Search for Yield Causing Risky Behavior

CHICAGO – Investment experts say the U.S. economy is heading for an abrupt wakeup call.

With the Federal Reserve keeping rates unchanged, experts at the Morningstar Investment Conference this week note that the economy is full of unfulfilled expectations and some are predicting that the marketplace is heading for a potentially devastating jolt.

“It’s really been a complacent market place,” says Bob Johnson, Morningstar’s director of economic analysis. “That probably is bound to be broken at some point, and it will probably be rather drastic.”

Johnson and other participants in a research roundtable dissected why they share an uninspired view of the market. Moderator Scott Burns, Morningstar’s director of global manager research observed some unusual trends. “Complacency, lowering of interest rates… That doesn’t jive with where people have been putting their money,” he said, calling on Russ Kinnel, director of manager research for Morningstar, to elaborate further.

“People have been buying lots of bets on potential rises of non-traditional bond funds, and loan funds until recently,” Kinnel said. He also noted the outflows on bank loans and that investors are “flipping” on U.S. equities after investing heavily.

“We saw $6 billion in outflows in May,” he said.  “Maybe it was just a blip, but it’s truly unusual, because of that complacent environment.”

Daniel Needham, global chief investment officer for Morningstar Investment Management, noted that low rates are driving investors to explore riskier options.

“The influence of having very low rates has meant that people have had to search for different places to generate returns,” he said.

“I think we’re in an environment where people who used to get 5% yield from a Treasury bond are now earning [similar amounts from] bank loans or high-yield rates,” he explained. “Despite the fact that this…doesn’t feel like 2007 or 1999, investors are taking much more risk to generate their returns.”

“Everybody is pretty uncomfortable when you have to take risk to generate returns,” Johnson said. Still, in this difficult market, he agreed that bonds need reconsideration, especially long-term Treasury bonds.

The participants were largely unmoved when the Fed announced its relatively optimistic outlook for the economy on Wednesday. The central bank lowered its 2014 forecast to about 2.2% (from an original prediction of about 3%) mostly because the harsh winter caused a significant economic pullback and put the original prediction out of reach. The expectation for 2015 is still about 3% to 3.2%

Despite the downgrade, the Fed said it plans to continue its phase out of the bond-buying stimulus program.

Equity Holdings

As for portfolios heavily-weighted in stocks, Johnson said, “You need something to balance that, and you don’t want to balance that with something that’s almost as risky.”

Michael Holt, global head of equity and corporate credit research for Morningstar, said his firm’s bottom-up research of 1,400 companies found 4% were overvalued. The remark drew gasps from some in the roundtable audience, noted Burns, the moderator.

To find the most attractive firms, he offered Morningstar’s approach, which is to examine companies by geography, sector and quality.

Looking at the firms geographically, stocks in Morningstar’s coverage of U.S. companies showed 6% were overvalued. European firms had 4% valuation. And Asia/Pacific names were more among the fairly valued.

On a sector level, basic materials and energy are fairly-valued, “So they are the most attractive,” said Holt. “The higher, or more expensive spectrum, are really the technology and utility stocks, which investors are chasing.”

Looking at quality, Burns said Morningstar uses its research to find firms that have a durable, competitive edge. He said he envisions an “economic moat,” around firms, to illustrate how they protect their profitability.

“If it has a viable economic moat, it’s got very good protection,” he said.

Applying a “quality lens,” he said, finds that U.S. firms without a moat are 10% overvalued. “Firms that do have this higher mote characteristic, only 3% are overvalued,” he said.

“Paying fair value for a company, you still expect it to compound, you still expect it to generate returns and be cost effective, so I’d much rather be taking comfort in these high quality stocks, he added.

Burns, returning to the 4% overvaluation, said he didn’t want audience members to believe they were being told to go into cash. But he admitted, “As a portfolio manager, it’s got to be hard to come to work these days.”