(Reuters) - It might be the most important question in portfolio construction this year: can Treasuries extend their winning streak to 31 years? U.S. government bonds outperformed yet again last year, and the overall bond market did even better, racking up a 28 percent total return in 2011 against a paltry 2.1 percent for the Standard & Poor's 500, according to Ibbotson Associates data.
There are, however, plenty of reasons to be leery. For one thing, rallies don't go on forever, just as trees don't grow to reach the sky, and with 10-year Treasuries yielding a paltry 2 percent, it is tempting to assume that the risks are not evenly distributed. As well, the flow of news in the U.S. has been encouraging of late. Private sector hiring measured by ADP jumped in December to a record 325,000 new workers, well above consensus. At the same time jobless benefit claims fell, extending a reasonably positive trend.
The fact is - we don't need a vibrant recovery to absolutely crater government bond returns. Especially if you consider that events internationally and a weak housing market may keep the Federal Reserve pinned down, it is not too hard to construct a scenario where official rates don't rise and an inflation scare punishes the long end of the bond market.
There is a lot of scared money parked in U.S. government bonds, money belonging to domestic investors and institutions and, crucially, to foreign accounts seeking a bit of shelter from euro zone risks. That money could cascade out, would cascade out, if the idea took hold that a solid U.S. recovery was at hand. Look too at the amount of real return offered by Treasuries. Real interest rates, as offered by Treasury Inflation Protected Securities (TIPs), are near zero for ten years and well into negative territory for five years. It is hard to square that with analysts' projections, which show annual inflation of 2.5 percent over the next decade.
In short, the risks of holding Treasuries are pretty high. You could lose money all of a sudden in the event of an inflation outbreak, or just little-by-little if the world does not prove to look like deflationary Japan over the next few years.
INVESTING IN SCARCITY
Having said all of that, Treasuries are where they are, and may beat equities once again, because the risks on the other side are if anything bigger and even uglier.
First, there is the possibility that the U.S. is in a long period of poor growth, all the while with a fragile banking system and dysfunctional housing market. The historical experience of economies which amass debt on par with the U.S. is not good. At the same time, moves toward reducing the deficit simply mean less money in corporate coffers and consumer pockets. Consumer balance sheets are stretched enough that even if employment does recover mildly, a lot of the extra income may go to repay debt rather than buy goods and services.
And then there is Europe. At the very least euro zone fears will continue to create a strong bid for safe investments, and though the U.S. may face further debt downgrades, the Treasury market is the only thing big, relatively safe and liquid enough to absorb the flows. If the euro fractures, then watch out, not only will there be massive flows into Treasuries the world will be facing a recession with deflationary risks.
The important thing to remember is that the world is facing a real scarcity of safe investments and growth at the same time. The irony is that the downgrade of the U.S. will make investors want safety even more, and tend to drive them into Treasuries and out of riskier assets.
Citing Ibbotson data that shows bonds have in aggregate generated a total return of about 11 percent - higher than equities - over the past 30 years, Gluskin, Sheff economist David Rosenberg sees the risk-adjusted writing on the wall. "Imagine being offered an asset class that actually pays you to take on risk instead of having to pay to take on the risk - this is the key towards effective money management," he wrote to clients.
"Stick with what worked last year: play it safe but not in 0 percent yielding cash. Growth is becoming increasingly scarce; stable income is becoming increasingly scarce. And what is scarce is what should be populated in a portfolio; just like the abundance of fiber optics should have been avoided in 200 and the abundance of housing and credit finance avoided in 2007."
Treasuries still offer relative safety in a world of high and increasing uncertainty. No rally lasts forever, but this one probably has a bit more room to run.