The U.S. economy will continue moving along at an even clip in 1995, which is more than can be said for the equity markets, according to participants in Pensions & Investments' 1995 market outlook roundtable.
Investment managers participating in the discussion don't see an immediate danger of recession or excessive inflation threatening the economy, but they cautioned the equity markets will not go on outperforming, and some even wondered whether a bear market can be far behind.
They predicted the gross domestic product will grow at a 3% rate or slightly higher, and inflation will move slightly upward to around 3%. The inflation figures will be slightly higher at year's end than in the first quarter, although it will be kept in check, no higher than 3.5%, they said.
The managers recommended a 1995 asset allocation strategy lighter on equity in favor of some cash reserves and bond exposure in the short-duration segments, and an increased focus on international investment or stocks of domestic companies with significant foreign revenues.
Participants were: Gary L. Bergstrom, president, Acadian Asset Management Inc., Boston; Mark Mallon, president, Federated Investment Counseling, Pittsburgh; Michael L. Green, president, EverGreen Capital Management Inc., Omaha, Neb.; Mark Stumpp, managing director and chief investment officer, Prudential Diversified Investment Strategies, Short Hills, N.J.; Elizabeth Bramwell, president and chief executive officer, Bramwell Capital Management Inc., New York; and Thomas M. O'Neill, president and chief executive officer, Aeltus Investment Management Inc., Hartford, Conn.
Most participants forecast a rate of inflation around 3% for next year, perhaps as high as 3.5% after midyear, but panelists agreed the economy's increased activity and GDP growth will not lead to runaway inflation. The restructuring of U.S. industry, the passage of the General Agreement on Tariffs and Trade, the global economic recovery and continued tightening by the Federal Reserve Board all will keep inflation in check, they said.
U.S. industry is experiencing increased productivity brought on by corporate downsizing and increased investments in technology, and companies achieved increased efficiency by spinning off non-core activities and refocused on basic business lines during the recession. At the same time, a weak dollar and improved economies abroad are driving increased export activity, which in turn is pushing up earnings for U.S. manufacturers. The passing of GATT will help U.S. exports along.
"I think we've got a reasonable shot in this cycle - if we don't get any nasty, exogenous shocks - of having a fairly good and protracted global economic growth cycle," said Mr. Bergstrom.
What could throw a grenade into this scenario? War and scandal, said the managers. The reopening of the Whitewater investigation, a major conflict in the Middle East or the former Yugoslavia, or an explosion in the ongoing derivatives drama could give the economy a shock that could skew all predictions.
"We haven't seen the end of what's out there in derivativeland as we flatten the yield curve," said Mr. O'Neill. "We will see additional icebergs appear that are now below the surface. There are still a lot of investors or pseudo-investors that have been out there, leveraging the system, playing the yield curve."
Despite the still healthy economy, the managers are wary of what looks like a lackluster domestic equity market in 1995. Most projected returns of less than 10% for the Standard & Poor's 500 Stock Index, despite expecting increases of about 10% in corporate earnings. Valuations are extended and dividend yields are low, all of which point to the end of double-digit returns.
"We think the combination of overvaluation, tighter money, and deteriorating (internal market) technicals are likely to overwhelm the favorable economic backdrop," said Mr. Mallon. Some sectors that still are undervalued now include interest-rate sensitive stocks such as insurance, banks and utilities; he recommends First Union Corp. and First Interstate Bancorp among banks and Lincoln National Corp. and American General Corp. among insurers. He also noted the defense electronics industry - companies such as Raytheon Co., Martin Marietta Corp. and E-Systems Inc. - could benefit from procurement increases by the upcoming Republican Congress.
Other managers also recommended some manufacturing, technology and energy stocks. Mr. Bergstrom suggested the energy sector, which is usually a late cyclical; Ms. Bramwell favored industrial products sectors such as paper, steel, construction and engineering, which she said have seen a big correction and are coming off a slump; and Mr. Green favored the telecommunications sector and basic technology stocks.
Both Mr. O'Neill and Mr. Mallon noted the potential for a bear market. With valuations at high levels and having outperformed for three years, the market is reaching the end of the cycle, said Mr. O'Neill. Equity returns are bound to regress to the mean, and considering the amounts of money invested in mutual funds, the market could go down sharply when it corrects and shares are redeemed, he warned.
"We're at high levels of exposure and valuations are low; that's a dangerous situation," he said.
On the other hand, bonds now are at low valuations and starting to look more attractive as the yield curve flattens. Most favored short- and intermediate-duration bonds, some municipals and mortgage-backed securities.
Bond yields are reaching 8% and have the potential of reaching 9%, which makes them a better value than stocks, said Mr. O'Neill. He noted Aeltus will be increasing its bond allocation as yields rise.
Short-term bonds are competitive with equities right now, said Ms. Bramwell. She noted a two-year Treasury note yielding 7.25% or 7.5% is attractive compared to the equity markets and even to a Treasury bill yielding 5.5%. Mutual funds' large exposure to long-term bonds makes them more vulnerable, so it makes more sense to choose maturities of less than five years, she said.
The brighter spots in the equity markets can be found overseas, according the panel. An ongoing worldwide economic recovery is boosting the stock markets of most industrialized countries, although some are moving faster than others. Japan continues to lag most of the industrialized nations, while the United Kingdom is leading Europe.
The conventional wisdom that the globalization of industry is leading to a higher correlation among the world's capital markets is not borne out by facts, said Mr. Bergstrom. He quoted research by his firm that studied the correlation between the U.S. equity market and the Morgan Stanley Capital International Europe Australasia Far East Index since 1980 and found it actually had dropped. The correlation went from 0.42 between 1980 and 1986 to 0.23 between 1987 and 1994 and to 0.1 during the first three quarters of 1994.
