Their attitudes range from extreme defensiveness to sunny optimism. Within that spectrum, we found some agreement. As bearish as some of the viewpoints are, none see a second dip into recession. Everyone is concerned about the spreading European crisis.
Differences? You bet. Some say economic sluggishness will be with us for a while and others predict improvement as soon as the second half of this year.
The concerned nod to a rise in regulation and onerous government debt in the developed world, while the glass-is-half-full crowd cites corporate America's hefty profits and copious amounts of cash on the balance sheets, available for M&A, hiring, dividends or share buybacks.
Michael Brandes, the head of fixed income strategy from the Citigroup Private Bank, is in the defensive camp. The private bank is recommending clients boost their fixed-income allocation and skimp on equities. "We think earnings and growth will disappoint relative to current consensus. The market, in our view, thinks a little too optimistically," he says. He added, however, that they do not see a return to recession. "It's not that we're saying growth isn't going to happen, just not at the level people are expecting."
Specifically, the private bank is advising clients to load up on investment-grade corporate bonds and high quality sovereign debt. "We thought there was a lot of safe-haven sentiment and that growth would disappoint, and I think we've made a good call," he says. "This is an uncertain time, and it pays to be defensive."
He adds that measures taken in both the private and public sectors to reduce debt and get back on track-from increased regulation of the banking industry, which has resulted in tighter credit, to companies delaying hiring or hoarding cash, to the government ending QE2-have been bad for growth. His group points to the favorable fundamentals for fixed-income: low inflation, the rebuilding of balance sheets that occurs after a crisis, falling default rates. All of this is good for the private sector. But as governments have had to take on toxic assets, there's been a transition of leverage from the private sector to the public sector. "We're seeing the consequences of this in Europe and in Washington D.C., where we're looking at largest deficit we've ever faced." He also believes investors' risk aversion will continue, which burnishes the case for bonds over stocks.
Hence, the private bank's preference for fixed-income. "It's a more resilient asset class. These days you want to be a creditor rather than an owner. We've favored high-quality, longer duration debt, which will be the most resilient in these volatile times." Yet, over the medium- and longer-term, they also like high-yield debt. In spite of its reputation for lower quality, it's still higher in the capital structure than equity. However, given market nervousness, he's advising new buyers to wait for the debt crisis in Europe and Washington to get closer to resolution, which could take two to three months. But he predicted that even so, high-yield will still be the best performing asset class is fixed-income this year.
Old World = New Problems
Brandes is worried about European banks, and not only those in the crisis-hit countries. He notes that although Greece is only 2.5% of the European monetary union economy, its debt is outsized. And two-thirds of that debt is held outside of Greece—roughly half by the European Central Bank and half by banks in France and Germany. UK banks rank as the third-largest holder of the Greek debt. "You have major economies whose banking systems may be depending on what happens with Greece, may require government support if Greece has a default. This is not just some random Mediterranean country. This is about banking losses in Europe and the contagion."
David Darst of Morgan Stanley Smith Barney is also concerned. But he is slightly more sanguine, saying he does not see "Lehman Brothers-style contagion or meltdown or a period of enormous turbulence or turmoil." He does think the crisis in Europe will continue, and that it will hurt bank stocks in Europe and, to a lesser extent, in the U.S.
Other strategists were also in cautious mode, but more upbeat about the prospects for growth. Ronald Florance, managing director of investment strategy and chairman of the asset allocation committee at Wells Fargo, preaches heading back to the markets, but with care. Advisors should work to manage volatility and diversify clients' income streams, he says. "We think volatility is here to stay, and a lot of shifting has to go around the world."
For evidence, he points to a hand-off of economic leadership from the U.S. and Europe to the developing world, removal of global stimulus, changing tax policy, the deleveraging of the U.S. and new austerity measures in Europe to bring budgets under control.
For the skittish, the havens aren't working anymore. He notes that if a spooked investor sat in cash over the last two years, she actually lost ground to inflation, a rare occurrence. (Generally, cash earns 25 to 50 basis points above inflation.) "So let's not hide from volatility, let's manage volatility," he says. His prescription includes asset allocation and diversification and rebalancing. Earlier this summer he advised investors to start thinking of using volatility to their advantage by heading back to the markets. He said then that valuations had moved from fair to attractive.
