Pru’s 2013 Predictions: Brighter Economy, but More Washington Brinksmanship

In an annual New York event, Prudential brings together some of its smartest leaders to help educate the press on its annual outlook for the markets and the economy.

The good-news consensus for 2013 at Tuesday’s gathering? An improving worldwide economy, helped by higher housing prices in the U.S., a likely increase in corporate earnings, lower gas prices, the lack of a hard landing in China and sustained growth in many emerging markets, greater stabilization in Europe and continued actions by the world’s central banks. “My guess is that the worst of the financial crisis is behind us,” said speaker Ed Keon (left), managing director for Quantitative Management Associates.

The bad-news possibilities? Some drag on the U.S. economy from higher taxes, potentially disruptive elections in Italy and Germany, the increasing chance of inflation and continuation of “policy dysfunction” in Washington.

How to invest at such a time? Quincy Krosby, chief market strategist for Prudential Annuities, said, “when you have markets driven by [government] policy, it’s impossible to figure out when (is the right time) to get into or out of the markets.” She argued that in such an environment, there’s more risk in “staying out of the markets than being in them” and said that the “barbell” investment strategy she recommended last year at this time remains pertinent:  be defensive on one end of the investing barbell, but take on more risk at the other end.

What kind of government policy are we talking about? “Over the last 16 months, there have been 326 eases or stimulus measures by central banks” throughout the world, Krosby (right) said. There may well be additional such central bank moves as inflation shows signs of returning. “Inflation pressures are building in emerging markets,” she said, a trend she expects to show itself in the second half of 2013.

Saying that we’re currently experiencing the “great muddle-through” in the economy described by Keynes, Krosby also voiced worry that we may not be totally out of the woods. “There may be dislocations hidden under the financial structure,” a phenomenon she called “tremors” that we can’t see right now, so she recommended “taking care of downside risk in both fixed income and equities.”

The “tremors” Krosby referenced are affiliated with the work of Hyman Minsky, the late economist whom Krosby said explored the relationship between risk and the markets (Minsky was dismissed by many mainstream economists, but his explanation of how markets react to speculation and cheap money and euphoria by coming to crisis and then contracting—the “Minsky moment”—gained much credence at the time of the 2008 financial crisis).

John Praveen, chief investment strategist for Prudential International Investments Advisers, half-smiled when he called 2012 “an interesting year,” and expressed the hope that 2013 would also be interesting.

He noted the “dichotomy” evident in 2012 where there were weak economies worldwide but stong markets, suggested that European Central Bank President Mario Draghi “could have been man of the year” for keeping the eurozone in one piece and said that some of the factors that drove the markets higher in 2012 were “still in play.” 

Among those factors, said Praveen (left), were the heightened level of activity by central banks; he said he wouldn’t be surprised to see more rate cuts by the ECB and the Bank of England—”maybe this Thursday,” meaning January 10—and by the Bank of India in the first quarter.

He expects to see further stability in Europe this year, despite elections in Italy and Germany; expects some improvement in GDP in Europe (slight), Japan (some) and in the emerging markets. With valuations “not so rich” in world equity markets, Praveen also expects corporate earnings will improve in all three of these areas.

About that dysfunction in Washington, Mike Lillard, chief investment officer for Prudential Fixed Income, said we can “expect the budget battles to continue in Washington.” Those battles will only produce “small deals” prefaced by “lots of gamesmanship.” Moreover, those small deals will also be time-limited: “they’ll need to be reviewed again in three months or six months.”

That kind of environment, he said, “offsets a lot of the positive news in the economy,” presenting his group’s expectation of GDP growth of 2% in the U.S., 5% in emerging markets and 3% globally. As for other Washington action, Lillard said he expects the Fed to “continue to buy bonds throughout the year” if the unemployment rate only comes down slightly; if the jobless rate stalls, “the Fed will be buying through next year.” As for potentially more bad news, he also said it’s “hard to see getting through the year without further actions by the ratings agencies” on U.S. debt.

So where should an investor look for returns when Treasury yields are so low? Lillard (right) continues to like high-yield debt, arguing that American companies won’t be spending “big” on capital expenses or on hiring. In the high-yield area, he expects “defaults at 2%,” so BB-rated high-yield bonds returning 5% and BBBs returning 6% “are still attractive.”

In addition, “we like U.S. money center banks, since tight regulation will keep risk at a minimum,” and within the structured products area “likes AAA-rated CLOs with floating rates,” which he said are yielding 140 basis points over LIBOR. That floating rate feature of collateralized loan obligations will be particularly appreciated by investors if inlation rears its ugly head.