Putnam bets against US equity optimism
The firm's CIO and head of global asset allocation discusses why US stock prices have yet to factor in a recession, but could nonetheless be attractive against other developed equity markets.
Jeffrey Knight, managing director and deputy head of investments at Putnam Investments in Boston, serves as CIO for global asset allocation. He spoke with AsianInvestor about the outlook for US equities relative to other asset classes.
AsianInvestor: It seems like the US equities market has rallied every time a big financial institution announces another write-down. WhatÆs going on?
Jeffrey Knight: The optimism in the equity markets just never goes away. At this stage we see an opportunity to trade against that optimism.
The S&P500 reached its all-time high just last Halloween, in late October 2007. And since then there have been 10 or 11 single trading days when the financials index gained at least 3%. The market keeps deciding the worst is over for the banks. But over the course of this year the S&P financials index is down nearly 25%.
Bond markets have been pricing in gloomy forecasts for the US economy. Are the bond guys right and the equity guys wrong?
IÆd say the fixed-income markets may not have such cause to be so pessimistic, but many in the equities market are too optimistic. Despite cumulative evidence of trouble in the financial sector, the optimism hasnÆt died. I think a lot of fund managers are afraid to miss the bottom. We believe, however, there is a case to shift exposures out of equities into the credit markets.
Will there be a day of reckoning for US equities?
ItÆs possible. There could be a period when this optimism is finally squared with reality.
What is that reality: after all, US corporate balance sheets are in very strong shape.
The focus is going to change. Until now, both the stock market and the bond market has been focused on the credit crisis. But since the weekend of March 17, when the Federal Reserve drew a line in the sand with the Bear Stearns collapse, the liquidity issues look better. That weekend changed the nature of this crisis. Since then, everything has changed: the dollar has strengthened, particularly against the yen; the bid to gold stopped; the VIX [a volatility index] is down by half ; bond yields have risen; the Treasury yield curveÆs slope has turned positive; and financial stocks have risen in value by 18%. WeÆre not out of the woods yet, but the crisis has been contained. And weÆve seen credit markets also respond to that.
OK, but.
ThereÆs a problem for equities. This has been a technical credit situation that looks like itÆs over for bonds, but not for stocks. The illiquidity among fixed-income instruments is beginning to ease, but the economic problem of credit contraction lives on. The FedÆs actions havenÆt made banks willing to lend. Over time this contraction of credit will become a corporate issue.
At a time of an economic slowdown?
Yes. Consumption drives the US economy, and thatÆs been affected by the problems in the housing sector. Another factor that the optimists overlook is that state and local government spending will also decline, because tax revenues will fall due to lower property prices. Many states by law must balance their books, so cuts in tax revenues will force them to also limit spending.
A lot of fund managers donÆt think the US will enter an actual recession. Do you?
IÆd say a recession is likely, and it will be deeper and longer than the previous ones weÆve experienced because itÆs been preceded by this debt bubble. Leverage exaggerated everything. So equity markets remain vulnerable and look less compelling than fixed-income securities with good credit.
What about against US Treasuries?
No, equities are more attractive than Treasuries. Treasuries have become expensive because of the recent flights to quality.
So should investors get out of US equities altogether?
No, because within the market there are winners and losers. IÆd expect the S&P500 to return something like 6% annualized over the next five years or so, but some sectors will be able to achieve double-digit returns. Tech is in the best position. Large-cap, good-quality companies will outperform, at least for the next year or so.
What about healthcare or energy and resources?
Healthcare faces political headwinds in this country. Energy stocks have compelling fundamentals but they arenÆt cheap, and it may be difficult for these companies to replicate the same growth rate as theyÆve enjoyed in the past few years. They could also be vulnerable to an economic slowdown.
How should non-US investors think about this asset class?
First of all, we suggest clients be more flexible and not be so tied to benchmarks, because the overall index wonÆt provide great returns in this environment. Overall, high-grade credit looks more compelling. But when you compare equities on a geographic basis, I think thereÆs actually a window here for the US stock markets to outperform.
ThereÆs been an exuberance for non-US investing, not just among foreigners but among American mutual fund investors. But the US stock market has actually outperformed just about every other developed-country market except for Germany on a non-hedged basis. And now with the dollar shoring up and slowing growth in Europe and Japan, the US could outperform on a hedged basis as well. American corporations aside from financials are in strong shape, and if they are able to weather the next two years, the US stock market may resume its global leadership. But the risk of recession lies ahead of us, not behind us.
