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Paths Forward for the Economy and Markets

The budget deficit, the debt crisis in Europe, the slowing rate of growth in China, geopolitical unrest in the Middle East – there's no shortage of risks in the world right now to keep investors awake at night. 

But looking at the direction of asset flows, which throughout the market recovery since the financial crisis have continued to favor bonds over stocks, it seems the majority of investors are overlooking a simple question: what could go right?  And if it does go right, will their conservative portfolios leave them ill-positioned for the market environment that may ensue.

Clearly, a well balanced portfolio will always include some allocation to conservative investments such as bonds to provide ballast against a turbulent equity market.  But a look at Morningstar data on mutual fund flows for 2012 shows a net inflow of more than $300 billion into bond funds, versus net outflow from U.S. equity funds of more than $100 billion.  That trend has been intact since the post-crisis market bottom in March 2009, despite the fact the S&P 500 has nearly doubled since that trough.

We do not have a bullish view of the economy or the markets, as the world faces a host of issues, most notably the deleveraging of developed economies worldwide.  Our investment view is that the relative valuations amongst markets are too slanted to the negative side. This type of risk-averse investor behavior tends to lead to mis-pricing of assets. A case in point – the 10-year Treasury bond in recent months has traded to yield near its historic low at just 1.7 percent.  With inflation running around 2 percent, investors are locking in negative real returns with this asset.

Equities meanwhile are historically cheap relative to bonds, as measured by the equity risk premium, which is the earnings yield on stocks minus the 10-year Treasury yield.  That difference currently stands at more than five percentage points, in stark contrast to the heady equity market environment of the latter 1990s when the difference was negative, implying stocks then were expensive relative to bonds.

I started in this business as a fixed income manager, and in 1999, when the NASDAQ traded at a price/earnings ratio near 50 and the S&P 500 over 30 while Treasury bonds yielded 6.5 percent, I would stand up in front of a crowd and tell them they should be selling stocks and buying bonds.  And they would look at me like I was crazy.  Today we see virtually the same situation in reverse.

Again, some allocation to bonds is always wise.  But the heavy investor preference for bonds over stocks at these valuation levels would tend to make sense only if all the global risks weighing on the market were to lead to the worst possible outcome and the market were in total disorder.

Rather than focus on the extreme risk in the tail of the distribution of possible outcomes, investors may want to think about the entire range of potential outcomes and position their portfolios accordingly.  We think there are a number of possibilities that are within the grasp of policymakers and have a reasonable probability of transpiring to help restore investor confidence in the equity market.

One potential boost to the economy and markets could come from the housing sector.  Housing  has a major impact on the economy.  It can make a significant contribution to GDP, it’s a labor-intensive business, it affects individuals' wealth and therefore their spending, it helps banks and provides revenues for the government.

As a transition mechanism housing did not work well in this post-recession period, largely because consumers came into the period with too much leverage, so when the Fed lowered interest rates it did not spark the usual level of housing activity.   Consumers have de-levered today, and financing costs remain extremely low, so when we begin to see more clarity around policy coming out of Washington and improved confidence levels, you could see housing become a significant source of growth for the economy over the next two to three years.

Another potential game-changer for the U.S. economy over the next several years could be energy.   The paths out of a debt crisis, other than default, include inflating your way out, growing your way out, or a technological revolution that moves the supply curve out for the economy.   The state of innovation in the U.S. energy industry has the potential to be a significant supply-side adjustment for the foreseeable future.

Based on technological innovation, it is expected the U.S. will surpass both Russia and Saudi Arabia in oil production in the coming decade, on our way to becoming energy self-sufficient.  The ensuing supply shock could create not only lower energy prices, but induce capital investment, create jobs, re-inflate the dollar and create tremendous tailwinds to economic growth.

And what about the deficit?  Much remains to be done on the spending side, but lawmakers' 11th hour agreement on taxes to avoid the fiscal cliff and its onerous consequences provides some measure of hope our elected officials will continue to work toward consensus to avoid driving the economy back into recession.  One of the biggest issues affecting businesses and consumers isn't the ability to spend, it's the confidence to spend.  If confidence is restored, that could provide a very positive backdrop for the economy, for spending and for the financial markets.

Europe, meanwhile, will continue to face challenges.  But the European Central Bank has announced its conditional willingness to step in and buy debt of Italy and Spain to help restore investor confidence in those troubled credits.  And Germany would face substantial damage to its own export-driven economy if it doesn't work to hold the union together, so the worst of the European crisis may be behind us.

Concerns about economic slowing in China may be overblown as well.  The central bank began raising interest rates in the summer of 2011 over fears of overheating, but inflation has subsided to less than 2 percent.  And with relatively low debt-to-GDP levels, the government has some room to stimulate the economy and restore economic growth.

In summary, there are several potential paths forward for the global economy that could leave investors behind if they continue to overweight bonds and shun stocks in anticipation of the worst possible outcomes.  Sticking to a well-balanced asset allocation plan may be the best way to avoid that result.

Michael Roberge, CFA, is President and Chief Investment Officer of MFS Investment Management