Investment Managers Predict Upturn In U.S. Equity Markets

Investment managers expect US markets to rebound in 2002, pointing to improved inflation and GDP outlooks, according to a new survey by William M. Mercer Investment Consulting. Sixty one US and international investment managers responded to Mercer's 2002 US Fearless

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Investment managers expect US markets to rebound in 2002, pointing to improved inflation and GDP outlooks, according to a new survey by William M. Mercer Investment Consulting.

Sixty-one US and international investment managers responded to Mercer’s 2002 US Fearless Forecast survey on expectations for the US economy and domestic and overseas financial markets. Together, the responding firms manage more than $3.6 trillion in the US and more than $4.8 trillion globally.

Reflecting an improving outlook for the US equity markets, the respondents predict a return to positive performance in 2002, with growth slightly outpacing value and small cap stocks outperforming large cap.

“Institutional investors have now experienced two consecutive years of sluggish performance,” says Barry McInerney, who heads Mercer’s US investment consulting practice. “The expectations for 2002 are for renewed confidence in the capital markets. However, 2002 forecasts are only calling for high single-digit returns for a typical fund.”

The managers forecast US equities to return 10.0% by year-end 2002, compared with the -11.9% actual return last year. The outlook for US fixed income performance is less optimistic, highlighted by a predicted increase in the Fed funds rate to 2.5% from 1.8% at the end of last year, and weaker core bond returns.

Looking at the economy, the investment managers see real GDP growth at 2% for 2002, with inflation falling to 2% from its current 2.8%. On average, they expect unemployment to rise slightly to 5.9%, compared to 5.8% at the end of 2001.

Overseas equity markets are expected to return only slightly more than the US, though the degree of confidence in the estimates is weaker. Emerging markets equity had the highest expected one-year return of all asset classes. Not surprisingly, the luster seems to have worn off alternatives, particularly private equity and venture capital. Longer-term predictions continue the favorable expectations for growth over value, small cap over large cap, and the US over non-US markets.

“Interestingly, managers favor traditional US asset classes – large cap and small cap equity – to alternatives such as private equity and hedge funds, which is somewhat contrary to the view of plan sponsors,” says Mr. McInerney. “Many plan sponsors are looking towards alternatives as a method of boosting investment returns in a market that they perceive will offer limited opportunities.”

Asked about the top issue facing financial markets, managers most often cited the US economy (cited by 30.5%), monetary policy (13.5%), the global economy (11.3%), and interest rates (10.7%) as the key issues affecting capital markets.

From an asset allocation perspective, managers favor allocations to large cap equity, fixed income, international equity, and small cap equity, in that order. Though some have argued that the equity risk premium is non-existent, the survey results indicate otherwise. The differential of expected annualized median returns between the S&P 500 and the Lehman Aggregate through December 2005 is 3.8%.

This is comparable to long-term estimates of the equity risk premium and would seem to support an ongoing high allocation to equity for most institutional investors. “The debate will continue,” says Mr. McInerney.

“Although managers favor international equities as part of the asset allocation process, they expect emerging markets to deliver higher returns in the short and intermediate term, based on the forecast,” says Brian Collins, who heads Mercer’s manager research unit in Chicago. “Plan sponsors are faced with the difficult choice of maintaining dedicated emerging market allocations or allowing their international equity managers to tactically invest in emerging markets.”

A majority of managers (57%) expect continued merger activity within the US investment manager industry, with 27% expecting the pace to decrease.