Part of the strategy is looking overseas. "Globalizing your portfolio is critical." He pointed to FedEx's strong quarterly results, noting they were due in large part to the delivery company's presence all over the world. He cites McDonald's and P&G, as well. "Your investment strategy should be mimicking the successful global strategy of these global companies."
He is recommending investors overweight the emerging markets—equities as well as debt—and said that with the recent price drops, valuations were "extremely compelling." He believes these markets are largely pulling off their hoped-for soft landings by easing inflationary pressure and interest-rate policies. Brazil and India appear to be in that category, he said, while China is to be determined.
For further exposure to the emerging market, Florance recommends commodities, which are correlated to emerging market economies because many of those countries are commodity rich. He suggests putting 10% to 12% of the portfolio in total real assets, split between commodities and real estate, accessed through REITs.
His advice on fixed-income is to keep duration short, credit quality high and make sure to have global exposure. Within the developed world, he's "leery of euro exposure until we have some clarity." He adds that clarity is likely more than a year away. In the equity portion of the portfolio, he recommended holding 35% outside of the U.S., but with a slightly more aggressive tilt, 65% in the developed world, 35% in the emerging markets.
But he said all of this has not been an easy sell. "The post-traumatic stress of investing 2008 and 2009 was so painful, getting people back into the markets is tough. It's an emotional leap for a lot of investors." He said many clients cling to safety, often in the form of cash, saying to him, "After what happened I just don't want to lose money."
Silent Enemy
Florance's response to worried investors is to discuss time horizons and inflation. "Sitting on cash [means] you are losing money to inflation, and we think inflation is going to sneak up here."
Even so, he doesn't like Treasury Inflation-Protected Securities (TIPS). He doesn't think they're a good value now and says they are taxed "so punitively" that the only time they make sense is in a tax-deferred account. "We think there are better ways to position your portfolio to hedge against and benefit from inflation than TIPS."
Not everyone agrees. Morgan Stanley's Darst is a fan of TIPS, although he does agree they should be used in non-taxable accounts. (See sidebar.)
On the other hand, to investors overly worried about inflation, Florance says, "Inflation doesn't happen in a vacuum." He counsels advisors to ask nervous clients what really inflates. Answer: prices of real assets, commodities and equities. "Let's make sure we're really exposed to the stuff that's inflating."
Florance's other theme is income stream diversification. Many clients who want cash flow automatically look to fixed-income, but he advocates thinking more broadly. "Our concern is [that] in today's low-rate environment people are buying yield. Credit markets are efficient, they're paying yield because you're buying risk. We feel that's a dangerous place to be."
He says in a rising-rate environment, advisors should look at cash-flow opportunities from all asset classes: lease payments from real assets, dividends from equities, cash -flows from liquidity events in alternative investments.
Show Us The Earnings
Some of the thinkers who shared with us are even more sunny. Ned Notzon, manager of the several of T. Rowe Price's asset allocation portfolios, including the Spectrum Funds, is upbeat about future growth. A member of the company's asset allocation committee (he was the head of it until he handed over the reins in April ahead of his December retirement) he says the group has "a relatively benign view of the world."
And James Swanson, chief investment strategist at MFS Investment Management, agrees: "I think fears are overdone that we're going into another recession. I don't see it," he said. Both he and Darst of Morgan Stanley Smith Barney point to rising corporate liquidity and profits, which tend to be a leading indicator of better jobs and GDP growth.
All three maintained that the second half of the year will turn out better than the first, as the world gets further away from events that caused the slowdown, including Japanese supply-chain cutbacks and worries about Europe, which stopped business from investing its cash pile.
T. Rowe Price's asset allocation committee is overweight stocks versus bonds, thinking equities will beat bonds over the next few years as the world economy recovers. "We don't treat seriously the possibility of a double dip, but do think growth will be quite slow and do see the possibility of inflation," Notzon says.
