Investment managers are again cautiously optimistic about the investment climate for the coming year and predict another up year for domestic stocks.
Money managers are echoing their sentiments of late 1995, predicting 1997 will show mild inflation, tame economic growth and single-digit increases in the U.S. stock market, with high-yield and municipal bonds being the bright spots in a largely lackluster domestic bond market.
Portfolio managers for Bankers Trust Co., Salomon Brothers Asset Management and Bessemer Trust Co. all are predicting the slow growth in gross domestic product (between 2% and 3%) and low unemployment, coupled with slightly higher inflation around 3%, will keep the economy healthy but slow-growing in 1997 and stocks will continue to outperform bonds in general.
The favorable fundamentals that have been helping the financial markets during the past couple of years are in for some tougher times in 1997, according to the portfolio managers at the global investment management unit of Bankers Trust Co., New York, who are taking a global look to find values in 1997. The unit is slightly bearish on the domestic markets, predicting the best opportunities will be found overseas.
There are signs of inflation "bubbling in the pipeline," in the United States, according to John R. Williams, managing director and chief markets economist. The labor force and productivity are both growing at an annual rate of 1%, but unemployment has slowed to approximately 5.5%, which puts the United States close to full employment and signals wage pressures to come, he said.
In this environment, the equity markets "are in some pretty tough sledding," said Mr. Williams, predicting the Standard & Poor's 500 Stock Index will edge up about 5%. Complacent investors could be easily disappointed, said Mr. Williams, citing overseas equity markets as more attractive alternatives.
By contrast, portfolio managers at Bessemer Trust, New York, are looking for continued corporate profit growth in 1997, with only modest increases in the cost of labor and a positive view on interest rates, said Timothy Morris, chief domestic investment officer.
"Things are leaning against inflation," said Harold Woolley, Bessemer's senior vice president. The price of gold, which rose in early 1996, has declined recently; the U.S. dollar has appreciated against the yen and deutsche mark, which makes it tougher for producers to raise prices; the yield curve has been flattening since the Federal Reserve Board's easing in February; and economic indexes, which spiked earlier in 1996, had been hitting new lows later in the year, he said.
The U.S. economy has settled into a period of steady growth without many inflationary worries, although high stock valuations are a concern, said Thomas Brock, chairman and chief executive officer of Salomon Brothers Asset Management, New York. Barring an unforeseen shock, nothing would force a market correction in this environment, he said. Mr. Brock guessed the S&P could reach trading levels of "730-ish or so" in 1997.
"We really don't see anything that would upset this apple cart," said Steven Guterman, senior portfolio manager in charge of government bond and mortgage portfolios at SBAM. The economy is showing continued low unemployment and low inflation as jobs are created at a more sustainable level, he said. As Alan Greenspan seems set to remain as Fed chairman, it appears monetary policy will continue its course as well, he noted.
The GDP is slowing as consumers pay down some of their installment debt, so it will remain "in the 2% to 3% area" for the next couple of quarters, said Richard Dahlberg, head of SBAM's U.S. equity group.
Equity returns next year will be found through company selection and by following earnings, said Mr. Dahlberg. He favors the financial sector, particularly real estate investment trusts and bank stocks; energy, thanks to recent increases in crude oil consumption; computer services; and Canadian stocks such Canadian Rail. In 1997, opportunities could include cyclicals that have been beaten down and technology companies that have lagged the rest of the sector, he said.
The market still has a lot of liquidity from mutual funds and corporate repurchasing, as well as continued merger and acquisition activity, said Rick White, SBAM's senior portfolio manager of equity, convertibles and derivatives.
The existing factors favoring corporate profit growth will continue in 1997, and the domestic equity market should rise 8% to 9% for the year, said Bessemer's Mr. Morris. Net employment growth has only brought small increases in the cost of labor; corporate America has been effective in cutting the cost of benefits, so although wages have risen, total labor costs have not gone up as much, he said. Bessemer remains fully invested, recommending an allocation of 25% bonds and 75% equities. Of the equity allocation, 30% is in international equities, 13% in domestic small- and midcap equity and 57% in a core domestic large-cap equity portfolio. But that allocation might change depending on the attractiveness of bonds in the new year, said Mr. Morris.
Bessemer also might reduce its international equity allocation, because the markets have had a good run and are not as cheap as they were, said Mr. Morris. The international equity portion is weighted heavily toward the emerging markets, with minimal exposure in Europe - where it is underweighted in the United Kingdom and Germany - and no exposure in Japan.
