December 9, 2010 / 2:57 PM / in 7 years

U.S. stocks likely winners after tax deal

NEW YORK (Reuters) - The tax-cut deal in Washington, which led investors to dump U.S. Treasury securities in the last two days, is likely to accelerate an asset-allocation shift into stocks from government bonds into 2011, top investment managers said.

The extension of the Bush-era tax reductions plus a payroll-tax cut dealt a blow to Treasuries, driving up investor expectations for economic growth and the federal budget deficit, both of which point to higher interest rates.

Tuesday marked the Treasury market’s worst one-day sell-off in 18 months, resulting in paper losses of $61 billion, Bank of America Merrill Lynch fixed-income indexes show.

That selling continued on Wednesday and is most likely not yet over.

U.S. fund managers boosted exposure to stocks and slowly cut back on Treasuries for the third month in a row in November, based on signs the economy is strengthening, a Reuters poll of 14 investment management firms showed.

The deal to extend the tax cuts will mean more money flows into stocks over cash and fixed-income securities, Bob Doll, BlackRock’s chief equity strategist, told the Reuters 2011 Investment Outlook Summit in New York.

“First of all, an unknown is removed,” said Doll, who helps manage more than $3.3 trillion in assets.

“Markets don’t like unknowns, and if you don’t know something you kind of tend to own a few more Treasuries and a few less stocks.”

The perceived risk of rising inflation as a result of the huge federal budget deficit, made even worse by the latest tax cuts, leaves fixed-income securities vulnerable. Rising inflation pressures erode bond values over time.

Tad Rivelle, chief investment officer of U.S. fixed income at TCW, called the Treasury sell-off “a return to bond vigilantism”, invoking a term coined by economist Ed Yardeni in 1984 to describe why major investors were demanding higher yields to compensate for perceived risks of rising inflation as a result of large deficits.

On Wednesday, the 30-year U.S. Treasury bond was down 1-9/32, with the yield at 4.453 percent, flirting with the 4.50 percent level. The benchmark 10-year U.S. Treasury note fell 1-1/32 to a yield at 3.265 percent.

Rivelle added: “It’s been a banner year for flows into fixed income” and investors including TCW shouldn’t expect the same phenomenon next year with inflationary pressures and growth on the rise.

“The Treasury market is not in for smooth sailing over the course of 2011,” Rivelle said.

Stimulus from tax cuts and Federal Reserve policy come as the economy was already recovering on its own.

“You had the real economy in the last couple of months slowly but surely getting better, and (the tax-cut deal) is some icing on that fairly newly baked cake,” BlackRock’s Doll said.

Even before the tax-cut compromise, investment bank Goldman Sachs raised its 2011 U.S. gross domestic product forecast to 2.7 percent from 2 percent. On Tuesday, Goldman said the tax package could add 0.5 to 1.0 percentage points of growth on top of that.

Legg Mason’s Bill Miller told Reuters the tax plan was “a very big deal” and could add between one half and three quarters of a percentage point to GDP in 2011.

Veteran money manager Martin Sass agreed the tax cuts were a timely boost and called the payroll tax cut specifically “a nice injection of stimulus to this economy”.

Sass called U.S. equities “the cheapest major asset class out there” and said equities growth was being fueled by corporations’ piles of cash -- money they will ultimately start spending on plants, equipment, or mergers and acquisitions.

His firm has a target for the Standard & Poor’s 500 index of 1,470 through year-end 2011. A year ago, Sass forecast the S&P 500 closing 2010 at 1,250. On Wednesday, the Standard & Poor’s 500 Index gained 4.53 points, or 0.37 percent, to finish at 1,228.28.

Editing by Dale Hudson

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