Fading: James Paulsen believes 'safe-haven premiums in conservative assets' could disappear in 2013.

Forecast optimistic for new year

Most see stronger economy, little chance of recession

Institutional investment strategists generally paint an upbeat outlook for 2013, including the S&P 500 and emerging markets, while seeing little chance of recession in a weak but slowly strengthening economy.

One investment strategist, however, predicts the S&P 500 falling some 40% and a likelihood of recession, although he is optimistic U.S. Treasury securities will produce double-digit gains.

As for the best and worst asset class, some predictions were polar opposites.

James Paulsen, chief investment strategist, Wells Capital Management, Minneapolis, puts equities, emerging and U.S. markets, at the top and Treasury securities and other high-quality bonds at the bottom.

A. Gary Shilling, president of A. Gary Shilling & Co., a Springfield, N.J.-based economic consultant and investment advisory firm, is bullish on Treasury securities and a major bear on U.S. equities.

“Next year could really be the year the fear premiums in the investment market go away, where the safe-haven premiums embedded in conservative assets go away,” Mr. Paulsen said.

“What"s ironic about it is people have run to these areas to avoid risk; they might be running right to the fire for 2013.”

Mr. Shilling, however, forecasts yields dropping on Treasury securities — the 10-year to 1% and the 30-year to 2% — producing a 10% or more return for investors. On the other hand, he predicts investors in high-yield securities will be hurt by their “zeal for yield.”

'Getting better'

Overall, Timothy Hopper, chief economist, TIAA-CREF, New York, said: “The economy is slowly getting better. It's not where we want it to be. It's not the kind of recovery we've wanted to have. But it is still moving in the right direction.

“We are positive on corporate earnings in 2013 and we think the effect of growth at the consumer level in the economy will provide that fundamental underpinning for earnings growth ... and for stock price appreciation.” Mr. Hopper said. “We are actually positive on market fundamentals, market prices and earnings next year.”

Mr. Paulsen ticked off bright signs in the “falling unemployment rate, increasing bank lending, rising housing prices, (and) a 4Ĺ-year high in consumer confidence.”

“My point is we just have so many more things working that weren't working,” Mr. Paulsen said. “It's a broader recovery right now than it's ever been ... Therefore it is much less vulnerable to external shocks. That's leading to high confidence, which will do even more for the growth rate in the coming year. I think that's underappreciated.”

What “we could get in the second half of (2013) could be the first major year of a start of a portfolio reallocation,” Mr. Paulsen said. “Maybe we will see the first movement toward equity funds and a drain from bond funds.”

Jim McDonald, senior vice president and chief investment strategist with Northern Trust Investments Inc., Chicago, expressed concern about getting too pessimistic, rigidly underweighting particular asset classes.

“When we think of risks, we all tend to fall into a trap (that) risks are only downside risks,” Mr. McDonald said.

But even asset classes to which he gives a negative outlook for 2013 have “a potential for an upside case,” Mr. McDonald said.

At Northern Trust, “we are careful about not getting too negative because you need to be in the market for times like 2012, when actually risk-taking has paid off and investors who have been too cautious have been left behind,” Mr. McDonald said.

Among forecasts for 2013:

  • Mr. Hopper said the S&P 500 return “will be better” than in 2012. “Generally speaking the economy is getting stronger and so economic performance is going to be stronger in 2013 than 2012. Market performance is also going to be stronger in 2013 than 2012,” said Mr. Hopper, who didn't have a range.
  • Mr. Paulsen said he expects the S&P 500 return “will be double digit” in 2013. “It's a matter of how much double digit,” he said. “I'm leaning toward a 1700 level. That would be a little over 20%” on price appreciation alone from early December. That rise would surpass the 1565.15 all-time high of the S&P 500, hit Oct. 9, 2007. “I think we're going to break that” in 2013, Mr. Paulsen said. The S&P 500 closed Jan. 2 at 1462.42.
  • Mr. McDonald said, “We will see a high-single-digit kind of return out of U.S. equities, which will look good to developed markets counterparts.” But emerging markets will outperform both, he added.
  • Mr. Shilling forecasts for 2013 the S&P 500 level falling to 800, a 40% decline that would be lessened a few percentage points by dividends.

