What a year it’s been. After a heart-stopping dive, the S&P 500® Index (.SPX) has rallied 65% since its March low. Will the rally last? What are the opportunities and risks ahead?
We asked five of our best and brightest — whose specialties include international and domestic stocks, bonds, markets, and economies — to share their insights. The good news: They see signs of a continued recovery in the economy, stocks, and markets. The bad news: It may be a choppy ride ahead. But not to worry. They see investment opportunities for careful investors. Among them: technology and industrial stocks, solar energy, treasury inflation-protected securities (TIPS), high-yield bonds, and emerging market stocks. Here are their perspectives to help you retool your portfolio for the new year.
Jurrien Timmer, director of investment research and co-manager of Fidelity Dynamic Strategies® Fund (FDYSX), has been analyzing financial markets for more than two decades, and specializes in tactical asset allocation.
A maturing bull
The economy is in the midst of a V-shaped inventory-led recovery, fueled by a potent cocktail of low funding rates, a steep yield curve, a massive increase in the monetary base and deficit spending, and narrowing credit spreads. Inventories have been depleted and so many workers have been laid off that there’s really only one direction to go — up. Whether the consumer will be in a position to sustain this recovery is a valid question, but one that we don’t really need to address until later. For now, I believe the cyclical momentum is up.
I expect the Federal Reserve’s stimulative policy stance to continue for some time because it is focused on unemployment rather than inflation. This suggests that risk assets including stocks, corporate bonds and commodities will continue to perform, and that the dollar will continue to decline. This is called the “reflation trade.”
While the weight of evidence suggests, however, that this bull market is likely to continue trending upward into 2010, a few technical indicators as well as sentiment surveys are starting to signal that the bull is maturing and perhaps transitioning toward a period of sharper volatility in the months ahead. So, I believe the easy money has likely been made for this cycle.
Investors are still skeptical, which is why they have been plowing money into bond funds instead of stock funds, but they are no longer as one-sidedly bearish as they were last winter. Usually the sentiment pendulum swings from one extreme to the other, and so far it has only swung from bearish to neutral.
From an asset-allocation point of view, I remain bullish on risk assets, especially emerging markets stocks and commodities. Stocks in energy, technology, materials, and financials could do well. Investors need to be selective in fixed income. I like TIPS and high-yield corporate bonds, but have no interest in Treasuries. The Treasury needs to refinance $2 trillion worth of short-term debt in 2010, in addition to $1.5 trillion of new debt. That’s a recipe for higher interest rates, if you ask me.
What am I concerned about? In particular, the difficult balance ahead for the Fed. That is, if it withdraws its stimulative policy too soon, it risks a deflationary relapse (like what happened in the mid-1930s). On the other hand, if it withdraws too slowly or too late, it risks rising inflationary expectations (which occurred in the 1970s).
Lisa Emsbo-Mattingly, director of economic analysis, keeps our fund managers and analysts informed on domestic and global economic activity to help them identify market trends and investment opportunities.
On the mend
The economy continues to show signs of recovery, but there are indications of a bumpy ride.
Unemployment: Glimmers of hope
Many leading employment indicators have been signaling improvements. For instance, layoff announcements and initial unemployment claims were down, temporary employment hiring was up, the number of manufacturing hours worked increased, and overtime hours continued to rise.
Consumers: Shaken but undeterred tomorrow
Two closely followed consumer sentiment surveys, the Conference Board survey and the University of Michigan Consumer Sentiment Survey, recently showed that consumers are not feeling good about their current financial positions and have low expectations for their income. They were much more positive, however, about future financial conditions, expecting business and employment conditions to improve over the next 6-12 months — another sign that the worst may be behind us.
Spending: Wallets beginning to open
During this recession, consumers increased their savings and paid down debt at the fastest rate in recorded history. Nevertheless, consumer spending has begun to recover. Retail sales and real consumer spending appear to have bottomed as long ago as December of last year. There’s still a strong unwillingness to “spend on things you don’t necessarily need.” But there’s a natural replacement cycle within consumer spending that should continue to boost spending.
Global growth: A boon for U.S. exports
The U.S., which historically has led other countries out of a global recession, is currently in the middle of the recovery pack, with leading economic indicators rising at a three-month annualized rate of 6.8%, consistent with economic recovery. The OECD (Organization for Economic Cooperation and Development) countries, which are a collection of the largest developed economies in the world, are seeing their leading indicator rising at a three-month annualized rate of 16%, the highest rate since the end of the 1975 recession. Much of the higher growth has been spurred by demand from countries like China, India and Brazil. This growth, coupled with a weak U.S. dollar, creates an excellent export environment for U.S. companies and should be a powerful positive increment to U.S. gross domestic product (GDP) growth.
