With an unprecedented interest rate environment and last year's bullishness gone, Putnam Investments will seek out micro opportunities in the market, according to Jeffrey Knight, managing director and co-head of the firm's capital markets committee.

"It's just starting to feel like the sleepy markets can't go on forever, but I'm having a hard time identifying what is going to break the markets out of this," he said. Knight, co-author of a recent Putnam market outlook research paper, said he expects it to be a stock-picker's environment, with both the equities and bond markets underperforming their historical averages for the next few years.

The best-case scenario for the remainder of 2004 would be modest gains in stocks and bonds, combined with subsiding volatility, much like what occurred during the first half of the year, according to the report. Knight forecasts returns in the low- to mid-single digits, with stocks producing 6% returns and bonds 4%.

As far as investment opportunities, Putnam is modest overweight, its second-highest rating, in both U.S. government and non-U.S. developed country fixed income categories. However, it is modest underweight on U.S investment-grade and emerging markets bonds. For bond investors, traditionally rising interest rates have spelled losses, as bond prices fall when rates rise. But this rising cycle should be longer and milder than in the past, and yields should peak earlier in the cycle, according to the report. This will likely lead to small, positive returns.

The firm is also slightly overweight in both U.S. large-cap and U.S. value equities, as well as Japan and emerging-markets stocks. The firm is not high on U.S. small-cap or U.S. growth, though, and is even less enthusiastic about European equities. European stock markets don't like strong local currency or high energy prices, according to Knight, and the presence of both makes the market unattractive. The Euro is currently strong, and unfavorable technicals combined with a sluggish regional economy make European valuations "questionable," according to the report.

Knight also expects dividend-paying stocks to play a more prominent role going forward. When searching for cheap stocks, often there is significant overlap with dividend-paying securities, Knight said. However, he anticipates dividends to become valued in and of themselves. "We've been expecting the dividend part to matter in its own right, not only as a valuation indicator, but as something investors will gravitate to," Knight said. "I think the case for that happening strengthens the longer we go on with a flat return profile."

Among the sectors, Knight said the firm likes energy and dislikes financials in the longer term, but that in the nearer term, financials are being fed by the Fed's interest rate policy, so there is some room for them to perform. That interest rate policy should remain accommodative for some time to come, as the tightening cycle will be relatively long and mild. "The economy is growing above trend now," Knight said. "We think it gradually falls back to more of a trend growth rate and that the Fed will be very careful not to make it worse by being too aggressive." However, the Fed's monetary policy should continue to remain stimulative for the remainder of the year. This is because the markets have been too aggressive in pricing in the Fed's tightening, mostly because of too much optimism over the strength of the U.S. economy, according to the report.

Retail sales, car sales and payroll growth are already softening. Combined with an environment of significantly higher oil prices, higher interest rates and fading fiscal stimulus, the next year should feature a moderate slowing, according to Putnam. Knight said that under historical trends, a neutral Fed funds policy would be at about 4%, but that it is a different world today and the Fed is just as concerned about deflation as inflation.

"I think it is a mistake to apply the old rules to what we expect from the Fed today, because for the last 20 years, they've been fighting the war against inflation," Knight said. "With that war basically won, they're fighting a war for price stability, which could be lost in either direction."

With the Fed concentrating on price stability as opposed to preventing inflation, as in year's past, Knight expects this tightening cycle to end at 3% or lower.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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