Stocks: Why "Risk On" Rules

While Washington continues its scrappy, small-minded approach to the nation's critical fiscal issues, investor sentiment seems to have begun a turn toward risk. Lipper, long a tracker of mutual fund directions, noted not too long ago that flows into equity mutual funds during the opening weeks of this new year topped any for the past 12 years.1 Such news is far from conclusive and could easily turn back, but it would seem to reflect two clear investment considerations: 1) Risk investments, equities in particular, show good value, especially compared to the high prices and paltry yields offered by Treasuries and other supposedly lower-risk assets; and 2) the major political, economic, and financial threats of the day, though no less frightening, seem more likely to avoid the worst-case outcomes for which risk assets seem to be priced.

Certainly, this year's turn toward equities occurred suddenly enough. Right through to the end of 2012, long-standing outflows from equity mutual funds continued. According to the Investment Company Institute (ICI), equity mutual funds suffered net outflows of some $34 billion in December 2012 alone, a bit more than $30 billion from domestically based funds and the balance from globally and internationally oriented equity funds.2 Meanwhile, presumably lower-risk bond funds continued to attract money, with net inflows of $13.2 billion. But the pattern changed abruptly with the new year. The turn noted by Lipper involved a net positive flow into equity funds amounting to $18.3 billion in just the first week of January. ICI reported a monthly rate of flow into equity funds at almost $50 billion, though the data are as yet incomplete.

It is not a coincidence that this turn coincides with the partial resolution of the "fiscal cliff" crisis. In the weeks leading up to the cliff deal, investors felt gripped by a kind of fear that Washington would fail to reach a compromise and that the economy would fall hard into recession. As it turned out, Washington made a muddle of its negotiations. Indeed, the agreement between the White House and Congress on the fiscal cliff might well qualify as the definition of a muddle. Taxes rose, but less than many had feared. Spending questions were postponed, as were any efforts to deal with more fundamental fiscal matters. But for all this, investors found relief from their worst fears. The stock market and other risk assets rallied—not from an enthusiasm about the future but from what seems to be a growing sense that other concerns, like the fiscal cliff, would result in comparable muddles. Investors, if denied their greatest hopes, would enjoy relief from their worst fears—fears for which they had braced themselves and pricing on risk assets had discounted.

Of course, a shock, particularly a thoroughgoing failure on a major issue, could scare investors away from risk assets again. But the probabilities would seem to favor outcomes more or less in line with this developing expectation that some kind of muddle will occur instead of disaster. Here is a sample of five of the day's larger concerns:

1. The latest slide away from a showdown on the debt ceiling reveals every sign of avoiding either the long-term fundamental fiscal solution that many investors hope for or the kind of failure that would stymie government. Because President Obama has made clear his reluctance to make spending cuts, a pattern seems to have emerged in which the Republicans offer a small rise in the debt ceiling that would postpone the matter for some months. It is a pattern that might repeat several times during the coming year. It would offer neither the resolution investors would like nor the disaster they fear.

2. The March debate over sequestered spending will likely also avoid either a fundamental solution or an impasse. Neither side wants to suffer the automatic cuts: defense for the Republicans and other discretionary spending for the Democrats. If there is little chance of the long-term fundamental deficit reduction that would lift the sequester, the sides in this standoff will likely find some way either to avoid its full weight or to postpone the decision.

3. Though Europe's financial/fiscal crisis will persist, fears likely will continue to fade about either a failure of the euro or a breakup of the union. This crisis has worn on for over three years now. At each stage, warnings of a breakup have dominated the headlines. Yet the eurozone has held together, largely through Germany's determination and the sometimes reluctant cooperation of the European Central Bank. Italian elections later this month and German elections later this year will test this solution, but given the record of these trying years, muddle seems the most likely outcome here too.

4. The slow growth of the global economy continually threatens another recessionary dip. There is little on the horizon to suggest an acceleration of growth, but at the same time, much argues against this still popular fear. For one, China seems to have avoided the "hard" landing many pessimists had projected. To be sure, Chinese growth, now forecast in the range of 7–8% a year, is far slower than rates of 10–12% averaged earlier in this century,3 but it is still robust growth. Half a world away, Europe, though it will remain in recession until the second half at the earliest, hardly presents much of a change from last year. Japan's new economic policies, too, may do little to help that economy deal with its fundamental issues, but they will help in the near term to bring it out of its present recession.

5. Meanwhile, the United States, though still stuck with a subpar recovery, offers few recessionary signs. Some fiscal drag from Washington will keep the pace of growth slow, as will continued business caution on both capital spending and hiring. But a modest improvement in housing sales and construction, as well as an improvement in household finances, which can support at least modest increases in consumer spending, should sustain growth, subpar to be sure, but enough to avoid recession.

It will likely take a while, even barring an adverse shock, for market prices to reflect this new, less fearful perspective. While the adjustment is taking place, risk assets, particularly equities, would seem to offer the best return prospects, even considering that adverse shocks, as always, could bring temporary setbacks. At some future date, when prices have fully adjusted, the market will need more than muddle to advance: it will need genuine good news. But that point of departure is yet some ways off. For now, as should be clear, muddle will do.

1 Data from Lipper Investments.

2 Data from the Investment Company Institute.

3 Data from the Chinese government website.

A Note about Risk: The investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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