One of the major questions being bandied about right now is whether the North American economic recovery will continue in a V-shape or whether it will move into the interior down leg of a W-shaped recovery, indicating stalling growth. Undoubtedly, the answer will play a major role in helping clients decide where to invest their assets.

“If you expect growth, go for stocks,” says Jackee Pratt, vice president and portfolio manager with Mavrix Fund Management Inc. in Toronto. “If you don’t expect much growth, go for bonds.”

As of early February, the outlook for stocks was not as rosy as it was six months earlier. Following the March 2009 market lows, the MSCI world index rose by 70% until Dec. 31, 2009, but then it backed off, losing 3.4% in January. Meanwhile, corporate bonds turned in a strong January as the Bank of America Merrill Lynch global broad market corporate index rose by 1.6%. So, the inevitable question is: will stocks beat bonds, or vice versa, in the remainder of 2010?

The main factor in this equation is government stimulus. As it is withdrawn and as interest rates begin to rise, loans will have to be repaid. That means deleveraging, which, in turn, implies dumping stocks purchased with borrowed money. That’s a case for slowing economic expansion, says Chris Kresic, senior vice president and head of the fixed-income team with Mackenzie Financial Corp. in Toronto: “The Canadian economy is still on a rebound, but the pace of the rebound will slow significantly in mid- and later 2010.”

So, the question becomes whether moderating growth will continue to support the idea of recovery as the driving force of the present market. There is much doubt that it can. Restocking of inventories has been underway, but most of that stimulus to production will be used up by mid-2010, according to CIBC World Markets Inc. chief economist Avery Shenfeld’s February forecast.

Moreover, Shenfeld predicts in a Jan. 25 report that “U.S. fiscal stimulus will turn from a source of growth to a drag by the fourth quarter.”

Finally, persistent negative wealth effects caused by the drop in housing prices across much of North America will cause household savings rates to rise, he suggests. The effect of the trends is slow growth.

Translated into earnings predictions, slow growth suggests lower earnings forecasts and stock multiples, and less enthusiasm for stocks. The financial advisor seeking a yield competitive with even reduced rates of growth for stock prices can consider putting clients with moderate risk profiles into long investment-grade corporate bonds.

Other bond categories have little appeal, says Vivek Verma, vice president of Richmond Hill, Ont.-based Canso Investment Counsel Ltd., noting that government bonds have yields ranging from trivial on shorts to low on longs. Furthermore, he adds: “High-yield bond prices have doubled from year-ago lows and are no longer attractive, especially if growth slows and defaults rise.”

Verma suggests the Canadian economy will move sideways in 2010 — a reason to buy bonds: “The Bank of Canada will not raise rates for most of the year and any rate rises will be modest.”

In other words, there should be no dramatic interest rate jumps that make existing bonds seem unattractive and cause them to lose value.

But he favours restraint in taking on risk: “The place to look for value is in high-grade, long corporates that are off the run — that is, not actively traded.”

Verma points to representative issues that provide significant boosts over long Canada bonds. He suggests that the GE Capital 5.73% AA-rated issue due Oct. 22, 2037, recently priced at $94.70 to yield 6.12%, offers a good boost over the Canada 5% issue due June 1, 2037, recently priced at $116.98 to yield 3.98%. The yield gain comes with relatively little risk. Moreover, Verma says, the income-maintenance agreement from the parent company has been strengthened.

In the Maples market, a Eurofima 4.55% issue due March 30, 2027, recently priced at $89.90 to yield 5.46%, offers a 1.47% boost in total return over a Canada issue due June 1, 2027, recently priced at $149.75 to yield 3.99%. (Eurofima is the supranational European railway network funding-support agency; it has AAA ratings on its debt.)

Finally, an Alta Gas 7.42% issue with a BBB rating due April 29, 2014, recently priced at $110.40 to yield 4.69%, compares favourably with a Canada issue with a 5% coupon due June 1, 2014, recently priced at $111.04 to yield 2.3% to maturity. For taking moderate credit risk, the investor gets more than twice the return of the federal bond.

@page_break@Long bonds have obvious duration risk — when interest rates rise, issue prices will tumble. For safety, Verma uses a barbell strategy, blending short issues that have low risk of price declines resulting from interest rate increases with long bonds that offer substantial yield.

Taking on some duration risk is worthwhile, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax: “We favour overweighting corporates compared with provincials and federal bonds. The best yield compression — that’s increases in bond prices — will be in corporate bonds. That is the place to be in the coming year.”

Strengthening corporate balance sheets have prompted markets to recognize that issuers of investment-grade corporate debt should survive to redeem their debts. If the interior down leg of the W-shaped recovery fades and recovery resumes, stocks will beat bonds. Yet, there’s still a good yield to be obtained in relatively safe corporates with a barbell of short bonds to cushion duration shock.

If a W-shaped recovery occurs, equities prices will decline, meaning more money will move to bonds, raising prices and boosting their total return. IE