Challenges abound

The following is an edited transcript of a Dec. 13 webcast, “Outlook 2012.” Deputy editor Evan Cooper and senior editor Jeff Benjamin moderated. InvestmentNews: James, please give us your overview of 2012. Mr. Swanson: My conclusion is that while the European zone is in recession, we muddle through and escape recession, and that equities do pretty well. The markets have been hijacked by trading influences, so the way to invest around this is to look for sustainable yields and equities — companies with cash flow. This is a remarkable period for U.S. corporations. They have cash, they have cash flow, and their balance sheets keep getting better. And I would point that out as submission No. 1 for my case that things are actually not that bad. Point 2 would be the U.S. consumer and the resilience behind that. Despite all of the comments about how the U.S. consumer is too strapped or too down in the ditch, it seems they are not. The [sentiment readings] are horrible, but consumers still go to the big stores, and that seems to be a pretty important case. So even if Europe is in recession, and China and Asia slow down, which would have some effect on earnings in the U.S., I think those negatives already have been discounted. Mr. Bernstein: Our big call for 2012 is really quite similar to 2011 in that we continue to expect the U.S. equity market to outperform many of the world's markets; most importantly, we expect the United States to outperform the emerging markets. And the line that I always use in doing an opening discussion of this is that I don't think people realize that the S&P 500 has now outperformed [Brazil, Russia, India and China] for four years. This is nothing new; it's been going on for a while. We are sort of in an environment very similar to "01, "02, "03, where people were waiting for the old theme — at that point, it was technology — to come back to life and missing that change was actually going on. We think that is happening again and we remain very bullish on the U.S. equity market. Valuations today favor the United States as much as they favored emerging markets 13 years ago, which we think is very, very interesting.

U.S. CORPORATE STRENGTH

One of our arguments has been that the U.S. has the strongest corporate sector in the world. The United States has been leading the world in earnings surprises all year, and U.S. companies actually have been deleveraging — putting up very strong earnings numbers, with less and less use of leverage. Chinese companies actually been levering themselves, which is curious because the story has been that the Chinese economy is so strong. Well, if it's so strong, why are Chinese corporations having to lever themselves more and more and more to make earnings growth? That doesn't make a lot of sense to us, and I think it shows a lot of problems within the Chinese economy. Most explicitly, we believe that the emerging markets are going to be hit by the deflation of the credit bubble in 2012-13. This is not just a U.S. event, which everybody thought it was. We are now learning it is a European event, too. I think people are going to find that it is an emerging-market event, too, and our argument is that the emerging markets have been the biggest beneficiaries of the global credit bubble. Bottom line: We are very big fans of the United States. We are dramatically overweight the U.S. in all of our funds and all of our accounts. And we think that this is a theme still in its infancy. InvestmentNews: Christine, give us a look at the fixed-income world. Ms. Hurtsellers: Let me tie together some of the themes put forward into what we do within fixed income. I agree with the U.S.-centric growth story. And since we are living in a more accommodative and volatile global environment, the place to play to get some very nice risk-adjusted returns over the long run is high-yield credit within the U.S., followed by some other strategies such as commercial-real-estate-backed securities. There's not going to be gangbuster growth in the U.S., since consumers are still deleveraging; it's a long, slow, multiyear process that we are going through. But that doesn't mean that you can't be long credit, because we've seen great profit growth in U.S. corporations, and strong fundamentals. With the whole world very risk-averse, 2012 is going to be a volatile year, but what you should be doing is not completely hiding from risk assets. Stick with the U.S. and high yield at spreads over 700 [basis points] to U.S. Treasuries. That way, you get to clip a nice coupon income, weather some of the market volatility and live to fight another day. InvestmentNews: The problems in Europe are likely to be with us throughout 2012. What do you see as some of the possible outcomes there? Ms. Hurtsellers: As we all know, Europe is not easily fixable and it's not going away. The big question is whether the market's going to push Italy and Spain, and continue to create headline crises for Europe and the [European Central Bank]? Unfortunately, I think it is.

