Fund managers are betting that emerging markets will be the best place for growth in 2010, due to their lack of correlation to the rest of the world and its sluggish, forecasted recovery, but lower correlation does not mean greater safety.
Energy, technology and health-care sectors will lead domestically, but unemployment will likely remain around 10% for at least another six months, forcing the Federal Reserve to keep interest rates low for as long as possible, experts say.
"Long-term growth will be outside the U.S.," said Timothy Clift, chief investment officer at FundQuest. "In the new global environment, the world is so interconnected that whatever happens in the U.S. spreads throughout the world like a ripple effect. Collapses can happen very rapidly."
For all their great potential, emerging markets pose a wide range of unforeseen risks. For example, since Dubai's central bank asked for a six month extension to repay a $60 billion loan, the Dubai stock market has plummeted 27%, and when the Dubai bank made its announcement on Nov. 26, the news roiled stock markets around the globe. The worst hit was Japan, where the Nikkei dropped 4%.
Fund managers also discovered this year that to make up for losses in other areas, they may also be forced to sell uncorrelated asset classes like emerging markets and commodities, causing them to be correlated after all.
"There is a web of complexity tied to the world of global finance and its interlaced agreements," said David Kelly, chief market strategist at JPMorgan Funds. "All these bets should be small bets."
He said 60% of gross domestic product outside the U.S. comes from emerging markets in Brazil, Russia, India and China.
"Every single year this decade, the world has beaten the U.S.," Kelly said. "I expect the U.S. to trail the world in GDP for years to come."
Kevin Shacknofsky, co-portfolio manager of the Alpine Dynamic Dividend Fund, said emerging markets and commodities will continue to outperform other areas and could potentially enter bubble territory if too much capital rushes in too quickly.
Most money managers who hold assets in emerging markets are attracted to their stellar growth prospects, lower overall debt levels, improved transparency, sounder macroeconomic policies and rising currencies, according to the USAA Investment Management Company.
The case for investing in developing markets is not as strong as emerging markets, but "the country of domicile of a corporation is becoming less important than where its revenues are derived," the USAA said.
"There is a pent-up demand for technology, and there are still areas in healthcare that remain attractive," said Jeffrey Knight, head of Putnam Global Asset Allocation at Putnam Investments. One area he is looking at is healthcare technology.
Congress' healthcare reform should also stoke enthusiasm for healthcare stocks, added Dan Chung, CEO and chief investment officer of Fred Alger Management.
"U.S. companies across a number of sectors offer a compelling combination of growth driven by international success, financial and intellectual property strength, and attractive valuations," Chung said. "The technology and industrial sectors are particularly well positioned, as are energy companies providing services and equipment to countries that are investing in and growing their infrastructure."
However, energy and commodities have fallen out of favor. "Energy has been a darling sector for the past decade, but it continues to disappoint on a year-to-date basis and has lagged the market," Knight said. He added that the relative weakness of the energy sector is intensifying, but if it rebounds, it could rebound big.
"From a supply and demand perspective, there is no reason to be positive about energy," Kelly said. "A lot of people are using commodities as an investment play. The whole sector has been hijacked by speculators. I'm still concerned with the financial sector, and we're steering away from utilities and staples."
With unemployment currently at about 10%, many experts are trying to estimate when it will peak and at what level.
"Unemployment rates will stay stubbornly high relative to the past 25 years and will not drop below 8% for next three to four years," said Gary Flam, managing director and portfolio manager of equities at Bel Air Investment Advisors. "Extended periods of high unemployment will lead to low wage growth, since an excess supply of workers will give employers little reason to raise wages."
Kelly thinks U.S. unemployment will peak in the next few months, but will remain high for most of 2010. The recent drop from 10.6% to 10% could be attributed to a boost from seasonal jobs and a growing number of unemployed who have given up looking for work, he said.
"Unemployment always spikes right at the tail end, as people see it's going down and rush out to look for a job," Kelly said. "We should see a sudden surge in unemployment to 10.7% before it comes down again."
Experts say it is unlikely inflation will be a concern with so much slack in the economy, leading most managers to believe that interest rates will stay low for some time.
"The Federal Reserve appears to remain committed to very low interest rates," said Neil Hennessy, president and portfolio manager of Hennessy Funds. "With 30-year U.S. Treasury yields at less than 4%, investors will need to look to the market for more aggressive returns and to stay ahead of inflation, and I believe this will drive increased investment into high-quality equities."
"To say that the market has moved irrationally higher since the March 2009 lows is to say that the March 2009 lows were a reasonable assessment of company prospects," said Thomas Villalta, co-portfolio manager of the Jones Villalta Opportunity Fund. "Mutual fund flows and money market balances do not support the assertion that the stock market is irrationally priced. Indeed, they make the case that the market is under-valued."
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