AsianInvestor: It seems like the US equities market has rallied every time a big financial institution announces another write-down. WhatÆs going on?
Jeffrey Knight: The optimism in the equity markets just never goes away. At this stage we see an opportunity to trade against that optimism.
The S&P500 reached its all-time high just last Halloween, in late October 2007. And since then there have been 10 or 11 single trading days when the financials index gained at least 3%. The market keeps deciding the worst is over for the banks. But over the course of this year the S&P financials index is down nearly 25%.
Bond markets have been pricing in gloomy forecasts for the US economy. Are the bond guys right and the equity guys wrong?
IÆd say the fixed-income markets may not have such cause to be so pessimistic, but many in the equities market are too optimistic. Despite cumulative evidence of trouble in the financial sector, the optimism hasnÆt died. I think a lot of fund managers are afraid to miss the bottom. We believe, however, there is a case to shift exposures out of equities into the credit markets.
Will there be a day of reckoning for US equities?
ItÆs possible. There could be a period when this optimism is finally squared with reality.
What is that reality: after all, US corporate balance sheets are in very strong shape.
The focus is going to change. Until now, both the stock market and the bond market has been focused on the credit crisis. But since the weekend of March 17, when the Federal Reserve drew a line in the sand with the Bear Stearns collapse, the liquidity issues look better. That weekend changed the nature of this crisis. Since then, everything has changed: the dollar has strengthened, particularly against the yen; the bid to gold stopped; the VIX [a volatility index] is down by half ; bond yields have risen; the Treasury yield curveÆs slope has turned positive; and financial stocks have risen in value by 18%. WeÆre not out of the woods yet, but the crisis has been contained. And weÆve seen credit markets also respond to that.
OK, but.
ThereÆs a problem for equities. This has been a technical credit situation that looks like itÆs over for bonds, but not for stocks. The illiquidity among fixed-income instruments is beginning to ease, but the economic problem of credit contraction lives on. The FedÆs actions havenÆt made banks willing to lend. Over time this contraction of credit will become a corporate issue.
At a time of an economic slowdown?
Yes. Consumption drives the US economy, and thatÆs been affected by the problems in the housing sector. Another factor that the optimists overlook is that state and local government spending will also decline, because tax revenues will fall due to lower property prices. Many states by law must balance their books, so cuts in tax revenues will force them to also limit spending.
A lot of fund managers donÆt think the US will enter an actual recession. Do you?
IÆd say a recession is likely, and it will be deeper and longer than the previous ones weÆve experienced because itÆs been preceded by this debt bubble. Leverage exaggerated everything. So equity markets remain vulnerable and look less compelling than fixed-income securities with good credit.
What about against US Treasuries?
No, equities are more attractive than Treasuries. Treasuries have become expensive because of the recent flights to quality.
So should investors get out of US equities altogether?
No, because within the market there are winners and losers. IÆd expect the S&P500 to return something like 6% annualized over the next five years or so, but some sectors will be able to achieve double-digit returns. Tech is in the best position. Large-cap, good-quality companies will outperform, at least for the next year or so.
What about healthcare or energy and resources?
Healthcare faces political headwinds in this country. Energy stocks have compelling fundamentals but they arenÆt cheap, and it may be difficult for these companies to replicate the same growth rate as theyÆve enjoyed in the past few years. They could also be vulnerable to an economic slowdown.
How should non-US investors think about this asset class?
First of all, we suggest clients be more flexible and not be so tied to benchmarks, because the overall index wonÆt provide great returns in this environment. Overall, high-grade credit looks more compelling. But when you compare equities on a geographic basis, I think thereÆs actually a window here for the US stock markets to outperform.
ThereÆs been an exuberance for non-US investing, not just among foreigners but among American mutual fund investors. But the US stock market has actually outperformed just about every other developed-country market except for Germany on a non-hedged basis. And now with the dollar shoring up and slowing growth in Europe and Japan, the US could outperform on a hedged basis as well. American corporations aside from financials are in strong shape, and if they are able to weather the next two years, the US stock market may resume its global leadership. But the risk of recession lies ahead of us, not behind us.
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