EUROPE'S BRIGHT SIDE

So what does this mean for investors here in the U.S.? Things are going to be volatile. But we look at valuations, and a lot of negative news is already priced in. So I would take advantage of the volatility and the cheap valuations to position yourself for a somewhat pro-growth U.S. and still-positive global growth story in 2012. InvestmentNews: Is there any eurozone sovereign debt you buy right now? Ms. Hurtsellers: If you are really risk-seeking and really in it for the long term, I would buy Italy, not Spain, because Italy is still running a fiscal surplus, and Spain has a lot of residential-real-estate issues. Ultimately, when you can get them north of 7%, Italian sovereigns are decent investments for the long run. InvestmentNews: But not Greece at 33%? Ms. Hurtsellers: No. InvestmentNews: James, could you talk about Europe and its impact on U.S. markets? Mr. Swanson: We have had a tremendous profits recovery from the Lehman [Brothers Holdings Inc.] crisis, and some of those profits have to be dented by a recession in Europe, which I believe is under way right now. So you can't expect the same kind of profits growth in 2012. Trade with Europe is not that big a part of our [gross domestic product] accounts, but it is of the S&P 500; it is about 8% to 10% of the profit-generating stream of the S&P 500. It's a lot of those big large-cap companies. And so as Europe slows down, it will ding profits a bit. We are going to have some profits disappointment. It is my contention, though, that the market has already applied a [price-earnings] discount to that and has already sort of adjusted it for that sort of macro event. And you see that in European stocks. But that doesn't kill the U.S. stock market, which of the three major arenas to play in looks the most interesting to me. Europe will dampen things here and in Asia, but it won't put us into a recession. InvestmentNews: Richard, what is your take on Europe? Mr. Bernstein: Valuations on European stocks have been very conservative for more than a year — kind of a value trap — in part because the profit picture generally has been eroding. The first whiff of that came when some of the [Portugal, Italy, Ireland, Greece and Spain] countries' yield curves begin to invert. That was your early warning radar that profit growth was likely to slow. Unfortunately, while we have very, very cheap markets in Europe, we don't have a “catalyst.” Usually that's something on the earnings front. And so far, earnings surprises and estimate revisions in Europe still look pretty weak. Our exposure in Europe has been predominantly very, very large-cap — and we're very, very, very defensive with what little exposure we have there. I should emphasize that in our strategies we are significantly overweight in the United States. We have what most people would consider to be probably a ridiculously small exposure outside the U.S. right now. InvestmentNews: Can you tell us what that overweight is? Mr. Bernstein: I'm going to say it is roughly about 80% U.S. InvestmentNews: What would be equal weight? Mr. Bernstein: Roughly between 40% and 45%. So we are very significantly weighted domestically, and what European exposure we do have is predominantly in Switzerland. In fact, Switzerland and Japan are the bulk of our non-U.S. exposure because we believe that profit cycles outside the United States are still weakening. That could change, of course, if we start seeing profit indicators get stronger in various European countries. Then, I think, you have your catalyst, and you can have sizable appreciation in European equities. But right now, it looks a little bit early to us to make that kind of leap, and it still kind of looks like a value trap. InvestmentNews: Consumer spending, higher savings and the significant deleveraging by consumers and corporations all sound like great reasons to invest in the United States. But the economy isn't growing much and unemployment is still high, so why are you so bullish? Mr. Bernstein: First of all, I am not saying that the U.S. economy will grow faster than a lot of other economies. Very often, I'm asked whether we'll grow faster than China. Of course not. But that's not the point. Remember, markets don't move on absolute rates of growth; they move on not good or bad but on better or worse. And it is our estimation