Investors should look at their 1995 asset allocation with cautious optimism, expecting slightly higher inflation and a slowdown in the rate of growth of the U.S. economy, according to investment managers from two New York firms.
But the investment climate will remain good for careful investors.
Careful stock picking - seeking quality growth stocks with an international flavor - will help in the equity area, while most of the bad news in the fixed-income arena already has been factored in and both price and quality are attractive in most sectors, say the experts from Bessemer Trust Co. and Smith Barney Shearson Inc.
Managers at Bessemer Trust Co. are maintaining an aggressive equity stance, said Robert C. Elliott, senior executive vice president.
U.S. large-capitalization stocks comprise is 35% of Bessemer's asset allocation; U.S. small-cap stocks comprise 8%; international equities, 27%; U.S. bonds, 20%; and alternative investments and real estate make up 10%, Mr. Elliott said.
That allocation is based on expectations of modest economic growth and higher corporate profits, said Mr. Elliott. Bessemer expects domestic equity returns of approximately 10%, international equity returns in the mid-teens, and bond returns approximating coupon rates.
The U.S. industry is in the best shape it has been in since the 1960s and this economic expansion - now on its 42nd month - could be third largest ever seen, after those of the 1960s and 1980s, said Stanley A. Nabi, chief economist at Bessemer.
Mr. Nabi said he expects the fourth quarter's economic activity will be higher than expected, including a strong Christmas retail sales season, higher durable goods orders and higher automobile sales. He expects economic growth for 1994 to be around 3.7%, but he warned consumer debt is up and consumers will be "stretched out" by Christmas.
The next year will see slower economic growth and inflation will creep up to 3.5%, rather than shoot up, said Mr. Nabi. Productivity gains are slowing down, wages are increasing and companies that had been constrained on raising prices - such as automobile manufacturers and steel producers - will take the opportunity to do so, he explained.
Corporate profits are expected to peak in the fourth quarter of 1994 and will continue to grow in the first quarter of 1995, but the rate of growth will slow down in late 1995 and total profits may end up lower than in 1994, said Mr. Nabi. He estimated a rate of 2.7% real gross domestic product growth in 1995, with unit labor costs rising 2.2%, hourly compensation increasing 3.5% and both consumer and producer price indexes up 3.5%.
The Federal Reserve will not be able to ignore the creeping inflation rate, so there is a 50-50 chance of at least two interest rate increases, including one before the Nov. 8 election, said Mr. Nabi. He noted other countries have acted to raise their interest rates and credit demand is higher in the United States and abroad, all of which tend to push rates higher. Despite the prospects of at least two more interest rate hikes, rates will not increase to "punitive levels" and secular inflation is not expected to increase, said Mr. Elliott.
There is a reasonable degree of skepticism about the stock markets among investors now, which is good for prices, and a high level of merger and acquisition activity, which also is a plus for investors seeking opportunities, he said.
Among large-cap stocks, Bessemer is mostly committed to quality growth stocks, particularly those that show good growth outside the United States, such as Coca-Cola Co. Inc., said Mr. Elliott. The market is beginning to see a shift from cyclical growth to secular growth, said Mr. Nabi; he recommends investing in global companies that make at least 30% of their earnings from foreign markets.
Cyclical stocks already have run through the entire economic cycle, and some companies are trading at double-digit price-earnings ratios already, said Mr. Nabi. On the other hand, secular growth companies actually have come down on p/es during the same period. As an example, he noted Bessemer bought Coca-Cola a couple of months ago for about $42 per share; the stock was trading around $41 per share in July 1991, but earnings have increased approximately 60% since 1991, which makes its ratio almost half what it was then.
Almost 50% of Bessemer's international equity allocation is invested in emerging markets: 12% in Latin America and approximately 38% in Asian markets, said Mr. Elliott. The developing markets are trading at good p/e ratios and are experiencing less political risk than in the past and higher rates of growth, said Mr. Nabi. Among developed markets, Bessemer is moving from core European countries and into the "fringe countries" such as Ireland, said Mr. Elliott.
Most of the international markets look reasonably priced against the U.S. market, except Japan, said Mr. Elliott. The firm has no investments in Japan at the moment, he said, adding he does not expect the Japanese stock market to benefit from an economic upturn in the near-term.
On the fixed-income side, all sectors - government, corporate and high yield - are seeing a better quality of debt, and returns will be reasonable but not spectacular, according to portfolio managers from Smith Barney's asset management subsidiary, Greenwich Street Advisors.
The fixed-income market has been behaving predictably, and it is entering a period where it's reasonably valued, so investors should expect reasonable returns and less interest rate sensitivity, said Managing Director John Bianchi, who manages the Smith Barney High Income Fund.
But fixed-income investors will not see the kinds of returns they saw in the 1980s.
"The double-digit returns of the 80s will be the 6% to 9% returns of the 90s," said Managing Director James Conroy, manager of Smith Barney's Managed Governments and Government Securities funds. He estimated returns on long bonds should be approximately 7% to 8% for the next six months. That could drop to 6.5% if the economy weakens, but he added that number is still approximately 100 basis points higher than what it was a year ago.
The fixed-income market in October 1993 through April 1994 was "the worst down market I've seen," said Managing Director Joseph Deane, who oversees the Managed Municipals Fund. But now, it appears to have bottomed.
The low interest rates of last year helped municipalities and corporations refinance their debt, which has improved their credit quality and should result in a lower supply of debt in the near future, said the managers. Mr. Conroy noted pre-payments have slowed in the mortgage-backed area, thanks to rising rates. The rate of pre-payments may drop even further, because the rush to refinance and beat the rising rates is past.
Mr. Conroy said he expects the Federal Reserve Board to enact another interest rate hike of at least 25 basis points before the election, although inflation should stay low in the near-term.
"It's more of a psychological move for the marketplace," he said. "I think it's a wake-up call to the market that rates won't stay low forever."
The debt market is oversold and pricing appears to have reached the cheaper end of the curve, said Mr. Conroy. Zero-coupon bonds, strips, and five- to 10-year Treasuries are attractive now, he said. He suggested a fixed-income portfolio allocation should be approximately 30% in mortgage-backed securities with 9% coupons, 60% in five- to 10-year Treasuries, and 10% in strips.
Pension funds seeking to meet their obligations should think of areas such as the high-yield and mortgage-backed markets, said Mr. Conroy. Investors already have realized that the quality of high-yield investments available is better now, said Mr. Bianchi. Although the high-yield market always has had some default risk, it has bottomed out, he said.
Corporate bond defaults have been running at a historically low rate of approximately 1%, said Mr. Bianchi. That rate is expected to trend upward, but there is no expectation the 10% rate seen in 1989 and 1990 will repeat itself, he said.
The economic expansion is expected to continue, especially on the manufacturing side, said Mr. Bianchi. As it continues, producers of raw materials - such as the paper and steel industries - will see earnings increases and credit upgrades, he said.