Recovery slow, but sustainable

Investors worried that the market’s recovery ended in October should remain calm but cautious as the coming year will see a sustained economic recovery in North America, according to the chief investment officers at one transnational private bank.

Momentum is driving the market, and since July, that has been tilted in favour of bulls, says Jack Ablin, chief investment officer of Harris Private Bank, Chicago. Investors have become sanguine, he says, though not quite optimistic.

“Given that we do expect we’re still in a sideways market with a big cycle up and down, we’re going to continue to put the momentum indicator on a pedestal until it doesn’t work anymore.”

Momentum has driven him to advise an overweighting in equities, but he warns that the recommendation will “soon” shift to a neutral weighting.

“We still believe that equities will be the prevailing asset class for the next four quarters,” he says.

The U.S. market is probably fairly and fully priced, based on price to sales. He said he prefers a target of about 1x sales, while the S&P 500 Index is currently reflecting 1.1x sales, suggesting a 10% increase in corporate revenues in the coming year, which, Ablin says, is not out of line.

“From a secular perspective, there is no doubt that emerging markets will dominate from an economic point of view and clearly will drag their equity markets along with [them],” he says. “Near term, I’m somewhat concerned that valuation of emerging [markets] is a little bit expensive relative to the U.S.

“Perhaps when we get this new next down cycle, maybe some time next year, the emerging markets will likely suffer more than the United States or, if we do gain, will incrementally trail.”

Over the next 12 months, Ablin predicts U.S. economic growth of between 2% and 2.5%, pointing out that 3% growth would likely be achieved only with a return to consumer debt-spending.

“We were growing an economy faster than it should have grown,” he says of the last economic run-up. “Now, not only do we have to earn more than we spend, but we have to spend incrementally less to pay back the debt.”

The 2.5% predicted growth rate will likely limit job creation to between 50,000 and 100,000 per month. At that rate, it could take more than five years for employment to recover the 7.5 million jobs lost in the downturn. Neither policy-makers nor the workforce will tolerate such a delay, so Ablin expects more stimulus is on the way.

“Policies will be implemented in some fashion to ‘shoehorn’ workers into an economy that can hardly accommodate them and that ultimately will result in inflation,” he says, but investors probably won’t have to worry about it for another three or four years.

Ablin’s Canadian counterpart agrees that a sustained recovery is the most likely scenario, with the Canadian economy expected to grow by more than 2.5%.

“We certainly think we’re in a global synchronized economic recovery,” says Paul Taylor, chief investment officer of BMO Harris Private Banking, Toronto. “We do believe that policy-makers have taken the right course of action [and that] a sustainable recovery is the odds-on bet.”

He warns, however, that the recovery will be fuelled by a return of confidence in the financial system and that if that confidence is again shaken as it was in 2008, the recovery could come crashing down.

He recommends an overweight position for equities, at about 55% of the portfolio (compared with a 50% neutral weighting), because the returns on fixed income and, in particular, cash, leave little alternative.

“Inflation is not a near and imminent danger, but we believe that yields of 3.35% on 10-year Canada [Treasury bonds] are not adequate compensation for the inevitable risks that are down the road, probably 24 to 36 months.”

Within the equity space, he says he is biased in favour of cyclical sectors, selling off utilities, healthcare and consumer staples stocks and adding to positions in technology, consumer discretionary, materials and energy.

Canadian banks were unfairly tarred with the same brush as their global brethren, selling off in 2008, but Taylor says he feels vindicated in holding on to them. He is now looking for opportunities to rotate out of banks and into life insurers and asset management firms.

“The risk at this point in time may be that folks get too conservative, too soon and that they underestimate the longevity of the turn that we have seen,” Taylor says.

(11/04/09)