that in major emerging markets, the economies are going to get worse. Meanwhile, U.S. statistics are slowly getting better. Now, is the U.S. economy growing faster than the Indian economy? Obviously, it isn't. But U.S. stocks are, we think, likely to outperform Indian stocks as the U.S. economy gets stronger — not strong, but stronger — and the Indian economy gets weaker. InvestmentNews: James, can you give us a global equities snapshot? Mr. Swanson: Ours, which is based on cash flows and balance sheets, goes back to fundamentals and gears you back to the U.S. Since 1999, we've seen debt-to-retained-earnings and debt-to-net-worth ratios falling here in the United States, which means less balance sheet risk compounded with very high cash flows. Now, I agree there are multiple reasons for that, but the cash keeps coming in the door. And these companies are operating very productively. Part of that is because unit labor costs in the U.S. are positioned very well competitively against the world. If you're taking a 10-year point of view, you probably would rather look at India or China. But the resilience of the U.S. consumer and the strength of U.S. corporations are behind a remarkable comeback in profitability. It is still going on and, yes, it will slow down because of the European recession that is under way. But a quick tour of the world tells me, looking at fundamentals, that the U.S. is the best. On a price-to-book basis, our valuations are higher than the rest of the world, but not excessively high compared to history. So there is still deep value here and there is the ability of these companies to grow their dividends. And that is my strategy for getting through this is: Get companies that can have sustainable cash flow to give you dividends or increase that dividend or maintain it. Because dividends, if you go back to Graham and Dodd, and [earnings before income and tax], all of those numbers show that dividends are 40% of your return over long periods of time, anyway. It is one way to deal with what we are seeing in the very volatile trading markets. InvestmentNews: In a global allocation, where would U.S. equity markets fit? Mr. Swanson: That's tricky without knowing the investor and their age or risk preferences, but since I run a strategy in a mutual fund format [the MFS Diversified Income Fund (DIFAX)], I'll tell you that right now, I am overweight in emerging-market debt and I've just gone to neutral in high yield, from being overweight. In equities, I'm probably going to be overweight, but I'm still concerned about how the European finance ministers deal with Italy. InvestmentNews: On the S&P 500, how much of the earnings is domestic and how much is international? Mr. Swanson: About 35% of earnings now come from abroad, and a big chunk of that is emerging-market earnings. But about 8% to 9% is from the eurozone, what we call the Group of 27. And that will slow down some in 2012, no question. InvestmentNews: Christine, what is your take on U.S. corporate debt right now? It seems like companies are in great shape. Ms. Hurtsellers: They definitely are. And if you look at just where the spreads are in U.S. investment-grade credit, they look very attractive relative to the risk-free rate, Treasuries and really historical spreads. Last year was interesting because we saw best-in-a-decade corporate fundamentals in terms of cash on balance sheet and debt to [earnings before interest, taxes, depreciation and amortization]. Yet credit underperformance surprised a lot of people due to the macro environment. In 2012, I think more and more people will be looking at U.S. credit fundamentals. Those are going to drive valuations, as opposed to some of the macro headline risks we saw last summer. So I definitely like investment-grade credit. Still, given Europe right now and the fear that if Europe really blows up the transmission mechanism into the U.S. will be U.S. financials, we are not overweight U.S. financial institutions — not that I don't think JPMorgan [Chase & Co.] is an outstanding credit and that U.S. banks in terms of Tier 1 are so much better capitalized than Europe and have really improved their capital by easily 4 percentage points in Tier 1 since the Lehman crisis. But outside of that, industrials have squeaky-clean balance sheets and make great long-run investments.

