06.28.2012
By Terry Flanagan

Institutions Eye Opportunities Despite Economic Uncertainty

With the constant barrage of news and headlines coming out of the eurozone, investment managers have been looking for opportunities in more non-traditional areas.

“We are now buffeted by relentless headlines from Europe,” said Michael Lillard, managing director and chief investment officer of Prudential Fixed Income Management. “We know it’ll be messy and there will continue to be headlines but, at the end of the day, we think European policymakers will keep it together.”

Prudential is forecasting a modest recession in Europe this year but is predicting a 2% rise in GDP in the U.S. and a 3% increase in global GDP. These figures are not great, but, equally, are not terrible either given the macroeconomic conditions. Prudential believes that growth will be slow with high unemployment, which will lead to low inflation and a low interest rate outlook.

“The 10-year Treasury is at 1.6% and Bunds in Germany are at 1.5%, so we don’t see any value there,” said Lillard. “The opportunities we see are in the credit sectors, particularly in high yield.”

While investors tend to prefer the safety and security of U.S. Treasuries, yields are at 50-year lows and the real interest rates on some government bonds are closer to zero, or even negative. On the other hand, high-yield credit is starting to become more attractive to investors seeking more substantial returns on non-investment grade bonds without incurring substantial risk.

“The quality of credit now is high,” said Lillard. “Companies are managing themselves conservatively, and they aren’t aggressively hiring. The precursors to default typically in high yield aren’t there now. The value is in the high-yield marketplace.”

Interest in emerging markets is also gaining in popularity again. While Latin America and Asia were hot topics of discussion over the past several years, that talk has died down as reality has set in and growth in those regions has plateaued.

“We also see opportunities in the emerging markets in local currency and debt,” said Lillard. “In developed countries you have what are essentially negative or zero real interest rates, but you can easily find 5% or 6% real interest rates in some of the emerging markets.”

While Europe continues to dominate the headlines, uncertainty is also a key topic in the U.S. markets, both politically as well as financially. Investors and corporations have taken a ‘wait and see’ approach as it pertains to the upcoming presidential election in November and also with where monetary policy is headed.

“We are the cleanest dirty shirt in the laundry,” said Edward Keon, managing director and portfolio manager at Quantitative Management Associates, a unit of Prudential Investment Management. “But at least we’re growing, particularly compared to Europe where most countries are in or are entering recession. The emerging markets of China, India and Brazil have slowed down dramatically. The optimism to start the year has slowly faded as the economy has slowed down significantly in the Spring.”

However, signs still remain that a turnaround may be just around the corner.

“Earnings forecasts haven’t slowed down as much, so that could be good sign,” said Keon. “Valuations are at a good value, but they’re not as cheap as in 2009. In the long run, stocks will be a good place to be, and will offer returns in the high single-digits over the next decade.”

Michael Pytosh, head of equities at ING Investment Management, added: “Europe is a big problem right now, but the U.S. and Asia may look much better six months down the line.”

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