The European debt crisis and global economic uncertainty were the dark clouds hanging over the Investment Management Consultant Association’s conference in New York recently. But a panel of high-profile investment strategists found a few rays of sunshine beginning to peak through the gloom: equities and municipal bonds.
While there has been a flight to quality amid the uncertainty recently, Milton Ezrati, senior economist with Lord Abbett, favors the risk-on trade, primarily because many companies’ dividend yields are higher than their bond yields. That suggests the market is “implicitly expecting dividend cuts or price depreciation or both.
“If you look at valuations, markets appear to be braced for disaster,” Ezrati said, and that creates opportunities in stocks and credit-sensitive bonds. While the market won’t recapture the high water marks for quite a while, it will appreciate, he predicts.
“I think what the market is basically saying is we’re going to have really punk growth and a lot of volatility,” said Jonathan Golub, managing director and U.S. equities strategist at UBS.
Because we know we’re stuck with low interest rates for the foreseeable future, investors might be OK with price multiples of 12.5 in this two percent growth environment, Golub said. The multiple has traditionally been higher. The current price to earnings ratio for the S&P 500 is 11.8, while the 10-year historical average is 14.6.
In 2010 and 2011, scares of a double dip recession were real, but if the market now believes two percent GDP is sustainable, “that’s a vast improvement on where it was in 2011 and 2010,” Ezrati said, and could explain why valuations have improved.
Regardless of whether the stock market will reclaim its high water mark, Golub said we can expect market growth simply because economies grow. “The market is going to get dragged higher just because the pie gets bigger.”
Paul Quinsee, managing director at J.P. Morgan Asset Management, said that while there’s plenty of fear and risk aversion in the stock market, he sees the best opportunity in large-cap equities. True, actively managed equity funds have seen net outflows of $400 billion since 2008, but “in investing, misery creates opportunity. I think the pessimism has gone way too far,” he said.
S&P 500 valuations are low and volatility has already dropped 20 percent this year, Quinsee added. The S&P 500 is still nowhere near the highs of 2007.
While municipal bond funds saw about $46 billion in net outflows over 2010 and 2011, Peter Hayes, managing director and portfolio manager with BlackRock’s fixed income portfolio management group, sees this as another bright spot for 2012. Muni bond funds have only recouped about half of the asset losses in 2011, Hayes said, and he expects to see another $10-$15 billion in flows to these funds over the next two to three months.
Because of the recent growth of “crossover buyers,” including hedge funds, pension funds, insurance companies and foreign buyers, the retail sector now holds about 65 percent of outstanding municipal securities through direct bond purchases, mutual funds and separately managed accounts, down from about 85 percent between 2008 and 2010, Hayes said.
The municipal bond market is becoming more attractive and competing with other types of bonds, Hayes said. The market is already up two percent this month, and credit revenues have turned dramatically better, with eight consecutive quarters of revenue growth. The fundamentals of state governments are in good shape; on average, the states are spending seven percent of their revenues to pay down their debt, and 29 states are going through pension reform.
In 2011, supply was down 30 percent in taxable municipal bonds, although much of this was due to the expiration of the Build America Bond program, Hayes said. He believes the market will continue to shrink in supply and develop a broader investor base for the next five years.
That said, Hayes expects there to be more “super downgrades,” or multiple notch downgrades, going forward, because of a change in methodology of the credit ratings agencies due to new requirements. The Dodd-Frank reform imposes new liability exposure on the credit ratings agencies and specifies methodologies to be used in their ratings. Also, because of the criticism they received due to their role in the credit crisis, the ratings agencies are becoming more proactive in how they look at and rate issuers, he added.