Economists and chief investment strategists are busy penning their second-half outlooks for the investment markets, and many of them expect a rerun of the so-called risk-on/risk-off mentality of investors that developed in the middle of last year.
Economists and chief investment strategists are busy penning their second-half outlooks for the investment markets, and many of them expect a rerun of the so-called risk-on/risk-off mentality of investors that developed in the middle of last year.
The issues underlying the volatility remain the same: the fate of the European Union, a looming post-election “fiscal cliff” in the United States and a slowdown in emerging-markets economies.
“Everyone has their eyes on the same things,” said Mark Sear, managing partner of Luminous Capital LLC, which manages just over $5 billion.
“What is going to happen in Europe? And more importantly, what are the policy responses going to be?” Mr. Sear said.
Most investment strategists think that, barring a meltdown in Europe, the U.S. economy likely will continue its anemic growth for the rest of the year, with economic indicators alternating between poor and moderately positive. Some signs suggest that the housing market is bottoming out, but the slowdown in job growth confirms that companies still are reluctant to invest their substantial hoards of cash.
Last week, the Federal Reserve opted to extend its Operation Twist program to the end of the year, buying long-term Treasury bonds and selling short-term bills.
TEPID RECOVERY
The Fed's ability to stimulate the economy further is limited, given that short-term rates are near zero and the 10-year Treasury is yielding about 1.6%, but Russ Koesterich, global chief investment strategist for BlackRock Inc.'s iShares business, thinks that the tepid recovery will continue.
“The global and U.S economies are in a slow but sustainable recovery,” he said. “Outside of a major shock, we see that continuing.”
The most likely source of that potential shock is Europe as it struggles to maintain its currency union and deal with still widening credit spreads between fiscally stronger and weaker member countries in the union.
Last week, stress tests on the Spanish banks sent stock markets downward worldwide. That nation's banking sector may need another 50 to 60 billion euros in capital.
The heads of government for the 17 EU member states will meet in Brussels at the end of the month.
“We may not get the grand solution we all want, but we'll likely get some more piecemeal relief,” said Mark Luschini, chief investment strategist for Janney Montgomery Scott LLC.
The third leg of the investment stool is the emerging markets, most notably China. China's rapid growth has made it now far more important to the health of the global economy, as well as to the other emerging markets from which it imports goods.
The jury is still out on whether the Chinese government can execute a soft landing of its economy to a 5% or 6% growth rate. After raising interest rates last year, it recently has loosened reserve requirements on Chinese banks and also cut interest rates to reboot growth, albeit at a slower rate than in the past decade.
Emerging-markets stocks have been hammered of late, with the MSCI Emerging Markets Index down 11% since the beginning of March.
Mr. Luschini said that he is tactically underweight emerging markets but is prepared to change his posture.
Although the United States has its fiscal cliff looming at the end of the year, the situations in China and Europe are likely to be the main drivers of sentiment in the markets for the rest of the year.
"WARM-UP'
“If you believe the eurozone is going to split apart and that China is going to have a hard landing, then you should panic, because that would make the Lehman [Brothers Holdings Inc.] crisis look like a warm-up,” Michael Hasenstab, co-director of international bonds at Franklin Templeton Investments, said at Morningstar Inc.'s annual investment conference in Chicago last week.
Mr. Hasenstab, who manages $160 billion in fixed-income assets in several funds, suggested that investors shouldn't let fear keep them from seizing opportunities such as those in emerging-markets debt.
Joel Isaacson, an adviser and principal at an eponymous firm with $4 billion under advisement, has a similarly sanguine attitude about the fears wracking the markets.
“Europe is not going out of business,” said Mr. Isaacson, who manages $2 billion. “I suspect we'll look back in five years and think we should have gotten [into Europe] in 2012 or 2013.”
Although Mr. Isaacson remains cautious and underweight non-U.S. stocks, he does expect a reversion to the mean for those markets that have been battered most recently, including emerging markets.
“They will be great over time but volatile along the way,” he said.
Mr. Isaacson's bigger worry is that investors may be stretching too far for yield into assets such as master limited partnerships, real estate investment trusts and high-yield debt.
Although he doesn't have anything against those asset classes, he worries that investors aren't prepared for a potentially wild ride.
“Europe and the U.S. election will add to the volatility,” Mr. Isaacson said.
For conservative clients, he is keeping substantial amounts of cash and large allocations to conservative funds such as the Pimco Total Return Fund. Mr. Isaacson favors dividend-paying large-cap stocks on the equity side.
STAYING CAUTIOUS
Mr. Sear is also cautious, though he doesn't think a stock crash is likely.
“A lot of people see the end of the world coming, but in my opinion, you don't have crashes when interest rates and earnings multiples are this low,” he said.
That said, most of Mr. Sear's affluent clients worry more about taking big losses than missing big returns. For the time being, he is investing in high-quality municipal bonds and low-risk bond funds such as the DoubleLine Total Return Fund.
Mr. Sear's top equity fund is the Yacktman Focused Fund (YAFFX), which invests in high-quality large-cap stocks. For investors willing to take risk, he likes the Fortress Credit Opportunities funds, limited partnerships that invest in distressed credits.
For the most part, however, Mr. Sear is in wait-and-see mode.
“We're aggressively looking for new opportunities, but we're paid to be prudent in this environment,” he said.
aosterland@investmentnews.com
