European Debt Crisis Seen Posing Greatest Risk to Equities Markets

Along with the negative macro outlook, institutional managers believe U.S. equities are undervalued and see investment opportunities in U.S. large-cap and Emerging Markets equities, and in the technology, energy, and health care sectors.

Following recent market declines, more than half (52%) of those surveyed believe the U.S. equity market, as measured by the S&P 500 Index, is undervalued by more than 10%. That is 26 percentage points higher than in the second quarter survey and marks the highest level for that view since the first quarter of 2009, when the equity market began a strong rebound.

At the same time, views on corporate profits and economic growth were more negative than the previous quarter. Over a third of respondents (36%) expect U.S. economic growth to decelerate over the next six months, compared to 21% who held this view in the second quarter.

Looking at corporate earnings, 39% of managers believe profits will decrease next quarter, compared to 15% who held that view in the second quarter. Those who expect corporate earnings to grow in the next quarter declined to 34% of respondents, down from 56% in the second quarter and the high point of 87% who held that view in the first quarter of 2010.

Following a quarter with elevated levels of market volatility, 40% of managers still believe volatility will increase in the next six months. More than 30% think the recent spike in volatility is temporary and will come down over the next two quarters. This is the highest percentage anticipating a decline in volatility since the first quarter of 2009. However, managers appear to have responded to uncertainty by holding more cash. Of those surveyed, 23% responded that cash was above normal levels in the quarter – a significant increase from 12% in the second quarter and the largest percentage since Northern Trust began its survey in the third quarter of 2008.

“After what was clearly an incredibly challenging quarter, our managers seem to be saying that although they see plenty of opportunities in the market at current valuations, it’s buyer beware given the considerable headwinds that may be coming our way,” said Christopher Vella, Chief Investment Officer for Northern Trust Global Advisors (NTGA), in a press release.

Asked to rank the risks to U.S. equity markets over the next six months, managers selected the European debt crisis as the greatest risk to equities, followed by a spike in U.S. unemployment and inflation in China. In addition, 63% of respondents believe the European crisis will spill over modestly to U.S. markets and that valuations are accurately reflecting the extent of the crisis. 

Other major findings from the survey include:

•  Forty six percent of managers believe emerging market equities are undervalued, up from 38% in the second quarter.

•  Managers were most bullish on U.S. large cap equities, U.S. small cap equities, and emerging markets during the quarter. Respondents were most bearish on conservative fixed income instruments such as Treasuries and investment grade bonds, as measured by the Barclay's Aggregate Bond Index.  

•  Only 20% of managers were concerned about inflation. That is down from 43% in the second quarter and 69% in the first quarter, a clear indication that growth expectations have been tempered by weakening economic indicators, Northern Trust said.

•  Managers identified technology, energy, and consumer staples as the three sectors that they are most bullish about going forward, while they are bearish on financials, utilities and materials.  

•  Consistent with their generally negative outlook, only 19% of managers believe that job growth will accelerate in the coming months, compared to 37% who held this view last quarter.

"There has been a clear trend in the markets away from more economically sensitive sectors in favor of those that can hold up if the economicn indicators and markets continue to be weak," said Kelly Finegan, NTGA Investment Analyst. "Overall, managers' outlooks are more negative than three months ago, but there is still some optimism and managers feel there are numerous areas of the market that offer attractive investments."

For its survey, Northern Trust polled a select group of respondents, including fixed income and equity managers across value and growth styles, with a bias toward fundamental, bottom-up stock picking strategies. The survey is conducted quarterly so that Northern Trust and participating managers can examine trends in attitudes and allocations. The latest survey was conducted in September.