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Economic Outlook: Favorable to Stable Value for the Long Term

When are market conditions most favorable for Stable Value fund performance?

• When the yield curve is positively sloped, Stable Value will outperform money market funds.
• When interest rates are rising, Stable Value will outperform bond funds.
• When equity markets are stressed, conservative assets will outperform.
• When long-term equity returns are unexciting, Stable Value offers an attractive long-term risk-adjusted return profile.

Most of these conditions describe today's environment, which is why Stable Value funds are so appealing. Plan participants continue to recognize the importance of Stable Value as they grow their balances in this fund when it's offered. A critical question - for consultants, advice providers, financial planners and plan sponsors - is whether the fund's attractiveness will remain for the long-term, or whether market conditions will change, and Stable Value will lose its luster? The answer is that Stable Value's return profile is strong not just today, but is expected to remain so.

For perspective, consider what would create an unfriendly environment for Stable Value:

• If the Fed raises interest rates sharply (400+ basis points), money market yields may rise more quickly than Stable Value returns.
• A significant fixed income rally could cause bond funds to outperform Stable Value.
• A sustained, significant equity rally could cause the market focus to return to aggressive risk taking, not balance and conservatism.

Are these conditions likely? No. Industry-wide economic forecasts do not anticipate long-term unfriendly skies. In this article, JPMorgan Fleming Asset Management and Pacific Investment Management Company (PIMCO) outline their expectations, which consistently support the appeal of Stable Value for the long haul.

Economic expansion to slowly gather strength
JPMorgan Fleming's strategists believe that a profit rebound in the corporate sector will continue through 2002. The corporate sector is still restraining growth in labor costs and capital spending to rebuild profit margins. Tax relief and a declining dollar will, in aggregate, contribute to improvement in profit margins and will allow the corporate healing phase to continue. With improved profits, firms will slowly increase their hiring and capital spending. Inventory dynamics remain positive for production as firms move from rapidly shedding their stock to slowly accumulating.

Low interest rates and a strong housing market should sustain consumer spending, despite slow income growth and a weak stock market. Federal spending remains a positive. The process will be halting, but the odds of a double-dip remain low.

Inflation to remain contained
Global excess capacity and a continued lack of pricing power support lower inflation. Increased inflation pressure comes from the weaker dollar, higher oil prices, and domestic capacity utilization that is beginning to inch upward. On balance, expect inflation to remain contained.

Return expectations
U.S. stocks and bonds are likely to provide positive but "unexciting" long-term returns. The slow and uncertain economic recovery may continue to disappoint an equity market that remains priced for a better outcome. The Fed will continue to wait until the equity market, capital expenditures, and the employment picture improve markedly before raising interest rates. As the global economic upturn progresses, yields are likely to begin a rising trend.

JPMorgan Fleming believes that the conditions favorable to Stable Value will remain: a positively sloped yield curve, gradually rising interest rates, and unexciting equity market returns.

Secular (3-5 Year) Economic Outlook
We believe we are at a secular turning (inflection) point. A 20-year era of disinflation, driven by forces such as globalization, technological innovation, shrinking government, and preemptive central bank tightening, is drawing to a close. Over the next three to five years, we believe reflationary trends will dominate and sustain a mild global recovery, with inflation peaking at three to four percent in the US by the next cyclical peak. Key reflationary elements of our secular forecast include:

• Governments and central banks, alarmed by the threat of global deflation, will employ fiscal/monetary stimulus to restore corporate pricing power and help overburdened borrowers service their debt.
• Private sector excesses such as the Enron scandal and dot.com/telecom fiascoes will result in increased regulation and closer fiduciary oversight. The impact of this "fiduciary enlightenment" will be an increase in the cost of capital, which in a finance-based economy will translate into upward pressure on prices.
• Political unrest and prospects for war following the terrorist attacks of September 11 point to reflationary increases in defense spending.
• The diminished allure of U.S. assets and concern about the persistent U.S. current account deficit will cause the dollar to weaken, adding to inflationary pressure.
• Reflation will be tempered by a significant increase in manufactured exports from China, which will remain cheap as 300 million farm workers migrate to factories.

Stable Value Investments Should Be Attractive
Our outlook sets a stage that should prove to be very positive toward Stable Value as an investment option:

• Yield curves will remain positively sloped, and even steepen, in the face of monetary and fiscal stimulus and more expensive long-term corporate debt. Short rates will remain at relatively low levels for a prolonged period of time. Stable value should continue to offer an attractive premium to money market funds as a result.
• Interest rates will be biased higher, with long-term yields climbing to six percent or more. Bond price erosion will be modest, with performance coming more from higher yields, rather than longer duration (price appreciation). Participants will likely value the principal protection and stability features that Stable Value offers relative to bonds and riskier investments in this period.
• We expect much lower long-term returns on stocks (six to seven percent) which should make bonds, and particularly Stable Value, look very attractive, on a risk-adjusted basis.

Interest rates to trend higher - Despite prolonged volatility in the financial markets, most 401(k) investors go it alone, relying primarily on themselves and the information provided by their employer or savings plan provider in making retirement investment decisions. SVIA's survey finds that 52% of all retirees and almost half of all workers (48%) rely on their own judgment and investment knowledge when it comes to making retirement investment decisions.

Limit price risk - A positively sloped and steepening yield curve argues for durations near or even shorter than a fund's benchmark index and yield curve strategies focused on short/intermediate maturities.

Own "safe" spread products - Bonds that offer yield premiums above Treasuries with a margin of safety should perform well. Among bonds that offer a "spread" above Treasuries, investment-grade corporates are an attractive alternative. We are targeting near index weightings of corporates to capture their attractive yields, which is a dramatic reversal from what we said and did in the 1990's, but that's what secular turning points are all about. Success in this sector demands selection of stable credits with transparent business models and accounting practices to avoid the "black holes" in the current market environment. Mortgages and limited allocations to top-tier emerging market bonds also meet this criteria for "safe" spread investments.

In sum, the renewed enthusiasm for Stable Value is neither a passing phenomenon nor an inappropriate investment strategy for long-term investing. Plan sponsors should not hesitate to continue presenting Stable Value funds as an attractive component of any retirement investment strategy.

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