FIXED INCOME

InvestmentNews: Across the fixed-income spectrum in the United States, sticking with corporates, where do you see the most opportunity? Ms. Hurtsellers: High yield makes a lot of sense right now and is benefiting from cash on the balance sheet and a lot of positive fundamentals. Corporate treasurers did a lot of debt refinancing over the last three years due to lessons learned in the crisis, as well as low interest rates. The pressure of having to come to market has really diminished. Within high yield, we still like some of the energy sectors, and believe it or not, we are starting to investigate homebuilders. It looks like U.S. housing is surprising to the upside, and I think people are way too negative, pricing in depressionary levels forever. In terms of emerging markets, I'm probably a bit more positive than Richard. We have some sovereign overweights in our portfolios, mostly in Latin America. Mexico and Brazil have pretty tight trading relationships with the U.S. Within emerging markets, you're starting to see central banks move more to a reflationary policy, which tends to be a good environment in which to be long local durations. Even dollar-denominated sovereigns are going to benefit from stimulus out of central banks. So globally — certainly within Latin America as well as in some of the Asian countries — there are good opportunities. InvestmentNews: It seems that the average person doesn't feel particularly enthusiastic or optimistic about the economy — or that we are even out of the recession. Meanwhile, big corporations are doing fabulously well. How does this disconnect between a booming corporate sector and a weaker consumer sector affect your thinking? Mr. Bernstein: Corporate profits are the largest percentage of GDP ever in the United States. The corporate sector has disproportionately benefited in this recovery. That's why you are seeing the Occupy Wall Street people and the Tea Party people. The disparities of wealth and income in the United States are historically wide — which is nothing new, by the way. But I think it's inevitable that the gap is going to close. InvestmentNews: In what way? Mr. Bernstein: I honestly don't know, but it's inevitable that the gap will close, because it creates an unstable situation. If you don't believe me, just ask Marie Antoinette. The question is how the gap will close. But there are some investment themes that one can play just based on the assumption that the gap closes through time. People often ask me why I have been so bullish over the past three years when my former colleague, Dave Rosenberg, was so bearish. That's an easy one to answer: Dave looks at the overall economy; I only look at corporate profits. And the fact that corporate profits are the largest percentage of GDP ever explains why I was so bullish and he was so bearish. While we look at the consumer sector and other factors, the driving force for the stock market is corporate profits. The corporate sector in the United States is not only strong within this country, it is the strongest corporate sector in the world, which is a point that I think people don't understand. InvestmentNews: James, what is your point of view on this disconnect between the real economy and the financial markets?

INEQUALITIES IN MARKET

Mr. Swanson: It is definitely there. The question is, how do we get from here to there if there are these inequalities, and corporate profits and the owners of stocks are doing so well? I would suggest that it happens via the labor markets. As unemployment comes down — and we see it slowly doing that — labor will get a bigger piece of the pie. And this leads to my investment theme. First, we're seeing the substitution of capital for labor, in which we use fewer people and more technology and capital to replace labor. Second is the exploitation of cheap labor overseas. Eventually, that gets arbitraged away, because as unit labor costs rise in the emerging countries, it gets more and more expensive. It also costs 1% per day to ship stuff back and forth to Asia. So over time, the unemployment rate comes down and labor gets a bigger piece of the pie because they can bargain for more. That leads me to one investment theme that people should think about: tech. The tech sector is awash in cash, has no debt, is geared to the growth of the consumer class in China and India, and is extremely productive. It uses labor, but the productivity of their output is incredible. And it is valued at the same forward P/E as utilities in Ohio that sell the same electricity they did 50 years ago. InvestmentNews: Where are the opportunities in the tech sector? Mr. Swanson: