Anemic economy to imperil stocks and bonds: fund manager

NEW YORK (Reuters) - Stock markets have become too euphoric about economic growth prospects, and the trillions of dollars of U.S. government debt issuance will trigger inflation and a long-term bear market in U.S. bonds, said Tom Atteberry, fixed income fund manager of Los Angeles-based First Pacific Advisors LLC.

Those concerns are keeping the prominent portfolio manager away from riskier high yield corporate bonds and mulling raising exposure to foreign bonds as a cushion against the falling U.S. dollar and higher U.S. inflation.

The Dow Jones industrial average .DJI is flirting with the 10,000 level, but what might also grab headlines in the coming days is a resurgence of worries that the economic recovery will be sluggish, making a further run-up in equities unjustifiable, he said.

"The stock market has a correction to come. It might be 10-20 percent," Atteberry told Reuters in an interview on Thursday. "I just don't see sustainable growth ahead."

The prices of government securities and investment grade corporate bonds are also at risk within the next three-to-five years, he said.

For now, the foreign investors who hold half of the nearly $7 trillion of government bonds outstanding are steadily buying U.S. debt. But sooner or later, the tidal wave of Treasuries issuance, running to some $2 trillion this year alone, will force foreigners to demand much higher yields, said Atteberry.

As government bond yields rise, so too will those of investment grade corporate bonds that key off them, pushing prices of these securities lower, he expects.

"We are about ready to enter a bear market in bonds," Atteberry told Reuters. "The catalyst is the government's borrowing and chronic deficits," he said.

"You cannot borrow yourself to prosperity," Atteberry added. "Either the interest rate level is going to give, or the dollar level will give," he said.

Over the next three-to-five years, he expects the benchmark 10-year Treasury note's yield, which traded at 3.40 percent on Thursday, will rise toward its long-term average just above 6 percent. U.S. 30-year mortgage rates could rise to about 7.5 percent over the same period, he said.

Rising mortgage rates could rock an already fragile housing market, while investment grade corporate bond yields are also expected to rise, raising the cost of borrowing for corporate America.

Lower-rated corporate bonds also will remain under pressure even after the long-running U.S. recession ends, Atteberry expects.

JUNK BONDS TO STRUGGLE

The outlook for U.S. high yield or "junk" bonds will be gloomy for years if in an anemic economic recovery, many companies do not generate enough earnings to offset their debts.

Atteberry remains very cautious about high yield bonds, investing less than 2 percent of First Pacific's fixed income portfolio in them in recent years.

That cautious approach helped save the portfolio from a battering when junk bond prices plunged during the global credit crisis. On the other side of the coin, however, Atteberry missed out on the record U.S. high yield bond rally, which has delivered total returns of some 46 percent since December as investors returned to riskier assets on hopes that an economic recovery was on the way.

Many bond market analysts now ask whether this rally has overshot, with the economy hamstrung by weak housing, a jobless rate nearing 10 percent and the reluctance of cash-strapped consumers to borrow and banks to lend.

"At the high yield level, corporate leverage is onerous and poor," said Atteberry. Among these U.S. issuers, debt is about 4.5 times total earnings, he said, above the roughly 4 times reached in the 2001 U.S. recession.

The default rate of U.S. corporate bonds will likely stay high for at least another two years as companies struggle with the effects of over-borrowing. Recovery rates, in cents on the dollar, for defaulted U.S. high yield bonds will be low by long-term historical standards, he said.

In the fixed income portfolio Atteberry manages, he plans to reduce the impact of inflation by holding shorter-maturity bonds. Longer-dated bonds are especially susceptible to rising inflation pressures, which erode bond values over time. He is also holding between three percent and four percent of the portfolio in Treasury Inflation Protected Securities, as a useful hedge against inflation over long periods, he said.

Atteberry is interested in buying more foreign bonds to counteract the effects of a falling dollar, although he is limited from holding more than 10 percent of his bond portfolio in foreign fixed income, he said.

(Editing by Padraic Cassidy)