Mr. Morris said he likes the banking sector, which is in better shape than it has been in years; the health care area, which is being helped by demographics; and technology, although most companies in the sector have become highly priced. Issues he recommends include Coca-Cola Co., Johnson & Johnson Inc., Merck & Co., McDonald's Corp., Chase Manhattan Corp., Citicorp, NationsBank Corp., Federal National Mortgage Association, Green Tree Financial Corp. and Merrill Lynch & Co.
Overall, the Dow Jones industrial average could trade in the range of 6800 to 6900 in 1997 and the S&P could add 8% to 9% during the year, said Mr. Morris. Inflation would remain in the 2.5% range and GDP growth could range from 2.5% to 3%, he said.
While 2% GDP growth is the "speed limit" for the U.S. economy, based on past experience, 1997 will see growth of 2.5% to 3% in the first half, which will lead the Federal Reserve Board to tighten early in 1997, said Banker Trust's Mr. Williams. GDP growth will slow to 2% in the second half, but inflation will edge over 3% in 1997, largely on the strength of the labor market, he said.
The Fed should tighten somewhere between 50 and 100 basis points in 1997, said Mr. Williams. He believes U.S. long bond yields will rise to about 7.5% early in the year and then fall to trade around 6.5% as the economy slows.
On the other hand, Bessemer's Mr. Woolley estimated the long bond could drop to a yield of 5.75% by mid-1997, an opportunity for the Fed to cut rates further. If the current fiscal policy continues on course, said Mr. Woolley, the Fed is more likely to ease than tighten the money supply.
Mr. Woolley argues various risks already have been priced into the bond market and cyclical risks have been diminishing, so bond portfolio managers should be slightly longer in duration than their portfolios' bogey. While there is little value in corporates, there are some opportunities in special situations such as takeovers and the utility sector, he said. Additionally, yields on taxable municipal securities look good and issues trade cheaply compared to corporates.
SBAM's Mr. Brock noted there is a better risk-reward ratio among intermediate duration bonds than among the long bonds and good opportunities in high-yield bonds and municipal securities, where the portfolio can earn both a high coupon and good rate of return compared with other fixed-income securities.
On the corporate sector, corporate spreads are tight, but opportunities can be found in specific names and situations, said John Dolan, Bankers Trust vice president and head of domestic fixed income and mortgage-backed securities. He mentioned Mutual of New York, a good BBB-rated insurer, as well as foreign issues such as Province of Quebec bonds and German Landesbanc bonds.
Mortgage-backed securities had a good run in 1996, returning 91 basis points on a duration-adjusted basis, and the market factors favoring them are still in place, said Mr. Dolan. They are cheap vs. corporates and they have low volatility, although there is the potential risk for a "pre-pay wave" among the $40 billion of 8% mortgages issued in 1995-'96, which are "very refinanceable," he said.
The high-yield bond market has become much more attractive to investors in recent years, thanks to low inflation and moderate growth, as well as improvements in the market itself, said David Reiss, vice president and portfolio manager for high-yield securities at Bankers Trust. With careful credit selection, high-yield bonds offer an attractive return relative to risk in the long-term, he said. Domestically, high-yield spreads are tight, but the fundamentals are still good and mutual fund assets continue to flow into the market, Mr. Reiss said.
Bankers Trust is bullish on emerging market debt, particularly soverign debt of countries that have controlled inflation and improved their economies, Mr. Reiss said. Russia had a good 1996, having restructured its defaulted debt, and bonds are showing yields in the low- to mid-teens, while Poland's bonds have been upgraded to investment-grade and are yielding 200 basis points over U.S. Treasuries, he said.
High-yield bonds were very strong in 1996, with $12 billion in inflows to high-yield bond funds, said Peter Wilby, senior portfolio manager in charge of high-yield and emerging market debt at SBAM. Credit quality has been stronger than ever and defaults have fallen to 0.25%, their lowest level ever. The corporate high-yield market also has become more global, said Mr. Wilby, with foreign companies coming into the U.S. market for dollar financing.
Within the market, the energy sector will continue to improve in quality thanks to continued usage and lower costs; hotels will benefit from a slowdown in building new properties; and retailers from a profitable Christmas season, he said. Mr. Wilby noted one high-yield sector he does not like is gaming, which has been weakened by overbuilding in certain parts of the country, such as Atlantic City.
Outside of the United States, MTwo new products present some good opportunities for inflation-wary investors in 1997; the new Treasury yield curve futures introduced in October by the Chicago Board of Options Exchange and the new inflation-indexed bonds, which start trading in January, said Bankers Trust's Mr. Dolan. The yield curve futures will offer investors an additional risk management tool and the inflation-linked bonds offer a good direct hedge against inflation that will likely do better than traditional hedges such as gold or other commodities, he said.