The committee has changed its preference in domestic stocks from value to growth, which they think is inexpensively priced. The group is also favoring large-caps over small-caps, largely because of valuations. "We don't think small-cap can justify the premium at which it's currently being sold."
Within international stocks, the group is overweighting emerging markets relative to the developed world. Ordinarily, the group looks six to 18 months ahead. But this time, they made the call for five years out. "We think fundamentally, emerging markets have more opportunity for productivity increases—they can copycat us, or develop their own. We have high debt, high unemployment and wages are not going up fast. In the emerging markets, they have almost no debt, sometimes double-digit wage increases and everybody's got a job. We think that's a better scenario."
In fixed-income, the committee likes high-yield slightly more than investment grade. Although that premium is less now than a year ago, they think high-yield is still a better value than its long-term record. For the same reason, the committee plumps for emerging market bonds.
Swanson of MFS likes U.S. stocks, particularly high-quality ones, which are priced attractively relative to their historic price-to-earnings ratios. He particularly favors companies paying healthy dividends, because they serve as a proxy for future growth. He noted that dividends are historically about 40% of the total return from stocks.
He argues that the signs of a recession—excessive borrowing, excesses in certain markets—are not there. "We've just hit a slow patch, and relief is coming in the form of lower energy prices."
"It's always important to have an asset allocation strategy, but it's also important to understand business. The average business cycle since World War II lasts four to five years. This [current] business cycle [was] only two years old at the end of June. It feels like we're mid-cycle through the business expansion. The correction was due to Japan and oil. People have the jitters, but this is not the end. I don't think this is the time to go to Treasuries."
Darst of MSSB agrees, pegging the slowdown as a mere correction. Although bullish overall, he acknowledges there are many worrying signs, including weak U.S. jobs growth, lower consumer confidence, housing prices 33% off their July 2006 peak (a bigger fall than in the Great Depression) and continued uncertainty over the debt ceiling.
All of these contribute to a general malaise on weighing on the U.S. consumer. However, he cites many positive signs: Those surging S&P 500 profits (up 19.2% in the first quarter, year-over-year), more corporate liquidity, M&A, buybacks and dividend payouts, a climb in the non-manufacturing index and rising consumer borrowing.
He believes the next wave of key news from Washington will be positive for jobs, investors and the economy. "The administration has played the monetary stimulus card, as well as the currency stimulus card, and the only one left is the structural card." He suggests structural boosts could take the form of reducing the minimum wage or allowing businesses another year of the depreciation bonus they got this year or perhaps tax cash repatriation. He notes that U.S. companies have hundreds of billions of dollars of cash in overseas units. Microsoft alone has $27 billion abroad. If companies bring it back to the U.S., it will be taxed at 34%. But if the Obama administration takes the same step Bush did and reduces that rate, it could be a windfall for the economy.
Like other business leaders Darst also expressed optimism about improvement in the U.S. economy in the second half of 2011 with help from Washington, soaring production from automakers and renewed cap-ex spending by corporate America. However, he recognizes that investors are still skittish. So until more good news rolls out, he's advising clients not to buy aggressively into market selloffs. In fact, in the short-term, the sectors he is emphasizing are defensive: health care, utilities and consumer staples.
But over the short-term—six months to a year from now—Darst is bullish. He likes high-grade corporate bonds, junk bonds, commodities and REITs. He recommends investors steer clear of cash and government bonds and short-durations bonds because of their low yields. Over the intermediate term—one to five years—he sees a sideways-trading market until structural improvements kick in. Over the long-term, he's bullish again, and a big fan of the U.S. and emerging industries including quantum computing, nanotech, biotech, mobile internet and alternative energy.
"One of our major conclusions is this is a rugged time and when we get past this there will be an amazing flowering of innovation, productivity and job creation," he says. He notes that there are 3.7 million unfilled jobs in these industries—not Nobel Prize work, but basic jobs of running computers and writing programs. "I think we're in a period of transition. This is a generational transition—just as the 1970s were from the Greatest Generation to Baby Boomers, now Baby Boomers are thinking about handing off pieces of the economy to the BlackBerry and iPhone generation."
Something to ponder while waiting for the summer doldrums—and the market jitteriness our panelists all mention—to pass.
