Fund Managers Keep the Faith

Mutual fund managers are finally starting to like what they see.

The surprising optimism was quantified last week in a Merrill Lynch survey of some 300 mutual fund managers. Essentially their message is this: Forget any economic woes; it's all going to work out fine.

Institutional investors are more confident that the Federal Reserve's current monetary policy is just as it should be. Fully 79% of the fund managers polled from Dec. 5 to Dec. 15 think monetary policy is "about right," up from only 56% in November.

In addition, 67% of the fund managers think the global business cycle will get stronger over the next 12 months, up from 42% in November and 37% in October.

Specifically, 71% of the survey participants said that cost-cutting -- rather increased sales or higher prices -- will be the key driver behind corporate earnings. The fund managers had a few suggestions for Corporate America as well: 55% said companies should use their cash to repay their debt, while 19% wanted companies to put the money towards paying higher dividends; 13% said companies should buy back stock with their excess cash.

Tactically, fund managers are getting more cyclical, with some 60% of those surveyed saying that cyclicals will do better than defensive stocks in 2003, compared with 45% in October. There's also a bit more interest in small-cap stocks, which is in keeping with an improving business cycle. Fund managers aren't expecting a rapid upswing in small stocks, though; 56% still favor large-caps.

Banking on the Big Picture

The fund managers polled said that today's monetary policy is "about right," and 55% said that short rates will be higher a year from now.

With monetary policy about where it should be, the next place to look is at fiscal stimulus, according to a few fund managers that spoke to TheStreet.com.

"Individuals and businesses still don't have a lot of confidence in the economy picking up," says Lisa Black, a managing director at TIAA-CREF. "The Fed has done its part to pump up the economy. Now it's up to the fiscal stimulus out of Washington to make the final push."

Fiscal stimulus generally comes in the form of tax breaks, but not everyone believes that tax cuts will solve the problem.

Whatever money flows back into the economy as a result of federal tax breaks will be mitigated or even erased by the cutbacks in state spending, says Rick Smith, a portfolio manager with MFS Investments.

Still, though, the Merrill Lynch survey found that, for the second month running, fund managers expect nominal GDP growth of 3%. That healthy growth rate is largely due to the fact that things are simply not as bad as they seem in the areas that make up the largest part of the economy.

Sure, manufacturing has taken a beating because domestic production is far more expensive than importing; and yes, the technology sector is still floundering. But those are not the areas to look at, according to the survey.

Essentially, while there's downward pricing pressure in the durable goods market (things like washing machines or cars), that manufacturing segment makes up just some 10% of our economy -- and that number is shrinking. Meanwhile, some 60% to 70% of our economy is based on services, an area that's growing and still has some pricing power. (The government makes up 18% to 22% of annual gross domestic product.)

That 60% to 70% of our GDP is -- and has been -- growing at roughly 3% a year. But in the late 1990s, the relatively tiny technology sector, which represents less than 5% of the economy, was growing at a whopping 40% a year. When that number went negative, people started panicking about the economy, Smith says.

But what everyone should realize is that the largest chunk of the economy is growing at roughly the same clip as it had been -- the economy just doesn't have the startling (and unsustainable) growth of the technology market dragging the rest of it to unbelievable heights.

"It's like being in a car with a teenager driving 85 miles per hour," Smith says. "At first you're nervous, but then you get used to it and it becomes second nature. But when you get in another car with a driver going 65 miles per hour, you feel like you're driving with your grandmother."

In other words, Smith thinks the projected 3% growth is exactly where we should be.

"The economy's not in bad shape," he says. "It just feels bad because we just got out of a Ferrari driven by a teenager."

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