Muddle through.
That's the sort of euphemism that might send money managers scrambling for meaning, much as they do whenever Fed Chairman Alan Greenspan speaks, but it's exactly how Merrill Lynch Investment Managers President and CIO Bob Doll characterizes the capital markets in 2005.
"Some pluses, some minuses, no big numbers," Doll said of market returns for the first six months of 2005, during a recent mid-year investment update.
"A muddle-through environment [is] a lot of rallies, only to be followed by declines, and vice versa, and we think we'll get more of that as the year unfolds."
For example, cash gained 1.3% over the first six months of 2005, while 10-year U.S. Treasury bonds added 4.1% and U.S. high-yield bonds rallied by 1.1%. But 0.8% loss in the S&P 500, a 5.1% deficit in Nasdaq and a 3.7% drop in the Dow Jones Industrial Average tempered those pluses.
Such unevenness can also be discerned in the behavior of mutual fund investors thus far in 2005. While mutual fund stock investors added nearly $150 billion to their holdings during the first half, according to New York research firm Strategic Insight, that money is broadly diversified between international and U.S. equities and fund-of-funds. Furthermore, value continued to dominate growth.
Value Rules
"With investors' tendency to react to, not anticipate, the cyclicality of style trends, value funds may continue to lead investors' demand during the coming months," said Avi Nachmany, director of research, Strategic Insight.
According to Financial Research of Boston, international fund flows netted roughly $76 billion over the first six months of 2005, versus $50.8 billion in the first six months of 2004. Domestic equities, however, have netted just $36.2 billion so far this year, down a whopping 72% from $108.27 billion over the same period in 2004.
Perhaps more dramatically, data from New York-based Lipper indicates that through the first five months of 2005, U.S. domestic equities have eked out just $2.94 billion, as opposed to $75.73 billion through he first six months of 2004.
The broader markets, however, are gathering a bit of momentum, Doll said.
"Over the last quarter and year-to-date, there has been some recovery in the equity markets after a disappointing first quarter," he said.
Doll expects the two-steps-forward, one-step-back environment to persist throughout the year, although he does anticipate that equities will enjoy a modestly better second half.
"When all is said and done," Doll said, "equities will have been, as was the case in 2004, the financial asset of choice."
Lack of Clarity
So what's been holding investors up?
First and foremost, Doll said, is a lack of clarity surrounding short-term interest rates. On June 30, the Federal Reserve completed its ninth consecutive interest rate hike, moving rates to their current 3.25%. Another hike is expected when it is scheduled to meet this Tuesday, although Doll and many of his colleagues feel that might represent the end of the tightening cycle.
"The consensus says at least one more increase, and then they'll stop," he said. "The struggle the equity market has had is the uncertainty of how far the Fed will go and what will the economy and the earnings environment look like when the Fed is finished. Once the equity market gets some more visibility and confidence around that, we can have some further rallying.
"In fact that's the main reason we think we've had the rally in the last month or two," Doll reasoned.
Stock Rally
Although it will take a stronger second half, Doll fully expects the stock market to outperform cash and bonds for the third consecutive year.
History, he said, is on his side. For instance, the average gain in the third year of the eight bull markets since World War II is 2.9%, which isn't a far cry from the 3.1% gain Doll predicted at the outset of 2005.
In addition, growth in the first years of the 14 presidential election cycles since World War II has been somewhat slower than the second half. Finally, since 1929, all years ending in five have witnessed positive gains in the S&P 500.
Despite his optimism for the equity markets, Doll does foresee a slowdown in U.S. GDP growth, from 4.4% in 2004 to a high of 3.5% in 2005, and consumer spending from 3.7% in 2004 to less than 3.5% in 2005. Again, he cites short-term interest rates, as well as rising energy prices and an uptick in the U.S. dollar as laggards on growth.
"It is not a disappointment for growth to slow in 2005, it's just that 2004 was so strong and, frankly, for an economy as big and mature as the U.S., unsustainably strong," Doll said.
The U.S., however, is not alone. Doll's group thinks economic growth will slow around the world. Asia will continue to lead, with real GDP growth of about 6.7%, Europe will bring up the rear at roughly 1.8%, and the U.S. will fall somewhere in the middle, returning a GDP of about 3.0%. Not surprisingly, China will continue to lead singularly with a projected real GDP growth of 8.0% in 2005.
What the world's economy does not need, Doll warned, are trade barriers, like the 2.75% tariff Senators Charles Schumer (R-NY) and Lindsey Graham (R-SC) have proposed for Chinese imports. Following a meeting with Federal Reserve Chairman Greenspan and U.S. Treasury Secretary John Snow more recently, the Senators decided to postpone a vote on the legislation.
"Protectionism is dangerous," Doll said, adding that such trade barriers hamper the ability of individual countries "to do what they do best and slows the growth rate around the world. So any and all of those kinds of notions are, from our point of view, not good for the capital markets."
Disappointments' Ahead
In terms of corporate earnings growth going forward, Doll is stepping back slightly from the 10% he predicted at the beginning of the year. Doll's group now expects profitability growth of somewhere between 5% and 8%, as consumer demand and productivity slow, unit labor costs increase and energy prices remain high.
"Disappointments will come in the second half of the year," Doll said.
As far as interest rates, Doll anticipates that year-end Federal funds rate will be 3.5% and that the yield on the 10-year note will finish above 4.5%, but slightly lower than the "5-handle" his group predicted in January.
Merger and acquisition activity should accelerate through 2005, Doll continued, while oil prices should remain stubbornly high.
Inter-party bickering will drown any meaningful, market-friendly legislation in Washington, and although the budget deficit should shrink by $75 billion to $80 billion, the trade deficit and current accounts deficit will continue to be problematic and unsustainable.
So how will Doll, who manages $500 billion in equity and fixed-income mutual fund assets at Merrill Lynch, navigate this muddling through environment? By picking high-quality companies with high-quality balance sheets, he said.
"Consistent with that is size," he added.
"Large tends to outperform small when profit and growth decelerate."
Exposure to the energy patch, greater global and international representation and underweighting in consumer goods and services also typifies a Merrill portfolio, he said.
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