MSSB urges safety first, citing worries over European slump

Researchers at Morgan Stanley's $1.6 trillion wealth management arm are favoring cash and investment-grade bonds even as stocks and junk bonds rally, claiming that a looming recession in Europe is keeping markets “far from worry-free.”

Morgan Stanley Smith Barney LLC recommends that investors be underweight riskier assets, maintaining cautious allocations adopted in October, strategists led by chief investment officer Jeff Applegate wrote in a report distributed last week. The strategists made the call last week as the S&P 500 climbed to the highest level since 2008. Speculative-grade debt gained 1.8% in February after the best back-to-back months since 2009.

“Despite the markets' positive reactions to the news flow, the fundamental backdrop is far from worry-free,” the strategists wrote, citing a lack of eurozone economic growth and a decline in German exports in December. “These data suggest Europe has already entered a recession. So far, knock-on effects to the U.S. economy have not materialized, but given the substantial trade linkages within the global economy, any European recession is likely to wash up on U.S. shores.”

While the MSSB report said it's “an opportune time to harvest gains in lower-quality credits,” JPMorgan Chase & Co.'s high-yield strategists raised their estimate for 2012 junk bond returns to 13.7%, from 9.4%.

Bank of America Merrill Lynch strategists anticipate a 12.3% rally for the assets this year. The bonds have gained 4.8% this year through Feb. 24, Merrill Lynch index data show.

“DUE FOR A PAUSE’

As of Feb. 24, relative yields on high-yield, high-risk debt had fallen to 6.01% above Treasuries, the lowest since Aug. 3, according to the index data.

“With less compelling credit valuations, a possibility that domestic economic data may struggle to surprise to the upside and the continuing sovereign-debt drama in Europe, we believe that the credit rally is due for a pause or possibly even a partial reversal in the coming months,” the MSSB strategists wrote. “Investors should consider harvesting some profits where appropriate.”

Reports issued last month showed that European services and manufacturing output unexpectedly shrank in February as the euro-area economy struggled to rebound from a contraction in the fourth quarter, and that German exports fell in December four times more than economists forecast.

In a moderate balanced strategic portfolio, Mr. Applegate's team recommends 30%in investment-grade debt, including short-duration government, corporate and securitized bonds; 4% in high-yield debt; 32% in global equities; and 26% in alternative and absolute-return investments, according to the report.