Horacio Valeiras

Massive amounts of government-supplied liquidity propped up asset prices worldwide in 2009, on the heels of the worst recession in many investors’ lifetimes. Have government efforts succeeded? Are global markets on terra firma or will a retraction in liquidity tip security prices back into the pre-recovery red zone? With more than 20 years’ experience assessing global markets and asset classes, Chief Investment Officer Horacio A. Valeiras, CFA, shares his perceptions of the macroeconomy and identifies asset classes, regions and sectors that are positioned to benefit from the liquidity infusion.

Last year was one for the history books in terms of the severity of the global recession. What were some of the key takeaways from your perspective?

The story of 2009 was the unprecedented massive amounts of liquidity that governments pumped into the market. The government-supplied liquidity acted as a floor to credit and propped up asset prices worldwide. Quantitative easing worked better than we thought it would. It gave investors confidence to move from non-risky to riskier assets, as witnessed by the market moves in 2009.

Have the government stimuli been effective?

The government responses to the crisis in the developed world have been successful in the short run in stemming the panic that emerged from the credit crunch; however, in the long term, these policies could lead to continued global imbalances. Look at the stimulus impact in the U.S. It is relatively small. Whether it created 600,000 or a million jobs is irrelevant given the 10.2% unemployment rate. Government spending stabilized the economy, but is it sustainable in the long run when the private sector is still cutting jobs? The government tax rebates and the “Cash for Clunkers’’ program largely provided one-time benefits.

Combine the lack of clarity surrounding the impact of the proposed 2011 budget with higher personal tax rates and continuing uncertainty over cap and trade and healthcare legislation, and it is likely the U.S. will experience a muted economic rebound compared to prior recessions. The situation is different in Asia, where economic recovery has been less dependent on government initiatives and more tied to fundamentals.

Will the U.S. economy grow in 2010?

We expect GDP growth on the order of 2% for the year. Growth rates could surprise on the upside because individuals will move activity forward to avoid higher tax rates in 2011. Continued growth also depends upon whether the Federal Reserve raises interest rates sooner rather than later. As expected, inflation is picking up. Including the December numbers, consumer prices will rise 2.5-3% for 2010. We can expect higher prices for goods as retailers carry very low inventories.

Given expectations for higher inflation, when do you expect the Fed will raise rates?

A rate hike could have a positive impact on growth. Remember that savers are getting zero interest on their savings, so a non-zero interest rate can stimulate the economy.

The yield curve is historically very steep, with high negative real rates at the short end. If this was a “normal” business cycle and we didn’t have political pressures, then I believe the Fed already would have been raising rates. The recent rally in the dollar has been technical. The dollar had sold off to the point it was bound to reverse. Our bond managers foresee U.S Treasury issuance of historic proportions in 2010, which will continue to put a lid on dollar appreciation. We would not bet on a dramatic strengthening in the dollar.

Does the prospect for higher interest rates and tighter monetary policy cause concern for equity prices?

It depends upon the government’s ability to make the correct decisions in removing liquidity from the system at the right times. We underestimated the amount of liquidity in the market a year ago, and expect liquidity will be abundant for longer than anticipated.

This will be a positive for equity prices. In addition, corporate earnings growth will be critical to supporting equity prices, and moving forward, that will depend more on revenue growth than cost cutting.

What is your outlook for corporate earnings in the U.S.?

History reveals that price/earnings multiples compress following liquidity rallies, so higher equity prices have to be driven by earnings growth. Analysts are predicting 25% earnings growth for U.S. companies in 2010.

Based on historical cycles, if earnings grow by 25%, then the equity market could rise by 15-20%. That seems too optimistic in my opinion. A more likely percentage gain in earnings would be 10-15%, because corporate profits in the U.S. are still largely being driven by cost-cutting rather than revenue growth.

With multiple compressions, I would expect equities could be up for the year. Liquidity is the wild card. Too much money chasing too few assets—what we saw in 2009—could drive equity prices significantly higher.

How are you structuring asset allocation portfolios?

In our asset allocation portfolios, we are overweight stocks versus fixed income and cash equivalents. We favor Asian equities over U.S. and European. In Asia, we prefer the dollar plays—Hong Kong, Singapore, China—over Japan. As long as liquidity is abundant, we are equal weight U.S. and European equities, and overweight emerging markets.

Within Europe, we favor German industrials and Swiss shares and are underweight France, the U.K. and the countries under scrutiny for meeting debt obligations — Spain, Ireland, Greece. In emerging markets, we hold select stocks in Brazil, emerging Asia and the Middle East and are avoiding Eastern European securities. Historically, however, investing in non-U.S. securities has entailed additional risks, including political and economic risk and the risk of currency fluctuations; these risks may be enhanced in emerging markets.

On the fixed income side, we believe U.S. high yield bonds still represent good value in that we expect continued spread compression, but investors shouldn’t expect the high double-digit return levels of 2009. We anticipate high yield investors will get the coupon of 10% plus some spread from price fluctuations. It is important to note that high-yield bonds typically have a lower credit rating than other bonds and they generally involve a greater risk to principal than higher rated bonds.

We are steering away from government bonds and feel an allocation to TIPS, inflation-indexed bonds issued by the U.S. Government, is warranted, given the prospects for higher inflation longer term.

Given the strong run-up in the Russell 2000 relative to the Russell 1000, what are your thoughts about relative performance along the market-cap spectrum in 2010?

We would expect free cash-flow generating companies to do relatively well, without regard to capitalization. In addition, companies that export or have significant operations overseas should outperform based on our outlook.

Which economic sectors should benefit from this market environment?

In general, technology is likely to benefit from a rebound in capital spending. Financials should do well in the steep yield curve environment. Global consumer product providers benefit from both a weak dollar and non-U.S. operations.

Conversely, consumer discretionary companies will have a tough go as consumers in the recession-hit economies opt to rebuild balance sheets over spending for discretionary items.

Can the U.S. economy truly gain traction until real estate recovers?

What is your take on the status of commercial and residential real estate? Residential real estate has stabilized, not recovered. There is too much supply to support a strong recovery. Prime foreclosures are still on the increase, and the question is how much of that market can Fannie Mae and Freddie Mac take up?

You could see weakness in the $500,000 - $1 million home price tag range that Fannie and Freddie can’t restructure. Commercial real estate is likely to take a hit in 2010, although the overall impact on the economy should be small relative to residential housing.