We think they're in the industries that deal with the public cloud. There is a huge migration going on and it will continue with tech users. And there is a lot of deferred spending on the part of U.S. corporations. Installed software is the oldest ever, 5.2 years, so when the refreshing comes, a lot of it will be done via the public cloud. Some of the companies adept at selling public cloud usage would be interesting to us. InvestmentNews: For people in their mid- to late 50s who are concerned about their retirement nest egg five or 10 years down the road, what investment suggestions would you make for 2012? Christine, let's start in the fixed-income area. What should a fixed-income portfolio for someone in this age group look like? Ms. Hurtsellers: At ING Investment Management, we don't manage municipal bonds, but I think there are some very compelling opportunities at the state level. If you are talking about income inequities and how it gets solved, a natural outcome could be higher marginal tax rates for many. That's why I think munis are a very good long-run investment story. And in that mid- to late 50s age bracket, I'd stick with high quality. People cannot survive in retirement off of U.S. Treasury securities. So in addition to municipals, I'd look at some investment-grade-credit funds and high-yield funds. Again, I think that sector is going to perform really well. But just try to balance things so that you survive a slow-growth world and yet provide some predictable incremental income for our clients. InvestmentNews: Richard, what would you suggest? Mr. Bernstein: I'm a little bit different. Our view is that people are generally so scared because their portfolios are tremendously underdiversified. They have confused the number of asset classes with diversification. I could name five to 10 asset classes that one might hold, and I would argue the portfolio has absolutely no diversification in it. There is really only one major asset class today that provides diversification — Treasuries — and of course, as always is the case with diversifying asset classes, nobody wants to hold them. It is the only asset class that provides negative correlation to all the other asset classes. Now, I'm not arguing that one should hold Treasuries for income. Treasuries are always the inferior route to income. All fixed income is priced above Treasuries, which are just about always the lowest on the income spectrum. But income is not my argument for Treasuries. Rather, it's to try and mute the volatility of one's portfolio. Of course, people say, “What if rates go up?” Well, if rates go up, then your stocks are probably going to do OK. Your spread fixed income is going to do OK, too. Your cyclical stocks are going to do very, very well; a lot of things will do well. People never want to hold an asset class they think is going to go down, but that's the whole point of diversification: You have some assets that go up and some that go down. Case in point: During the summer, Treasuries once again worked where everything went down, including the much heralded gold — which is in no way a diversifying asset class. [Bank of America] Merrill Lynch's 10-Year Plus Index was up about 20%-plus from June to September. And 30-year zeros were up, like, 50%. So the point is that when everything goes down, Treasuries rally. But people never want to hold this diversifying asset class. So I would argue that you want to look for the opportunities that we have discussed, whether you agree with my opportunities or not, or whether you like other people's opportunities. The point is, I think the reason this environment seems so scary is that people are grossly underdiversified. InvestmentNews: And James, what should someone in that pre-retirement phase be doing? Mr. Swanson: Since people in that group could live another 40 or 50 years, an entire bond strategy doesn't work, because eventually, capital erodes. You need some growth. So I would balance out. Some things I would select in my diversification package would be emerging-market sovereign debt and higher-yielding or lower-quality U.S. corporate bonds, because the fundamentals and balance sheets are actually better there and we don't see a recession on the horizon. In the rest of the portfolio, I would do a mixture of high-quality dividend-paying stocks, going not just for yield but for companies that have sustainable products and the sustainable cash flow to make those dividend payments. One very interesting point: Over time, dividends are about 70% less volatile than earnings themselves. I'd also have some international equities and bonds, but not in too great a degree.

