By Juliette Fairley

High-quality and defensive stocks, as well as high-income bonds, can help investors hold steady in uncertain times, said speakers at the MFS investment outlook on Tuesday at the Essex House in Manhattan.

While corporate America is prospering, Europe's insolvency and the Congressional super committee plan due on November 23 may impact the current upswing, speakers said.

"The stock market is discounting the political risk that exists. If bubbles are being created, it is not in stocks but rather in U.S. government debt, such as Treasuries, because of a flight to safety by large and small investors," says James Swanson, CFA, and MFS's chief investment strategist. "If there is a yield shortage out there, it is being created by the Fed, which is holding down rates throughout 2012."

"We are dealing with an enormously complex system, and developments tend to lag behind, especially in establishment surveys that measure non-farm payrolls and household surveys that measure unemployment," says Erik Weisman, manager of MFS's domestic and foreign government bond portfolios.

As for U.S. consumers, their ability to service debt is the highest in 13 years, the average credit score, at 695, is the best since 2006 and spending is up by 3.9 percent for retail sales through August 31, according to Bloomberg.

"Given the lack of job growth, the explanation is that people are working longer hours," said Swanson. "If history is any indication, we are mid cycle in this recovery and this business cycle is not as anemic as people portray it. Interest rates are on hold at 2 percent for two years. The shape of the curve is still positive."  

About 60 percent of U.S. companies beat revenue estimates and 71 percent beat Wall Street earnings estimates, high by historic standards, according to MFS data. But instead of being invested in jobs, corporations are funneling money into capital expenditures, such as equipment, IT, software, factories, infrastructure and transportation.

"Labor is more expensive, so companies are relying more on technology and automation to get products to market quicker," says Swanson.

A turning point looms, however, on November 23 when the 12-member Congressional "super committee" is to propose a plan to cut $1.2 trillion from the federal deficit.

"If unemployment insurance benefits and payroll tax cuts are not extended, then 2012 will be a dicey year. If they are extended into 2012, then the outlook will be improved," says Weisman.

The bipartisan super committee could propose cuts to Medicare, Medicaid and the health reform law. "The most rational policy is some combination of generating higher revenue and cutting entitlements such as Social Security, Medicare, Medicaid, prescription drugs and Obama care. We need a technocratic compromise that aims to solve the problem and to not be ideological," said Weisman.

Another risk factor that could impact 2012 is the European debt crisis. U.S. federal government debt to GDP is 92 percent compared to Italy's 120 percent, according to Bloomberg.

"Recalcitrant players such as Italy and Greece played nice by forming technocratic governments and were willing to enact and implement structural and fiscal reform thinking the European Central Bank (ECB) would come to the rescue, but that's not what's happening," says Weisman. "As a result, the global financial markets are left adrift. Either Germany or the ECB are playing an extreme game of chicken because they have the most leverage right now or they just aren't going to be the backstop we thought they would be."

More than 50 percent of Germany's growth is driven by exports compared to 10 percent in the U.S., according to Deutsche Bank, making Germany the China of Europe. Italy's economy minister Giulio Tremonti has discussed selling assets to ease the country's 1.9 trillion public debt load.

"Italy is the big debtor, but the country has 1.7 trillion in assets that are marketable in the form of partial shares in oil companies, wineries, land and airlines. They could sell 5 to 10 percent of that and get breathing room. Their per capita wealth is as high as the U.S. and higher than Germany," said Swanson.
About 12 percent of all assets of U.S. corporations are in cash, which is the highest since 1954, according to JP Morgan.

"In our opinion, it's largely because publicly traded companies are building a reserve for the next crisis. That's why we are seeing a dramatic rise in capital. This cash will find its way into the market place through dividends, capital expenditures and high quality stocks," Swanson said.

Defined as companies with stable balance sheets, positive earnings growth and established management, high-quality stocks often outperform, according to MFS data through October 31.

Although old defensives, such as telecom, staples and health care are under the gun, new defensives have emerged in technology stocks paying dividends for the first time.

"The margins of technology stocks are 3 to 4 times what they were 10 years ago and many are now paying dividends. Betas are falling. They have no debt but do have excess cash. So technology companies are behaving more defensively," says Swanson. According to Credit Suisse, 40 percent of an investor's long-term return is driven by dividends that stocks pay and U.S. companies have a free cash-flow yield of 8 percent. Meanwhile, the high-yield credit market offers equity-like returns over time and can be less volatile.

"The door is open for new financing, defaults are running close to zero, balance sheets are better and cash flow is still coming in," says Swanson of high yield bonds.

According to Credit Suisse, 23 percent of profits come from outside the U.S., which has contributed to the profit recovery of corporate America. "Companies have found ways to make money through our biggest trading partners, including Canada, Mexico, Latin America, South Korea, Thailand and the Philippines. The trend is very pronounced in the last few years," said Swanson.

Although U.S. companies are doing amazing things with productivity, balance sheets, sales and earnings, danger lurks in the growing power of emerging markets, such as China, Brazil, India. As these countries stand on their own two feet, the U.S. is losing importance as far as consumption is concerned.

"There's a change taking place in the dynamic between the developed world and emerging markets. Emerging markets are now self-sustaining, good at discipline and not in the same situation as the developed world," says Thomas Melendez, institutional portfolio manager of MFS's global portfolios. "They have lower public-sector indebtedness, strong balance sheets and better fundamentals."
China's GDP is expected to decrease to 8 percent in 2012 from 9 percent in 2011 and the amount of trade China has with Portugal, Italy, Ireland, Spain and Greece is 3.5 percent of exports, according to MFS data.

"China will become the world's largest economy sooner than we think, probably in 20 years rather than 50. It's an accelerating changing of the guard that is of concern for America," said Melendez.