NEW YORK -- Experts predict equities and equity mutual funds could have a double-digit rally later this year -- if investors respond as they should and flee a future correction in the bond market.

Retail and institutional investors still leery of the stock market have been pumping billions of dollars a week into municipal bond funds (see related story, page one), causing bond prices to soar and stock prices to struggle, but some portfolio managers say they're worried that the natural balance between stocks and bonds has swung off-kilter and may be headed for a short-term price correction.

"Fund flows into open-ended mutual funds that are focused on high-yield investments have been phenomenal," said Daniel Fuss, vice chairman and portfolio manager at Loomis, Sayles & Co. "Capital markets have re-liquefied. I've never seen a snap-around like this before. The money just keeps coming in."

He said so much money is being pumped into the fixed-income area, particularly in high-yield bonds, that spreads are now selling at premiums.

"These are very, very liquid markets when it comes to money that's available to invest in the fixed-income side," Fuss said.

While February was disappointing for stocks, it was a good month for bonds, and their continued rise since the beginning of last year has been coaxing assets out of money market funds and bank deposits as investors look for higher returns than 1% or less.

Bond mutual funds had approximately $26.65 billion in inflows for February, according to the Investment Company Institute, with the majority coming from taxable bonds. By contrast, equity funds had $2.63 billion in outflows in February. Money market mutual funds had $58.36 billion in redemptions during the same period.

Fuss is worried, however, that the heavy financing going on in the corporate bond sector could be a "looming specter" that could help contribute to the continued compression of yield spreads.

Many institutional bond buyers are required to buy tax-exempt bonds, but since the government flooded the market with its taxable, municipal Build America Bonds, the supply of tax-exempt bonds has dropped, causing prices to go up.

"The government market has become more volatile," Fuss said, adding that an increasing hunger for these funds could lead to rising rates in the corporate sector.

Massive Debt

The recent sovereign debt issues in Greece and other European countries have revealed a complicated and confusing mess of external factors that could further shake up the global markets-and after asset-backed securities, turn out to be the second shoe to drop.

"Governments naturally aspire to overcome bad debt dynamics through the orderly (and relatively painless) combination of growth and a willingness on the part of the private sector to maintain and extend holdings of government debt," said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co. "Such an outcome, however, faces considerable headwinds in a world of unusually high unemployment, muted growth dynamics, persistently large deficits and regulatory uncertainty.

"Countries will thus be forced to make difficult decisions relating to higher taxation and lower spending," El-Erian continued. "If these do not materialize on a timely basis, the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation."

This puts the U.S. in a tricky spot. Already saddled with trillions of dollars in debt and stimulus programs, the U.S. needs to find a fiscal exit strategy and eventually raise interest rates, but such a move could cripple the recovery if enacted too soon.

The massive supply of Greek debt has put pressure on the euro and has made the U.S. dollar look safe by comparison, said David Rolley, a vice president and portfolio manager at Loomis, Sayles.

"In February, the U.S. dollar traded higher than the euro because it was perceived as un-euro," he said, adding that currency investment can be like trying to lose an ugly contest.

However, Rolley added that portfolio managers are running out of markets to like, and the realization that European nations may not be able to raise their interest rates before the U.S. could play out very well for U.S. markets.

"We will see very important equity positions by sovereign wealth funds," he said. "The same folks who gave us a tongue lashing about our Treasuries will turn around and buy our corporates."

While some bonds may be overpriced in the short-term, many managers say the long-term growth outlook looks good.

"The high-yield market offers many individual opportunities that are reasonably attractive," Fuss said.

"You can see bubbles in some areas of the world, but you don't really see bubbles in the U.S.," added Warren Koontz, a vice president and portfolio manager at Loomis, Sayles. "Corporations right now are the most efficiently run as they have been in a long time. We could be pleasantly surprised with the performance of many companies."

The S&P 500 has seen a 72% run on the closing lows from March 9, 2009 but is still way down from 2007 levels, noted David Sowerby, a portfolio manager at Loomis, Sayles. He predicts double-digit returns for stocks in 2010, but is worried about 2011 and 2012, when the U.S. will have to pay for all the stimulus programs it enacted last year.

Volatility and chaos create opportunities for savvy money managers, but there are also some pretty solid investment areas out there, such as the railroad industry and natural gas.

"This year, fundamental valuation rules," he said. "The right stocks will go up."

(c) 2010 Money Management Executive and SourceMedia, Inc. All rights reserved.

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