After S&P warning, a shift in investing strategy

BOSTON Mon Apr 18, 2011 4:12pm EDT

Trader Michael Pistillo calls out a price on the floor of the New York Stock Exchange, April 8, 2011. REUTERS/Brendan McDermid

Trader Michael Pistillo calls out a price on the floor of the New York Stock Exchange, April 8, 2011.

Credit: Reuters/Brendan McDermid

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BOSTON (Reuters) - Investment advisers and fund managers tried to look past a market-wrenching downgrade of the U.S. credit outlook and pointed out that bonds, defensive stocks and non-U.S. dollar investments will survive better in a slowing economy.

Standard & Poor's on Monday downgraded its credit outlook for the United States to "negative," citing the risk that policymakers may not reach agreement on slashing the huge federal budget deficit. The warning heightens pressure on Congress to agree to more cuts.

In the immediate aftermath, nearly every investment vehicle went off the rails. Only flight-to-safety harbors like gold and short-term T-bills climbed. So top investors were sorting through the rubble and trying to position for a slower economy with less spending.

Investors' initial reactions to flee any risky markets was fed not just by S&P's move but also by China tightening credit earlier. The tide should reverse as the implications of a weaker U.S. economy and currency sink in, managers and advisers said.

The declines in emerging market stocks and currencies were more of a knee-jerk reaction that will reverse over the long-term, said Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund.

"Longer-term, a great way to correct the imbalances between the developed and developing world is for the currencies to appreciate," she said.

U.S. stocks fell to a wide loss, with the Standard & Poor's 500 Index down 1.5 percent in afternoon trading. But in a sign of what might come next, the pain was spread unevenly. Dividend-paying stalwarts with reliable income streams, like Kraft and Microsoft, eased 1 percent or less. Economically sensitive companies like Alcoa and Caterpillar slid more than 3 percent.

"The defensive categories are faring slightly better than the cyclicals today," David Joy, chief market strategist at Columbia Management, said. "Potentially higher rates suggest slower economic activity, all else being equal, and in that context, defensives, especially those with attractive dividend yields, should outperform, albeit to the downside today."

Among exchange-traded funds, the Consumer Staples Select Sector SPDR was off 0.8 percent in midday trading on the New York Stock Exchange, while the Consumer Discretionary SPDR was off 1.5 percent, for example. The Utilities SPDR was off 1.0 percent while the Materials SPDR dropped 2.1 percent.

BONDS AWAY

Though U.S. bond prices were initially hit hard, they will eventually draw sustenance from lower spending and a reduced threat of inflation while U.S. equities will suffer from economic weakness, said bond fund manager Jeffrey Gundlach, who runs DoubleLine Capital LP in Los Angeles.

S&P's warning to policymakers is "good for Treasuries and bad for the economy and stocks," Gundlach said, because the U.S. economy will "soften substantially" with less stimulus.

Ultimately, the weakened U.S. financial situation will exert pressure on the dollar to weaken further as well, fund managers and advisers said.

For those who want economic growth, it could be time to bargain hunt elsewhere.

"As we continually experience these periodic crises, investors around the world will lose faith in the dollar as the risk-free currency," Aaron Gurwitz, chief investment officer at Barclays Wealth in New York, said. "We're using this as an opportunity to remind people about the percentage of their portfolio that is denominated in U.S. dollars."

Investors should be increasing their allocations to non-U.S. bonds, particularly local currency emerging market debt, non-U.S. real estate and commodities, Gurwitz said.

Money manager Roger Nusbaum at Your Source Financial in Phoenix, Arizona, is spreading client assets across a wider array of non-U.S. bonds, including sovereign debt from Australia, Denmark, New Zealand, Norway and Canada as well as the PowerShares Emerging Market Sovereign Debt Fund.

PLACE TO AVOID

"More and more the U.S. is becoming something to avoid or more practically underweight in investment portfolios," Nusbaum said. "There are many countries on the planet that simply had normal cyclical downturns and have not had to resort to desperate action to stimulate economic activity."

Jeffrey Sica, president of SICA Wealth Management in Morristown, New Jersey, is even more bearish. Sica is slashing U.S. equities holdings of his clients in favor of cash, precious metals and commodities. He favors exchange-traded funds like the ETFs Gold Trust and the PowerShares DB Agriculture Fund.

"This just creates a lot of uncertainty and insecurity that will affect any markets that were vulnerable to begin with and that includes U.S. stocks and bonds," Sica said.

GOLD'S ALLURE

Gold is the most popular hedge against the weakening dollar as well as the possibility of further financial crises. It jumped to all-time highs as other investments slid on the S&P news.

"Gold is going to benefit for an extended period, meaning that we are not going to resolve those issues," said Axel Merk, manager of the Merk Hard Currency Fund in Palo Alto, Calif.

As budget negotiations come to a head in coming weeks, politicians will also have to vote to raise the U.S. debt ceiling. The back-and-forth jousting could unnerve markets in the short term even if a deal is ultimately struck.

A short-term hedge for investors with substantial bond holdings might be to purchase put options on Treasury bond exchange-traded funds, like the iShares Barclays 20+ Year Treasury Bond Fund, some advisers also said.

(Reporting by Aaron Pressman in Boston, with Jennifer Ablan and Herb Lash in New York)(Editing by Richard Satran and Chelsea Emery)

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