The following is a commentary by Matthew Rubin, senior vice president and director of investment strategy at Neuberger Berman LLC.
1. A strong year for the economy
We expect to see job growth in the first quarter of 2010 and an improvement in labor and housing fundamentals throughout the year. Initial jobless claims, hours worked, job openings and temporary employment figures continue to move slowly in the right direction, and we believe housing trends could
follow suit. We will closely watch the leading economic indicators for clues pointing to the strength and duration of the recovery.
2. Inflation… not a near-term concern
Inflation typically falls during and following recessions due to high levels of excess capacity. We think inflation is likely to remain in a low range in the near future, but massive stimulus, the resumption of worldwide commodity demand, and an accommodative interest rate policy may open the door to higher inflation down the road. We think equities, commodities and TIPS, which tend to be more attractive in inflationary environments, should be considered.
3. Fed tightening remains months away
Given the Federal Reserve's expectations for stable inflation, we believe they will likely hold off on raising the federal funds rate until they see a meaningful drop in the unemployment rate. As the year progresses, we anticipate investors will focus more on the timing and path of Fed tightening. Look for the Federal Open Market Committee (FOMC) to slowly adjust its language in statements well before raising the target interest rate.
4. Underweight bias on fixed income
Treasury yields essentially have nowhere to go but up — the timing is up to the Fed. While timing is uncertain, history shows that rates tend to move higher as markets begin to anticipate tightening — so if you wait for the announcement, it may be too late. Any increase in interest rates is likely to place downward pressure on the prices of existing bonds, and possibly have a negative impact on the total return of a fixed income portfolio. For investors with income needs and the risk tolerance for equity exposure, equity income products should be an attractive option for income-seekers in 2010.
5. Bullish on equities
We believe the equity markets are fairly valued, currently trading at a price/earnings ratio that is in line with the long-term average. We are bullish on equities for 2010 and believe the equity markets should benefit from further earnings growth as the economy continues to regain its footing. We favor a slight overweight to equities relative to long-term allocation targets, particularly in light of the potential for equities to serve as a hedge against longer-term inflation.
6. Earnings surprise to the upside
Deep cost-cutting in the downturn has positioned many companies with lower costs than average, which should positively impact their profitability in recovery. In fact, 25% of companies in the S&P 500 have already re-attained their prior peak (2007–2008) level of earnings. According to estimates, 40% of S&P 500 companies will be within 5% of 2007–2008 earnings by the end of 2010. We anticipate further top-line revenue growth as economic fundamentals stabilize.
7. Global equity exposure
International equities can provide long-term diversification benefits. What's more, we think it's more attractive to add exposure early in the recovery cycle, as high-growth countries resume their upward trends. Emerging markets in particular, which account for 83% of the world's population, have shown great resiliency in returning to prior levels of economic growth and lack many of the household balance sheet problems that plague consumers in more developed nations.
8. High quality should lead the way
On average, the lowest-quality and most-leveraged companies experienced the largest gains off of the March 9, 2009, bottom. In 2010, we believe investors should increasingly focus on high-quality companies with low earnings risk and compelling valuations. Recent flows and performance across the quality spectrum of equities have become more balanced and supportive of this potential new focus.
9. Sector positioning
Equity sectors tend to exhibit varied performance trends at different stages of recovery or growth. We think sectors with the greatest leverage to the current state of global growth (energy, materials, industrials and information technology with largest portion of foreign sales) have the potential to benefit the most from a global economic recovery. However, much like the potential for a change in performance leadership between ‘high-quality' and ‘low-quality' companies in 2010, we are mindful of changes in sector leadership as the rally matures.
10. A year for stock-pickers
In 2009, only 48% of large cap managers outperformed the Russell 1000 Index1, a trend we think can be partially explained by the phenomenon of a ‘rising tide lifting all boats.' Now that the broad P/E expansion of the early recovery seems to be subsiding, we think 2010 should be a great year for stock-picking. Improving economic visibility and declining stock correlations should produce more distinct winners and losers among equities. We think there is potential for greater active manager outperformance in 2010.
1 Source: Lipper Analytical Services. Based on a peer group of 645 managers in the Lipper large cap universe.