Stock picker’s market: Focus on market share
How might investors take advantage of these economic developments? The early cyclicals (sectors and companies that tend to do well in the early stages of an economic recovery), such as home builders, autos and retailers, have already rallied. The next wave could be a further rally in technology and industrial stocks. This stage of the cycle, however, may be choppy. While the overall market will likely follow earnings trends, the market has already rebounded strongly, and it appears to be a stock picker’s environment. For example, in consumer staples, some companies may outperform due to market share increases even though the overall sector might not. Identifying these market-share leaders both in the U.S. and global markets may be a recipe for investing success.
John Roth manages several Fidelity funds including the Fidelity New Millennium Fund® (FMILX).
Look for turnaround stories
We’re at an inflection point in the economic cycle — the end of the bottoming process and the beginning of a recovery. Historically, that points to a number of stock-picking opportunities. I’m looking for cyclical turnaround stories. The question is, what industries and companies have taken advantage of these hard times? By that I mean, who has restructured, consolidated, and gotten their costs in line? These are the ones that may be well positioned to return to profitability once a recovery takes hold and demand rekindles. Here are some that I am taking a closer look at:
Financials: Survival of the fittest
I’m bullish on the financials sector, which was in the eye of the 2007-09 storm. Since then, financial executives have gone through the painful process of writing down bad assets and raising capital to strengthen balance sheets. As more and more of the weaker players are flushed out, I think the financials sector has a chance to perform well over the next couple of years. Home prices appear to be stabilizing, which should also help bank balance sheets.
Technology: Plugging into the recovery
Over the next 12 months, I see opportunity in the technology sector. As we emerge from this recession, the tech industry is in relatively good shape, in part because it was quick to cut production and lower inventory levels as demand slowed early on.
Solar: Here comes the sun
Alternative energy is going to be an important secular growth driver for the equity market down the road. In particular, I see solar businesses as an opportunity that got derailed during the recent downturn. As the global recovery takes firmer root, the economics of solar energy could brighten up again.
Out of favor — but too compelling to ignore
Finally, there are always stocks where expectations are very low and their valuations are just too compelling to ignore. Pharmaceuticals are among those areas currently out of favor.
Jed Weiss manages Fidelity International Growth Fund (FIGFX) and Fidelity International Small Cap Opportunities Fund (FSCOX), and co-manages Fidelity Total International Equity Fund (FTIEX).
Think emerging markets
In some ways, the recent global crisis unmasked the U.S. and Western Europe as the real emerging markets. We were the ones with the huge fiscal and credit deficits, debt loads and troubled financial system. A lot of emerging market countries found themselves with ample reserves, trade surpluses and relatively healthy financial sectors. All the more reason to have a portion of your equity portfolio investment in emerging markets — yes, even after the Dubai World debt default, which briefly roiled world markets. Of course, broad diversification is key. You never want to be tied to any one country, currency or sector.
Favorable countries: Brazil, Turkey, South Africa
I find myself investing more in Brazil, Turkey, South Africa and greater China — not necessarily China itself, but the surrounding countries benefiting from Chinese growth, like Singapore. Each of these countries offers penetration opportunities for financial products and consumer-oriented goods from mortgages to autos to clothing to beer. A sound research process can help uncover hidden treasures in emerging markets because they are less efficient than U.S. markets. By that I mean, there are fewer buy-side and sell-side analysts looking at any given company. I’ve often visited firms in Southeast Asia, Africa or Latin America that no other investment professional has talked to for a while.
To Russia with love — not
My greatest success in finding stocks that fit my investment parameters — multi-year growth stories with high barriers to entry and cheap valuations — have lately come from Brazil. But I’ve also successfully invested in Turkey, South Africa, India and China. I’ve had less success in Russia, a sometimes challenging market for private enterprise. The government there can be heavy handed and unpredictable in its regulatory and business dealings.
China syndrome: Surging
Government stimulus has been more effective for China than for much of the rest of the world. Their economy has emerged relatively unscathed and has resumed its pre-crisis boom. I don’t know how long it will last, but for now China is helping to drive the global economy. While I wouldn’t bet the farm on China because it, too, will go through cyclical booms and busts in the future, you can’t close your eyes to this structural growth opportunity.
