Equities will outperform bonds, says MFS boss

Despite this year's big run-up in stock prices and the resulting caution among fund managers in recent months, some still favour equities over fixed income.

Robert Manning, chief executive and chief investment officer at MFS Investment Management, believes high-quality stocks will provide the best long-term returns.

Boston-based MFS is betting that fiscal stimulus and monetary easing in the US and worldwide will carry the economy into a self-sustaining recovery. The firm is tilting towards equities and no longer favours fixed income, says Manning. In the US, retail fund flows have mainly been into bonds, but MFS has not tried to get onto this marketing wagon.

"From an investment point of view, it's a lay-up," Manning says. "Capital has to flow into riskier assets and high-quality stocks have room to appreciate in value." With US short-term interest rates at zero, bonds offer no value, but there are plenty of multinationals that pay decent dividends.

Manning points to the fact that, over the past decade, broad market equity indices have lost money, while major bond indices have made terrific gains. The S&P 500 has dropped by 11%, Nasdaq by 19% and Topix by 41% over the past 10 years for a buy-and-hold investor. But bond market indices in the US, UK and Europe are up 70-85% over the same period.

Yet this cycle is over, Manning says. So far this year, the S&P 500 has rallied 55% from its bottom in March. But low-quality or junk stocks have led the rebound. They have left companies deemed high-quality (based on strong balance sheets and other financial metrics) at reasonable valuations of 13-14x 2010 earnings. They also on average provide a better earnings yield than the 3.5% returned by a 10-year US Treasury bond.

"When top-line growth returns to the economy, these are the companies that will do well," Manning says.

The risk is that top-line growth doesn't return. Manning acknowledges the US has long-term structural problems and that unemployment levels must fall below 7% to get the economy moving -- which could take years to realise. They have been able to retain their current level of profitability due to cost-cutting, but if the US economy "double-dips" into recession, companies would have to wield the axe again, which would be disastrous.

Manning says home prices are the key factor to watch. He notes that in some parts of the US, these have stabilised or are even nudging upwards. Rising home prices underpin local consumption. Government stimulus can serve as a bridge from recession to a growth environment, but it needs to be followed up by commercial banks reviving lending, mortgage origination, credit card businesses and so on. The US Federal Reserve will keep interest rates ultra-low for a while, to re-liquefy financial institutions and help restore confidence.

"We're betting this works, but we realise it will take time," Manning says.