Most strategists expressed cautious optimism.

“If you think about the fundamental categories in the economy, consumers, businesses, housing, the things that we need for growth are starting to percolate,” Mr. Hopper said. “It's not fantastic growth or even normal growth, but it's moving in the right direction.”

Mr. Hopper forecast a 2.2% growth in the gross domestic product in 2013. “You'll have slightly weaker growth in the first quarter and then progressively stronger growth” as the year continues, Mr. Hopper said.

The 2013 GDP growth sets up the economy for 2014 “where we no longer need the Fed” stimulus, Mr. Hopper said. “We think at the beginning of the year 2014, we can actually think about unwinding the Federal Reserve balance sheet, start shrinking it” and ultimately lead to rising interesting rates.

The 10-year Treasury yield for 2013 could rise to about 1.8% to 2%, from the early December 2012 rate of 1.6%, Mr. Hopper said.

He forecasts for 2013 a 2.3% inflation rate, measured by the consumer price index, in line with the end of 2012.

“The reason ... is there still is a lot of liquidity in the market and ... still is a lot of spare capacity in the industrial sector in the U.S. and, in fact, all around the world. And because of that there is very little pressure” on prices, Mr. Hopper said.

Biggest risks

Investors face the biggest risks in 2013 from the European sovereign debt crisis, emerging markets slower growth and the fiscal cliff. But Mr. Hopper added, “Our expectations for Europe is continued slow growth, but the drag that Europe has experienced on the U.S. economy is now beginning to dissipate.”

Mr. Hopper's said his forecast “sounds optimistic, but it's not overly optimistic in the sense that we are moving in the right direction. I'm paid to make a call and (mine is that) we're not going into recession and that things are getting better. I wish I could say ... we are going to have GDP growth of 4% next year. It's not going to happen.”

Mr. Paulsen is the most optimistic of the forecasters for U.S. equities. He thinks the trend of an increasing price-earnings ratio of the S&P 500 in 2012 will continue in 2013, meaning investors “are willing to put a higher valuation on earnings stream because they are more confident. ... That is a very important part of the stock market potential for the next few years. ... Yes, earnings may grow a little bit but the bigger potential is confidence starts to improve more.”

Mr. Paulsen believes institutional investors will begin to shift more toward equities. “It won't be dramatic,” he said. That move “will come with confidence and that will come with people realizing we are just way overallocating to fixed income and not enough to stocks.”

Rising economic and equity market confidence next year and the idea that the global recovery looks sustainable “could radically raise yields on Treasury bonds because they (will) start getting repriced (based) on fundamentals rather than fears,” Mr. Paulsen said.

“So if you start to put some pain of rising rates onto bondholders, that also could accelerate (investors') shift away from bond funds to stock funds. One of the reason we haven't had any shift is there hasn't been any pain” of rising bond yields forcing down bond prices and hurting bond returns, Mr. Paulsen said.

Mr. Paulsen predicts 10-year Treasury yield will be between 3% and 3.5% for 2013.

Emerging markets' failure to revive their economies poses the biggest risk to investors in 2013, Mr. Paulsen said.

“The second biggest risk is an overzealous grand bargain coming out of Washington ... tax hikes and spending cuts that are too aggressive,” Mr. Paulsen said.

“Longer term, beyond next year, the biggest risk ... for the recovery and the investment cycle is inflation.

“We are going to be worrying about how do we exit the overly aggressive monetary policies, not only of the Fed, but China, Europe, Japan, everywhere. How do we unwind this ... liquidity cycle and what does it mean for inflation?” Mr. Paulsen asked.

He recommends including real assets and other inflation-protection assets in portfolios, such as commodities because he believes commodity prices in general will rise next year.

As for the best asset classes, Mr. Paulsen thinks emerging markets will outpace the big return he forecast for U.S. equities.

“I also think the dollar continues to weaken,” which will enhance emerging markets returns as currencies are converted into U.S. dollars, Mr. Paulsen said.

But he warned investors not to link economic performance too closely with market performance.

This article originally appeared in the January 7, 2013 print issue as, "Forecast optimistic for new year".