Japan: Finding small-cap gems
Though my funds tend to be underweight in Japan on the whole, I’m bullish on Japanese small-cap companies. They tend to be domestic-oriented businesses that don’t appear on the radar screen of many investors, whereas Japanese large caps tend to be well-researched exporters that have been hurt by a strong yen. I’ve recently uncovered a number of Japanese small-cap stocks that were extraordinarily cheap, yet growing their earnings at a faster rate than their large-cap brethren. From a cyclical standpoint, small caps have tended to outperform the market in the early stages of an economic recovery.
Inflation: Dark cloud looming
One common concern — to both the U.S. and international markets — is inflation. True, some areas of the market can benefit. Gold, for instance, has the potential to do well. But as the discount rate goes up, stock performance — particularly for financials — tends to suffer. Although inflation doesn’t seem to be a problem currently, it’s something I’m watching closely.
Dubai troubles: Limited exposure
When I travelled to Dubai in the fall of 2008, I took home an important conclusion: Its real estate market was in the late stages of a colossal bubble. Therefore, I’m not surprised by the latest developments there, specifically the concerns regarding Dubai World’s debt. But I don’t believe that the global financial community is susceptible to a contagion similar to what followed the subprime crisis here in the United States. Many foreign banks and investors also viewed Dubai’s growth as unsustainable and thus limited their exposure. That’s not to say that there won’t be losses associated with Dubai World outside of the region, but I think they’ll be relatively contained.
Ford O’Neil manages Fidelity Total Bond Fund (FTBFX) and Fidelity Intermediate Bond Fund (FTHRX) and Fidelity U.S. Bond Index Fund (FBIDX).
Mine is a cautious outlook for 2010. The good news is the U.S. economy is getting better; the bad news is there probably won’t be the typical economic spike that follows many past recessions. I am preparing for a muddle-along economy.
The Fed: Likely on hold for 2010
Inflation does not appear to be building in the near term. I expect prices to rise in the lower end of the recent 1%-3% range in 2010. In turn, I expect little or no change in the federal funds rate next year, although the futures market is expecting a hike before year end.
Inflation protection: Consider TIPS
Once the economy starts to gain momentum, hopefully by the end of next year or early 2011, the big question will become: Does the Federal Reserve have the ability to unwind its quantitative easing policies and start raising interest rates at the appropriate time? If they don’t, that could ignite inflationary pressures in 2011-12. Given that potential, I think treasury inflation-protected securities (TIPS) are an attractive investment with break-evens in the 1.5%-2.25% range. Today, I have about 7% of my funds’ portfolios in TIPS.
Sectors to watch: Banking and financials
Today, far and away, the cheapest sectors in the fixed-income market are banking and financials. With spreads over Treasuries averaging 250 basis points or wider, I’ve been buying securities in these sectors with an emphasis on corporate bonds issued by money-center banks, regional banks, insurance companies, and real estate investment trusts (REITs). Going forward, I expect the spreads to continue tightening at a faster rate than those of utilities and industrials—and that’s the way I am positioned. However, I would caution that we are likely in the seventh or eight inning of this spread-tightening scenario.
High yield: Still in play
Following a horrific fourth quarter in 2008, the high-yield sector enjoyed an extraordinary 2009. A year ago, many pundits were anticipating default rates in the 15%-20% range for bonds rated BB or less. However, according to reports from S&P and Moody’s, default rates will likely be closer to mid-single digits for the 12-month period ending December 31, 2010. Although I think the majority of capital gains have been wrung out of the high-yield market, signs seem to indicate a double-digit yield on our non-investment-grade bond portfolio going forward. And, in a low-interest rate environment, that looks very attractive.
Mortgage-backed securities: Buying opportunity ahead
My bond portfolios have been underweight in agency mortgage-backed securities because, in my opinion, the government has artificially depressed the level of mortgage spreads in buying $1.25 trillion in mortgage-backed securities to restart the housing market. My team’s strategy is that when the mortgage-purchase program ends on March 31, 2010, we may be able to buy these same assets at a cheaper price because the largest buyer of mortgages over the past year — the U.S. government — will be out of the market.
In conclusion: What to do?
Don’t swing for the fences with any of these ideas. The key is weaving them into a well-balanced investment mix that aligns with your goals and time frame. Getting that right can be critical to the overall performance of your portfolio.