Welcome to the summer of 2012, investors. The U.S. markets, like the weather, have been strangely moody — with sudden storms, drought conditions and an overall sense of uncertainty clouding the landscape.
For the third straight year, stock markets began the year with healthy gains only to decline on fears of a global economic slowdown, say analysts with T. Rowe Price Investment Services in a summer outlook published Wednesday.
Nevertheless, the T. Rowe analysts say, the total return of the S&P 500 Index was up 9.49%, which put the U.S. markets well ahead of the international markets.
“The solid U.S. gain testified to the slow but sustained recovery of the American economy, given that markets faced significant obstacles,” according to the report, which notes that the continuing eurozone crisis, slowing Chinese growth and the looming U.S. fiscal cliff have meant no end to the “risk on, risk off” trade as the third quarter begins.
So what’s an investor to do in the summer of 2012? Here’s what the experts at T. Rowe Price say:
Investors this summer are seeking solid ground despite the United States’ economic struggles. While there is optimism that the slow expansion is intact, according to T. Rowe Price Chief Economist Alan Levenson, U.S. policymakers must refrain from jumping off the “fiscal cliff” and seek broader fiscal reforms. Certainly, this will become a more pressing issue as summer gives way to fall even with the ray of hope from the spending deal announced Tuesday.
The fiscal cliff of tax increases and spending cuts scheduled to take effect as of Jan. 1 are a major source of uncertainty for the U.S. outlook, writes Levenson, who anticipates that the U.S. housing headwind has not entirely subsided and should keep real GDP growth in a 2.0% to 2.5% range through next year. But Congress’ failure to act on tax and spending cuts would amount to a fiscal tightening of about 3% of GDP, he warns.
“Policymakers are aware that such a blow could well tip the economy back into recession. We—like most forecasters—assume that about half of the force of these measures will be deferred into 2013. An additional 12-month extension of the Bush-era tax cuts would fit this bill. Alternatively, an extension of just the middle-income tax cuts and a deferral of the super committee budget sequestration would have a similar impact,” Levenson writes.
A wave of improved natural gas and oil extraction has given rise to a seismic shift in U.S. energy production, says Tim Parker, T. Rowe Price’s natural resource stock portfolio manager, in this short video.
“Manufacturing companies have in the past few decades felt that they were working at a cost disadvantage relative to the rest of the world. Now, because prices are so cheap in the U.S., with gas being so cheap and oil cheaper than average, they’re at an advantaged cost position,” Parker says.
Environmental concerns aside, fracking has resulted in a substantial pickup in natural gas and, increasingly, oil production, he notes. For example, U.S. natural gas supply skyrocketed 12% year over year in January. But demand has grown at only about 1% per year, and this means that consumers as well as industrial companies are now benefiting from lower energy costs.
For investors, lower prices may challenge energy producers, but they also should create the following opportunities, according to Parker:
- Energy producers that maintain low operating costs or find new reserves are still attractive.
- Chemical and paint companies using natural gas-linked hydrocarbon inputs may have a cost advantage over global companies using oil-linked hydrocarbons.
- Heavy energy users, such as metal fabrication and steel production companies, also are attractive.
T. Rowe Price asset allocators are leaning more than usual toward stocks, according to company Chairman and CIO Brian Rogers, who asserts that stocks retain a valuation advantage over bonds.
“There are plenty of headline challenges, but this is nothing like 2008,” he says in reference to the last global financial crisis. “Financial system liquidity is strong, valuations reasonable, and earnings growth positive, and there’s a lot of cash kicking around in the world. If you look at companies’ fundamentals, the progress is reasonably good.”
Rogers says investors should seek high-quality large-cap companies with low valuations, stable earnings, good dividend yields and promising dividend growth.
T. Rowe analysts recommend that investors look beyond the challenges to these opportunities in equities:
- The relative haven of U.S. stocks, as led by large-cap growth stocks
- Stocks in the U.S. technology and, yes, financial sectors, which should continue to do well.
- Quality emerging market and European stocks, which are trading at discounts.
The midyear outlook for bonds is murky given the risks muddying the global economy and U.S. Treasury yields sunken near record-low levels, says Steven Huber, manager of the T. Rowe Price Strategic Income Fund.
“There are a lot of risks, the primary one being the debt crisis in the eurozone,” Huber says. “We are also seeing slowing growth in China and emerging economies, particularly commodity-based economies. And we have the fiscal cliff coming up after the U.S. election. We don’t know if the Federal Reserve will provide more support to the economy through quantitative easing, though we do not think it is a certainty.”
Given the market’s low yields, T. Rowe Price’s analysts say investors may find better returns in high yield bonds, bank rate loans, investment-grade bonds, and emerging market bonds.
Municipal bonds have provided stellar returns this summer, with yields in excess of Treasuries, according to T. Rowe Price analysts.
Aside from a few defaults in municipalities such as Jefferson County, Ala., and Stockton, Calif., the market’s overall credit quality remains high. And clearly, with so many small issuers in such a large market, independent research is essential, says Jim Murphy, manager of T. Rowe’s Tax-Free High Yield Fund, who notes that the Barclays Municipal Bond Index had a total return of 9.9% for the 12 months ended June 30.
“In absolute terms it’s hard to get excited about investing in yields of around 4%, but yields have declined significantly among all fixed-income sectors,” Murphy writes. “So in a relative sense, munis are certainly attractive for investors in high or medium tax brackets. A 4.5% muni yield would equate to a taxable yield of 6.9% for someone in the top tax bracket.”
For more on summertime investing, read Best 5 Investment Picks for Midyear 2012 at AdvisorOne.