NEW YORK - Don't tell James Swanson there's a recession brewing.
Sure, as chief investment strategist at Boston-based MFS Investments, he's obliged to be optimistic outside the office, but Swanson says persistent rumors on Wall Street of an impending recession simply run contrary to some of the industry's most basic economic indicators.
For starters, Swanson said during a 2006 economic outlook in midtown Manhattan last week, corporate earnings through this year stand at about $74.36 a share, or roughly 13% ahead of last year. Secondly, corporate profit as a percentage of GDP, or after-tax income that's being booked by businesses ranging from neighborhood pizza parlors to blue-chip heavyweights like General Electric, is at a 40-year high.
"If you're looking for signs of deterioration, you're sure not finding it in this part of corporate America," said Swanson, who believes the economic cycle is at its mid-point. "The owners of capital are doing quite well."
Drilling down even further, MFS research reveals other positive signs. For example, Swanson offered, business spending, which typically accompanies any surge in corporate earnings, is growing at a brisk pace of 15%. That number takes into consideration the fact that consumer spending has grown downright anemic.
"That 20% of the economy that is not consumer-driven is continuing to move up quite nicely, and we certainly shouldn't expect any contraction," he said.
And, finally, the average wage and benefit increase for American workers is running close to 6%, which is substantially above its 10-year average. New job creation, meanwhile, is clicking along at a pace of about two million annually. Based on an average income level of $30,000 a year, those two factors combine to overwhelm economic drags like rising mortgage rates and soaring energy prices, Swanson said.
As for the red flags that traditionally signal a recession, Swanson doesn't see any.
For example, corporate debt hasn't expanded over the last few quarters; in fact, companies are borrowing less. Capital expenditure, a key barometer for the manufacturing industry, hasn't declined over the last 12 months; it's actually risen. Corporate interest coverage, or the ability of a company to pay interest on its debt, isn't declining; it's at multi-year highs. Corporate borrowing hasn't exceeded cap-ex spending levels; it is generally subdued and in many cases is declining. And lastly, inversion of the yield curve, where short- and long-term Treasury notes fall precipitously over an extended period and cause a corresponding lull in the equities markets, hasn't occurred either.
"So, if you're looking for a recession in these time-honored ways, I don't see it," Swanson said.
As for the shock from Hurricane Katrina, Swanson said the nation's economy has proven to be awfully resilient in the wake of other major storms. Historically, the nation has bounced back a month afterwards. The key to determining how the markets might behave, he said, is to examine exactly what areas were most impacted.
"If you look back over history, the knee-jerk reaction is the wrong one," he said. "The second lesson is that these shocks have huge idiosyncratic effects on the marketplace, different sectors, different companies." The mid-point of an economic cycle also tends to be a stock-picker's market, as opposed to a beta market, which exacerbates the issues, he added.
Hurricane Andrew of 1992, for example, primarily destroyed housing. As a result, the home building sector surged by more than 45% between the first month after the storm and six months after the storm. Energy and oil services stocks suffered. By comparison, Hurricane Ivan of 2004 wreaked havoc on the energy and oil services and destroyed homes. As a result, after six months energy stocks were up 28.5% and oil gained 15.5%. Housing stocks witnessed a modest increase.
"So you move from more of an index-type market, to more of a careful where you step' market," he said.
As for the disastrous energy shock that many were anticipating, Swanson said it went unrealized because the nation, in terms of energy consumption per dollar of GDP, is half as dependent on energy for heating and transportation than it was 30 years ago.
But in the end, Swanson added, the economy has held up so well in light of recent shocks, "because these cycles are deeply rooted in systemic origins, things that really were under way three or four years ago. They're very hard to kill. When you have corporate America in this strong shape and a consumer who continues to make money, we don't see a recession on the horizon."
In fact, Swanson thinks the days of big booms and deep recessions might be over.
"It's either monetary policy or outsourcing inventory, but GDP volatility is being dampened out. Not taken away entirely, but it sure has become less drastic."
Turning to the equity markets exclusively, Kevin Beatty, a portfolio manager in the large-cap core equity discipline at MFS, said the industry should gravitate toward growth stocks a bit more in 2006, although growth valuations are basically on par with value. Large-cap stocks are also becoming more attractive, he said, as earnings growth will decelerate to about 7% in 2006 and create a more favorable environment for blue-chippers.
"We've found that in an environment of decelerating earnings, large-cap has outperformed nicely," said Beatty, who also serves on the management team of the firm's Massachusetts Investors Trust Fund, America's oldest mutual fund.
Large-cap stocks will also put forth higher-quality earnings in 2006, Beatty said, because their accounting and governance procedures have undergone greater scrutiny than that of small- and mid-cap companies.
"The numbers that they are going to put up are going to be very clean, going forward," he said.
As such, MFS portfolio managers will favor large-cap growth stocks in sectors like healthcare, "where we see fundamentals very strong and demographics very strong, as well; a couple of ideas in tech and a couple of selective ideas in terms of financial," he continued.
"The flip side to that is, generally speaking, we're not big fans of the financial [sector], particularly regional banks, where we see the revenues very hard to get to and expenses going up," Beatty said.
On the international front, Thomas Melendez, a portfolio manager in international equity portfolios at MFS, said emerging market stocks would play a more integral role in well-diversified portfolios in 2006. That's because the consistent boom-and-bust cycle of markets in countries like Russia, China, India, Latin America and Eastern Europe have been stabilized through structural reforms that were implemented several years ago. That's given way to sustainable economic growth.
Evidence of that, Melendez said, is the remarkable fact that emerging markets have significantly outperformed U.S. and developed international markets over the one-year, three-year and five-year periods, and that outperformance has continued in 2005.
The balance sheets of emerging countries have never been stronger, he added. Interest rates and inflation rates have come down significantly, and most emerging market currencies are no longer pegged to developed countries. In fact, many are free-floating.
"The risk profile has come down as emerging countries have done a great job of getting their economic houses together," Melendez said.
Emerging market countries are also putting forth more than just cheap labor these days, he noted. China and India, for instance, are graduating more than 500,000 engineers and scientists annually. By comparison, the U.S. graduates 60,000 every year. Demographics are favorable, too. About 50% of the people in emerging countries are under the age of 25, which means there's lots of pent-up demand and room for growth.
MFS favors basic material commodity companies and raw material extraction companies. In a well-diversified portfolio, they demand a 5% to 8% representation.
On the fixed-income side of the business, Michael Roberge, chief fixed income officer at MFS, said expectations are that the Federal Reserve will continue its "quarter-percent" strategy over its next three meetings and hike short-term interest rates to 4.75% by the end of the first quarter of 2006.
Ten-year Treasury notes are expected to stay under 6% next year, Roberge said. Due to cash on corporate balance sheets, MFS is "extremely cautious" in the high-grade corporate bond sector, while risk in the high-yield bond sector has diminished greatly and favors investors.
The bank loan market, however, represents the best opportunities.
"You earn a very nice yield in this marketplace, and you don't take a lot of volatility. We think this is the best place for investors to be positioned in fixed-income today," Roberge said.
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