Um, no Champagne just yet

The credit crisis hangover might be over, but pension funds and other institutional investors are not about to start partying again — despite 2009's rally in stocks, credit and some alternative investments like hedge funds.

That's because for institutional investors, 2010 is going to be a year of change as central banks react to the global economic recovery and begin to withdraw the fiscal stimulus that seeded the recovery and to raise interest rates.

Nonetheless, the move into equities and credit is expected to continue even if rates of return are only mediocre, according to leading market strategists.

After hitting bear-market lows in March at the height of the credit crisis, stocks surged, with the Standard & Poor's 500 index gaining nearly 65% from early March through Dec. 31. Over the same period, the blue-chip Dow Jones industrial average rallied 59% and the Morgan Stanley Capital International Europe Australasia Far East index skyrocketed 73%.

“Although things have come a long way, those assets don't necessarily look expensive,” said Richard Lacaille, the London-based global chief investment officer at State Street Global Advisors, referring to stocks and bonds. “There's still potential in equities, potential in credit. And we're still a little bit overweight in emerging markets relative to developed markets.”

Strategists agree that what's likely to keep returns moderate at best this year is policymakers' response to a growing global economy.

“The (equity) market is waiting for a change in policy, both monetary and fiscal,” said Milton Ezrati, senior economist and market strategist at Lord, Abbett & Co. LLC, Jersey City, N.J. “If the authorities fail then the market will face a headwind.”

“The Fed has to withdraw the stimulus,” said Mr. Ezrati, who is also a partner at the $89 billion manager.

Jeff Saef, director of multistrategy investment solutions at BNYMellon Asset Management, New York, agreed that any interest rate tightening by the Federal Reserve is unlikely until the second half of the year, but only when the labor market has improved.

At Pacific Investment Management Co., Newport Beach, Calif., market strategist and portfolio manager Tony Crescenzi said there's typically a multimonth lag between a peak in the jobless rate and a change in monetary policy, and if the unemployment rate doesn't peak until much later this year, the Fed might not raise interest rates until 2011.

“Our general view is that there are no signs that governments — whether in the U.S. or around the world — are withdrawing (fiscal) support in any meaningful manner,” Mr. Saef explained. “There's a healthy supply of global liquidity from central banks.”

Given that backdrop, and the rally in capital markets last year, he said he is mildly bullish on U.S., eurozone and emerging market equities, neutral to bearish on Japanese equities and moderately bullish on government bonds, emerging market debt, corporate credit and high-yield bonds.

“You're not getting paid to stay in short-term Treasuries and that encourages you to take some risk,” added Larry Kantor, head of research at Barclays Capital in New York. “Following the panic of the fall of 2008, a lot of money went into money market mutual funds, T-bills and all that. The reverse of that process is not spent.”

The reverse of that process — what Mr. Kantor called the “recovery trade,” or investing as if the economy is going to get better — is continuing, but is likely to end sometime in the first half of the year, which could throw a wrench into investors' best plans.

“Institutions — pension funds, big asset managers — are gradually moving back and taking risk,” he explained. “But when you bring in the idea of (credit tightening), that causes a bit of a hiccup and it may interrupt the trend.”

But he was quick to add that a bear market in either stocks or corporate bonds is not likely “because while there are no screaming buys out there, we don't see valuations in either stocks or corporate bonds as being excessive and profit margins are quite good in the non-financial sector.”

Other strategists said that in order for stock prices to continue to climb, corporate earnings are going to have to show top-line improvement — gains in sales and revenues.

One investment area likely to see some renewed interest, albeit with a fresh sense of diligence, is alternatives.

After a disastrous 2008 and early 2009, hedge funds and funds of funds recovered nicely through the balance of last year even as investors wielded some new-found power in the area of fees and transparency.

That trend could continue this year although investment strategists and consultants agreed that institutional investors, while stepping back into the risk pool, are not ready to jump in with both feet.

“We're not seeing people engaging in massive re-risking,” said Carl Hess, global head of investment consulting at Towers Watson & Co. based in New York. “Nothing looks all that attractive.”

SSgA's Mr. Lacaille noted that in 2009, pension funds and other institutional investors pulled back from investing in hedge funds, which were busy trying to deleverage their own portfolios, and moved to passive strategies from active strategies.

“We may see a return to alpha-generation strategies” this year, he explained. “Opportunities in hedge funds and alternative assets. That may have been somewhat interrupted in 2008 and 2009, and we anticipate that returning.”

Mr. Saef at BNY Mellon Asset Management added that he expects to see public pension funds increasing their commitments to emerging markets equity, hedge funds, private equity and real estate this year, with the “goal being increased expected rates of return.”

He also said that while he doesn't expect inflation to be a factor for another year or two, he is beginning to raise the issue with institutional investor clients, pushing them to carve out modest allocations to Treasury inflation-protected securities and real estate as an inflation hedge.

Mr. Lacaille echoed the sentiment.

“There are quite significant flows into strategies that are helping people hedge that perceived (inflation) risk and that's going to continue this year,” he said. “We're not forecasting a big upturn in inflation — over the short- to medium term, there isn't much inflation pressure at all.

“But that doesn't mean it's not prudent to start planning” for it.