A man walks out of Merrill Lynch's headquarters in New York.
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TIME: When talking about fallen stars, it's hard to ignore China. What's ahead?
Hartnett: Pure and simple, emerging markets go up when people get more optimistic on the global economy and they go down when people get more pessimistic. And certainly the deep, deep losses you've seen particularly in the second half of 2008 coincided with a very, very big downgrade to expectations for future economic activity. Our outlook for 2009 and 2010 is for an L-shaped recovery in economic activity [an L implies a prolonged period of no growth.] And that would be consistent with a trading range going forward for emerging markets, rather than the quick resumption of a vigorous new bull market.
TIME: Is China just lumped in with the emerging markets or is it on a different trajectory?
Hartnett: It's both. I mean, it's clearly part of the emerging market story because it's so integral to Asian economies. It is the odd man out in that we feel that the growth slowdown there can be cushioned much more dramatically than it can elsewhere thanks to the policy tools that the state has in China and the big share of the economy that's taken by the state. So we think that Chinese growth is going to weaken, particularly via exports and to a lesser extent investment, but we are pretty confident that the consumption side of the Chinese economy is going to remain fairly robust.
For example, there's an emerging middle class story in China. The one child policy has produced a lot of disposable income for young consumers. Also, you've got policies in place to encourage consumption in the rural areas, including the recent liberalization of land ownership. All of that is trying, at least, to reduce savings in China, which we know are very, very high. So, we think that will cushion some of the growth slowdown in China, but you can't reverse it.
TIME: Back in the U.S., many stock-fund managers think corporate bonds are the smart buy today. Are you of that camp?
Bernstein: Well, I may be the biggest Treasury bull in the free world. I think we are in just an amazing bull market for Treasuries and nobody wants to take part. To me this is one of the most astounding things I've seen in my career. You have major bond managers talking about how we're in a bubble for Treasuries, but bubbles don't occur when people think there's a bubble, right? Bubbles occur when people are starting new Treasury funds, and that's not happening. So I don't think we're in a bubble, I think this is actually quite fundamentally based. Plus, we now have the Fed who's going to be buying Treasuries on top of everything else. So there's every reason to stay in Treasuries.
As for corporate bonds, I personally think over the next couple of quarters we are going to see pretty poor earnings reports and pretty poor cash flow reports in the United States. And that could cause some downgrades in terms of corporate bonds. I don't think people are thinking about that because they say that these bonds are so incredibly cheap.
TIME: Does your bullishness extend to the Treasury's inflation-protected securities, known as TIPs?
Bernstein: If you want to hold TIPs to maturity for five or 10 years, there may be something there because the odds are we're going to have a little bit of inflation in the next five to 10 years. But if you're looking at this for a one or two year time frame, I'm not sure inflation protection is the best theme for your portfolio.
TIME: What could be the big surprise for 2009?
Bernstein: Many people think the stock market is going to muddle along. I think that in the U.S., 2009 will either be big up or big down. We're not going to muddle. Also, volatility's going to stay. That's going to be a surprise for people.
Hartnett: On the international side, the number one surprise could be this: China doesn't recover and the Chinese are thereafter forced to dump a lot of exports internationally, worsening the bias towards deflation, and that ends up causing some flare-up in terms of protectionism towards the end of next year. I think trade politics could surprise.
TIME: I didn't mean to limit you to one surprise. Do you have others?
Bernstein: If I could add one. It's not mine, but my colleague Dave Rosenberg (Merrill Lynch's chief economist) has noted that people forget that Japan did just about everything we're doing: huge infrastructure projects, lots of liquidity of the banking system, things of that nature. And Japan's economic slump lasted for many years. We're doing it a little more quickly than they did. But there's nothing that says that infrastructure is going to save the day. As Dave points out, it's a cushion, not a remedy. It's a cushion and people are looking at it maybe as a remedy.
TIME: Ouch. So the downside has more chapters?
Bernstein: It could. I personally think — this is not shared by everybody in my building — but I personally think that one of the keys to recovery that has not happened is you have to have massive consolidation of the financial sector here in the United States. We had some pretty notable ones — one I don't particularly want to talk about — but in terms of overall capacity to lend in the United States, it's really not gotten much smaller.
TIME: Let's end on a truly speculative question. At the end of 2009 we can look back and see how every asset class performed. What will be at the top of that list?
Bernstein: Personally, I'm going to say Treasuries because it's still the most hated asset class in the world and that usually is good news.
Hartnett: Chinese equities, just because they were so beaten up. They could go up 50 % next year and still be in a bear market.