WILL EUROPE INFECT U.S.?

InvestmentNews: If Europe enters into a full-blown recession, how likely is the U.S. to move into a recession as a result? And if that doesn't happen, what impact would a European recession have on the record corporate profits we see in the United States? Mr. Swanson: First of all, the size of the current crisis, the inability of peripheral countries to pay off their debt, and the losses that we see in Europe are much different than the Lehman crisis we went through, which was very severe and led to the most severe recession since the Depression. In Europe, the losses are not as big as the mortgage losses in relation to our economy. There, they are more known and not hidden like they were here in special investment vehicles and all that sort of thing. Today, the U.S. is much less leveraged than it was when we went into that crisis, and our trade with Europe is not that severe. And the banks in Europe, which will take the brunt of this, have enough reserves to weather the storm. If they don't, the German taxpayers know that it is cheaper to pay up now. Of course, it would have been a lot cheaper if they did this in April, but they know that it is still a lot cheaper now to backstop these banks than to let the euro collapse or to let their banking system collapse and go into a recession. Germany exports 50% of its economy, so if they went back to the Deutsche mark, it would be curtains for them as far as being an economic powerhouse. I think they will muddle along and stitch things together, which allows the U.S. some breathing room as we grow at a 2% rate. That will affect corporate earnings here, bringing them down some, but nothing disastrous; nothing like you saw in 2008. InvestmentNews: James, you said that Germans realize that it is cheaper for them to bail out Europe now. Yet it doesn't seem that German policymakers are jumping to do that. Mr. Swanson: You're right. Germans remember the days of great inflation in the early part of the last century. And they remember being told that bailing out the East Germans would be good. But that didn't work out the way they were told, and now they don't want to pay for Greece and Italy. But they also understand that they are an export powerhouse — almost the China of Europe. They could not sell all that stuff if they went back to the Deutsche mark or if their banks started collapsing because of default. As a result, they know that whatever they have to put into a special fund or whatever is need to get France in line, they will do it when push comes to shove, and they will hold it together. InvestmentNews: So if Germany will step up and be the savior, why are things so volatile there right now? Mr. Swanson: In the end, economic interest wins out. And even [German Chancellor Angela] Merkel knows that. And the citizenry know that. I think they realize that they will step up to the plate. InvestmentNews: Richard, what is your take on the European contagion? Mr. Bernstein: I think it's the second leg in the deflation of the global credit bubble. The first leg was here in the United States, and I don't think people realized then that the credit bubble was a global phenomenon, because you heard everybody saying how horrible things were in the United States but how wonderful things were elsewhere. Well, in the last six or nine months, we have learned that Europe has had a credit bubble as well and that they are starting to deflate from that credit bubble. I believe that's No. 2 of 3. No. 3 will be the emerging markets. And that follows the historical precedent, by the way, that cycles start in the United States, then go to Europe and end up in the emerging markets. That is the normal cyclical effect, which I think we are going to see in this cycle, as well. In terms of the earnings impact, most people have had a strategy of either investing in emerging markets or trying to find companies that sell to the emerging markets. Our attitude has been to do the exact opposite because we don't think the emerging markets are really quite as healthy as other people do. Our idea has been to try and protect ourselves from the globe. When we saw large-cap domestic stocks outperforming large-cap multinational stocks over the summer, I think that was the market's way of kind of saying that maybe we are onto something there. While you still want to protect yourselves from the earnings risk in Europe, I would argue that the 2012 story will be to protect yourself from the earnings risk in the emerging markets. By the way, we continue to be very big fans of the dollar. And I think one has to consider what happens if the dollar starts appreciating and we see the translation effect of earnings of all these multinationals. What we have tried to do, as you can imagine from my comments here, is look for U.S. companies often with defensive characteristics but that are not multinational. They have proven to be more defensive than multinationals. InvestmentNews: What impact will the presidential election have on the markets? Christine? Ms. Hurtsellers: I think the market is looking to the election to break the stalemate of “don't want to raise taxes, don't want to increase spending,” etc., that is pretty unsustainable for the long run. We all know the ugly little secret that the U.S. needs to deal with this sooner rather than later; otherwise, the problem just gets worse. For the market, it would be very positive if we get a Republican president or Republicans in the Senate. However, it is not going to be a huge majority to get the agenda through, but maybe the market says, “Hey, we can actually get things done.” A couple of worries for 2012: I can see us having sort of a front-loaded growth event. Given that the supercommittee did not pass its targeted spending cuts, I think we are going to run up against that Treasury debt ceiling debate again in the summer. InvestmentNews: If Europe and the United States go into a recession, it seems the credit-generating capacity of the central banks is really kind of limited.

TIME FOR QE3?

Ms. Hurtsellers: Yes, the central bank is sort of running out of levers to pull. Will the Federal Reserve — and they have given hints that they will — do QE3 if things get bad enough? Absolutely; we need it. InvestmentNews: It is time for some final comments. Let's start with Richard. Mr. Bernstein: I think people are way too bearish on the United States and way too bullish on the emerging markets. And I think we will see a continuation of the outperformance that has been going on for four years now of the U.S. stock market versus the emerging markets. InvestmentNews: Christine? Ms. Hurtsellers: I agree. In the first part of the year, I'm afraid people will be way too risk-averse and negative, hiding in cash. That's going to turn out to be a mistake. They need to be deploying into some of the riskier asset sectors. However, I'm concerned about growth in the second part of the year, so just be careful. I think traditional risk assets will perform in the first quarter, and then really disappoint into the summer. So be nimble, be tactical, but for now, be long risk. InvestmentNews: James? Mr. Swanson: Investors ought to investigate the largest sector of the S&P 500, which used to be leveraged banks and is now tech. We are the best at the world at this. Investigate what goes on there and then investigate companies that have the sustainable cash flow to pay dividends. And while you sleep at night, get some of that compounding and ignore the headline risk and ignore these risk-on/risk-off markets. That is noise. Go back to fundamentals. They will win out in the long run.