Among specific markets, Mr. Bergstrom likes France, which has disappointed investors recently, but still has attractive valuations. If the government did more to alleviate the 12% unemployment rate, the market could surprise investors, he said. He added most of the other foreign markets he expects to do well fall under the emerging markets area: Greece, Indonesia, Portugal, Turkey and the Philippines.
The development of free markets and a rising middle class around the world are the big trends of the 1990s, and provide a good backdrop for foreign investing, said Ms. Bramwell. She likes Latin America, particularly Argentina.
Both Ms. Bramwell and Mr. Green, however, noted U.S. multinationals offer domestic investors an opportunity for foreign participation. There are two levels of investment strategy available this way, said Mr. Green: One is companies participating in infrastructure development, such as AT&T's work upgrading Eastern European telephone systems, and the other is consumer product companies, such as McDonald's Corp. and Coca-Cola Co., that are increasing their sales in emerging markets.
"Twenty percent of our economy and 20% of corporate profits are related to foreign business activity. That's a big chunk of the U.S. economy. As those countries start to expand domestically, those profits are going to flow into the United States. That's the place to look," said Mr. Stumpp.
Mr. Mallon said he likes Canada and Australia, two economies with vast natural resources that will benefit from the worldwide recovery and should grow at 3% to 4% annually; Latin America, where growth could pass 5% annually; and continental Europe, which he said is "modestly undervalued," particularly France. Mr. O'Neill agreed on France and Canada.
Most managers see Japan as a laggard in recovery and its capital markets still rather overvalued. Mr. Mallon projected 1% to 2% growth in 1995, after a 1% rate in 1994. Japan is going to have more long-term problems because of its conservative immigration laws and shrinking population growth rates, said Mr. Green. Those factors will put pressure on wages in the low end of the range, he said.
Predictions among other financial services firms are mildly optimistic, but with reservations:
The economy is moving at a faster pace than either the financial markets or the Federal Reserve would like to see, said Keith Brodkin, chairman and chief investment officer of Massachusetts Financial Services, Boston. But he added the pace will slow in early 1995 and the inflation rate will stay around 3.5%.
An aggressive Fed is bound to act again, and the many adjustable-rate mortgages written at low rates will start climbing upward, said Mr. Brodkin. The ARM rise will leave consumers with less disposable income to pour into the economy. At the same time, capacity utilization is running near inflationary levels, and manufacturers have been experiencing commodity price increases they have been unwilling to pass on to consumers so far, he said.
He estimated the Fed will raise rates again, which would be a good time to buy bonds. He guessed short rates could increase 50 to 75 basis points and long rates could reach 8.25% or 8.5%. With bonds at 8.5% and inflation at 3.5%, it would be a good time to buy bonds, but he recommended investors get in during the first months of the bond rally.
On the equity side, Jeffrey Shames, MFS' president and chief equity officer, said if 1995 price-earnings ratios are at 12 to 13 times earnings, "we still have a leg in the bull market."
Mr. Shames favors software stocks in the technology sector, such as Microsoft Corp. and other software and imaging technology companies, as well as some selected turnarounds in areas such as systems software. Hardware stocks can be used as trading stocks - his favorite is Intel Corp. - but not as long-term positions.
MFS sold its auto stocks at the beginning of the year and Mr. Shames noted chemicals and papers will follow auto stocks downward. MFS is making the transition into the consumer goods area, where volume gains are being translated into p/e gains. He named Sara Lee Corp., Procter & Gamble Co. and Gillette Co. as attractive stocks that have increased their overseas growth thanks to the weak dollar and that have undergone restructuring.
"We think the Fed is ringing a big bell to get out of cyclical stocks," said Mr. Shames.
Overseas, the main factor continues to be interest rates, although the markets are expected to make the transition to more fundamentally led markets in 1995, said David Mannheim, vice president and global equity portfolio manager.
Valuations, high at the end of 1993, have come down thanks to an average earnings growth of more than 20% worldwide, he said. High interest rates had offset most of the gains until now, but with the worst of the hikes over, there is lots of corporate earnings growth ahead.
Cash is not trash. Stocks are about 10% overvalued and investors should sell into a year-end rally before the market decline expected in 1995, according to year-end predictions by David Shulman, chief economist of Salomon Brothers, New York. Making money in stocks is difficult when they are 10% overvalued and earnings are peaking, while the bond market will remain unmoved by the Fed's tightenings until stocks drop, said Mr. Shulman. In that environment, two- and five-year Treasury notes, yielding 7.4% and 7.8% respectively, are attractive.
In his December report, Mr. Shulman recommends continuing an asset allocation of 45% stocks, 30% bonds and 25% cash and favors the domestic oil refining sector. Mr. Shulman recommended Valero Energy Corp. and Unocal Corp. among oil stocks; and is holding technology stocks Microsoft and Motorola Inc., that show good long-term prospects. He also recommended the financial sector.
The chances of the economy sliding into recession in the next 12 months are running about 16%, according to Comerica Bank's Recession Watch index. The index has risen from 2.5% in June, indicating the economy will slow down, although not into recession.
The federal funds rate will reach a peak level between 6.5% and 7.5% in 1995, predicts Leif H. Olsen, president of Leif H. Olsen Investments, an economic research firm. In a recent memorandum, he predicted the 30-year Treasury bond yield probably won't exceed 8.5%. If it does, it will be by no more than 10 or 15 basis points for just a few weeks. The yield spread between the two-year note and the 10-year bond will narrow to nearly nothing, he said.