat but remains in the Fed’s targeted range of 1.7% to 2%.

Weak housing has contributed to the overall slow growth and benign inflation environment. The significant decline in national housing prices ended over two years ago, but we have been in a rocky bottoming process since. The two rounds of first-time home buyer tax credit stimulus were a temporary help that has now reversed. On the positive side, housing affordability is the best it has been in 30 years.

The credit bubble, driven by too much lending to the housing market and the resulting need to de-lever after the bubble burst has been a primary headwind to the U.S. economy. Though the deleveraging process is underway in the private sector, the level of government debt has grown rapidly as deficit spending was used to stimulate the overall economy and pull it out of the deepest recession in over 75 years. Effectively some of the leverage in the private sector was shifted to the government’s balance sheet. And this level of deficit growth is unsustainable. Over the last 3 years, the federal government spent approximately $1.60 for every $1 they received in tax revenue. A credible 10 year deficit reduction plan is needed in the near-term to avoid further downgrades and reduce the uncertainty surrounding these unsustainable deficits.

The current focus on deficit reduction and the strong resistance to additional fiscal stimulus has put the burden on the Fed to help the economy as it slows to a dangerous stall speed. In early August the Fed again reached into its extraordinary monetary policy toolbox and surprised the market with a new form of monetary accommodation. They pledged to keep the overnight Federal Funds rate effectively at zero, where it has been since the end of 2008, for another two years. As we have said in the past, we believe the Fed’s move to zero overnight rates was the most effective monetary policy response during the entire crisis and recovery because it forced investors out into riskier assets and provided a steep yield curve to help the banking system.

In an effort to address slow economic growth, in September the Federal Reserve implemented Operation Twist to bring down longer-term interest rates by buying longer maturity and selling short maturity Treasuries. The policy had an immediate impact on the long end of the yield curve with yields moving sharply lower. But while Treasury yields plummeted, not all bond yields have fallen creating opportunities for bond investors.

Can Bernanke save the world? Not alone. While we think the additional monetary accommodation of Operation Twist will help, it is unlikely to be sufficient to return the U.S. economy to a self-sustaining level of growth. The Fed will need some help. First, we believe the Fed will get help in providing accommodative monetary policy. The slowdown in global growth has likely kicked off a global easing cycle starting with Brazil. Second, the Fed will need help from Congress and the President. They will need to agree on a credible medium-term deficit reduction plan and possibly additional short-term fiscal stimulus to reverse the economic slowdown.

In conclusion, we are in uncharted waters with extreme volatility in bond markets. The economic environment is unlikely to rebound any time soon, and the sharp decline in Treasury yields has created challenges for income-seeking investors. We expect yields to stay lower longer than many people expect, yet we believe recent volatility has created opportunities for added yields in selected investment grade corporate and mortgages exist for investors willing to move away from low yielding Treasuries.

About Mary Ellen Stanek, CFA
Mary Ellen has over 30 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Mary Ellen was President and Chief Executive Officer of Firstar Investment Research and Management Company (FIRMCO) and was Director of Fixed Income. She is responsible for the formulation of fixed income strategy as well as the development and portfolio management of all fixed income services. Baird Advisors manages $15 billion in fixed-income assets.

About Baird
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,600 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of $89 billion. Committed to being a great place to work, Baird ranked number 14 on FORTUNE’s “100 Best Companies to Work For” in 2011 – its eighth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at

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This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources considered reliable, but we cannot guarantee the accuracy. The source material for all statistical data cited is available upon request.

In a rising interest environment, the value of bonds generally decreases. Investments in mortgage- and asset-backed securities which include interest rate, prepayment and default risks more pronounced than those of other fixed income securities.