“The recovery is over. Welcome to the expansion,” independent broker/dealer giant LPL Financial Corp. asserts in a mid-year outlook report released Thursday, July 8, that expects the U.S. economy and markets to stay on course for growth in 2010.
LPL Financial predicts in its outlook that economic growth will slow from its current 3% to 4% range to a below average 2% to 3% in the second half of the year. Stocks are expected to post modest single-digit gains on solid earnings and high volatility, while bonds are seen posting flat to mid-single digit gains as interest rates slowly begin to rise.
“You look at the data points and you see that GDP has now surpassed its pre-crisis peaks,” said John Canally, LPL economist/investment strategist and one of the report’s authors, in an interview. “That’s a sign that the recovery has ended, and we’re in an expansion where the economy can resume growing rather than recover. And we want to signal to investors that the easy part is over. Governments threw a lot of money at the problem and a lot of fiscal stimulus, a lot of monetary policy, and we got recovery. The hard part is to hold onto it and churn out an expansion.”
The report concludes with investment recommendations that focus on yield, particularly the asset class of high-yield bonds.
“In an environment where volatility is the primary characteristic, LPL Financial Research prefers strategies that focus on the income stream of an investment rather than solely on potential price appreciation to generate total returns,” the report says. “Our favorite way to increase yield remains the high-yield bond asset class. In addition to offering a solid yield, this asset class benefits from contracting yield spreads and improving financial conditions of underlying issuers.”
When interviewed, Canally explained that the high-yield space will benefit from the expansion because the corporate default rate is low and companies are enjoying a lot of cash flow that presents “more exit strategies for high-yield issuers these days,” including initial public offerings.
“The high coupon in the high-yield space acts as a good cushion for volatility,” Canally said. “You can get a coupon on a high-yield bond of 7%, 8%, or 9%. If you’re getting a semi-annual coupon averaging 8.5%, if nothing else happens, you’re getting an 8.5% return, and that will smooth out some of the volatility in other markets, like equities. That’s a way to lock yourself into a pretty decent return stream, and we also think you can still get some price appreciation in high yield as the economy recovers.”
The long-term average of high-yield spreads to Treasuries is 500 basis points, Canally noted, but in December of 2008, high-yield bonds were 2,100 basis points over Treasuries, and earlier this year spreads were as low as 575 basis points over.
“We are currently at 720 bps over, so there probably is room for some further contraction in spreads (price return) on top of the 8.5% coupon (income return) available on the average high-yield bond,” Canally wrote in an email.
The LPL report also recommends the “stable fundamentals” of real estate investment trusts that cushion portfolios from unexpected market volatility, emerging market bonds that offer exposure to fast-growing economies, and dividend-paying stocks.
Using a sailing metaphor to lay out their argument, the report’s authors said that back when they were preparing their original 2010 outlook in late 2009, they foresaw a challenging 2010 second half as “extraordinary global policy efforts that created tailwinds for markets in 2009 would fade, or even transition, to headwinds.”
But, they noted: “We now believe some of the tailwinds we cited are likely to be with us for longer. For example, the Federal Reserve is less likely to hike rates this year given the continuation of low inflation and the emerging concerns in Europe, leaving potent monetary stimulus intact. However, some of the headwinds we anticipated in the second half of the year have hit us sooner, such as China’s slowdown fears.”
Now, at the midpoint of 2010, sustaining the recovery as the stimulus begins to fade “is the hard part,” the report states. “The pace of economic growth is likely to slow, and the two-steps-forward, one-step-back pattern of data points will contribute to volatility.”
With approximately 2,500 employees and offices in Boston, Charlotte, and San Diego, LPL Financial is the nation’s largest independent broker dealer. The firm, which in June announced plans for an initial public offering of common stock, reported record net income for the first quarter of 2010 of $25.6 million, an increase of 72.7% compared with $14.8 million in the prior year period.
Read a story about LPL’s June IPO announcement from the archives of InvestmentAdvisor.com.