Why Our Current Economic Expansion Has Room to Run
Written by: Brent Schutte, Chief Investment Strategist, Northwestern Mutual Wealth Management Company
The reports of the coming economic demise continue to prove premature. For much of the past few years, we have filled these pages with our data-driven retort to the constant noise about the next impending economic and market downturn. One year ago, after United States gross domestic product (GDP) fell to 1.2% year-over-year from a recovery high of 3.8% in early 2015, we titled our commentary, “To Every Season Turn, Turn, Turn.” We expressed our belief that the conditions for rising future U.S. and global economic growth were in place. After a weak first-quarter 2017 U.S. growth report caused many to doubt the accuracy of our prior forecast, we reiterated our position in a commentary titled, “It’s More Than a Feeling.” Why? Because we noted that even with the weak first-quarter GDP report, the forward-looking economic leading indicators – notably business and consumer confidence – pointed to stronger growth ahead.
Consider it done. Indeed, second-quarter U.S. economic growth recently clicked in at a robust 3.1% quarter-over-quarter rate, which pushed the year-over-year number to 2.2%. And we note during the third quarter that these same leading economic indicators leading us to forecast rising economic growth in the second quarter kept expanding. Indeed, both the Institute for Supply Management’s Manufacturing and Non-Manufacturing Index reports on business continue to post extremely strong readings in the third quarter, with the leading indicator of new orders at expansion highs and at levels that have historically led to strong future economic growth.
On a more granular basis, consumer confidence during the quarter remained near levels last witnessed during the strong expansion in the late 1990s. The same can be said of business owners who are finally expressing their belief that it is a good time to expand their companies. Regardless of whether the proposed tax reform becomes law, we believe that business owners must invest to improve the productivity of the millions of workers they have already hired, substitute for the workers they can’t currently find and replace aged plant property and equipment. The confluence of these factors plus a global economy that is accelerating continues to shape our forecast that the U.S. economy is all right and primed for the above-trend growth in the coming quarters.
Does Economic Expansion Have Ample Time To Run?
With the economy having turned the corner, the chorus of naysayers has shifted the conversation to a question of how much longer this aging expansion can last. My answer to this is the same as it was to my children for most of our long summer vacation, when they continually asked “Are we there yet?” from the backseat: Be patient; the journey is not yet over.
The conditions that have historically marked the end of an economic cycle are an out-of-slack U.S. economy with rising inflation and a Federal Reserve rushing to tighten interest rates to snuff it out. During the third quarter, inflation remained at moderate levels. While we believe that it will begin to rise in the future, all indications remain that the Fed will not be in any hurry to stomp on the brakes this time. Our current analysis remains that both the U.S. and global economy have further room to expand; and as history has shown, this means the economy will drag the U.S. and global equity markets higher.
The Fed is an entity that wants to be overly sure everyone is all right. They can’t just let it be. The last sentence of the prior paragraph is exactly opposite of recent history. Quite the contrary: Over the last 10 years, the Fed has prodded the financial markets higher first with a goal of dragging the economy into expansion. Their prescription was to 1.) Lower short-term interest rates. 2.) Buy large amounts of intermediate- to longer-term Treasuries to push their prices up and yields lower. 3.) Make promises (forward guidance) to solidify their actions and reassure investors to take risks in equities and the economy.
The big event of the third quarter was the Fed’s announcement of the commencement of the second step in the process of unwinding the application of their above prescription. While they have previously begun raising short-term rates, at their September 2017 meeting, they announced they will begin shrinking the $4.5 trillion balance sheet of U.S. Treasury bonds and mortgage-backed securities they have accumulated to push long rates lower. The adjective they used to describe their planned process was “gradual.” You may ask, why? Because, as Fed Chairwoman Janet Yellen mentioned during her last press conference, the Fed’s latest research estimates that its actions have lowered bond yields by around 1%. Yellen added this color to the importance of “gradual” when she said, “By limiting the amount of securities that private investors have to absorb as we reduce our balance sheet, the caps will guard against outsized moves in interest rates and other potential market strains.” In my opinion, this translates into layman’s terms that the Fed wants to keep financial markets elevated because it fears any market volatility (stocks or bonds) could cause a financial market shock, which could spill over into the real economy and cause a recession. The Fed remains supportive of financial markets in the nearer term.
While the past few years have led the Fed to more aggressively backstop financial markets as described above, we believe this is a culmination of a path the Fed has been on since the 1980s. Many long-term Fed watchers and investors have likely heard the following terms: the “Greenspan/Bernanke” and now “Yellen Put.” These are terms investors have used to express their belief that the central bank stands ready to bail them out in times of need. Perhaps the Fed of the future will just let the markets be and focus their actions on the U.S. economy; however, as of now, the Fed appears to be fully behind keeping financial markets and the economic cycle afloat.
The Bottom Line
Given the confluence of the above observations, we continue to believe that in the nearer to intermediate term, equity markets, even at elevated levels, will continue to rise. While we’re certainly not near equity exuberance highs, we do worry that there are increasingly fewer people willing to give us a fight on our positive market outlook. We also note that while we believe the economy has time left to expand, we must acknowledge that we are lurching toward the end of the economic cycle. These two realities are beginning to shrink the margin of safety in our equity call. Therefore, we want to take the closing moments to reiterate the merits of our old friend – diversification.
Diversification pays the most near the end of business and market cycles. While we worry about a rise in bond yields and continue to express our desire to favor equities, we encourage investors to own bonds for the great qualities they possess. Bonds provide an asset class that has a high probability of maturing at par and ballast portfolios if our economic outlook is incorrect, and most importantly, they help fund an investor’s nearer-term liabilities.
We must also acknowledge that the Fed’s action that has pushed bond yields lower has also helped support equity markets. Therefore, if bond markets have difficulty, equity markets could have a nearer-term hiccup. However, equities retain their long-term, attractive proposition. To give an extreme example, October 2017 marks the 10-year anniversary of the U.S equity market peak of the prior expansion. The unlucky investor who bought at that peak in October 2007 would have had to ride through a harrowing downturn of nearly 57% during the Great Recession. However, the recovery that has unfolded over the past eight years would have pushed that investor’s return to over 100%, or 7% plus per annum, since 2007.
We remind that we continue to direct equity investors to diversify across the globe to take advantage of cheaper valuations. Both emerging and international developed equity markets, after years of languishing relative to U.S. equity markets, have recently provided strong relative outperformance. While we spent 2015 and 2016 worrying that investors were abandoning these markets and trying to persuade them that better days were ahead, recent data shows that the average investor fell prey to their emotions and lessened their diversification. A recent Fidelity study noted that investors who had 21% in international markets in 2009 had shrunk that level to 13% by year-end 2016.
This brings us to our last worry. After years of underperforming, there is an asset class that we are gradually warming up to as a potential future portfolio hedge or diversifier. A key lynchpin in the above economic and Fed calculus is that inflation remains low. If it doesn’t, the Fed’s gradual plan may speed up, which could disrupt both bond and stock markets. As such, we are seeking out a third asset class that will provide a hedge if inflation ticks higher than expected. The asset class that is at the top of our list is Commodities. After all, it is highly correlated to inflation.
Diversification remains a foundational investment strategy. Remain patient.
An Emerging Theme In Thematic Investing
Exchange traded funds (ETFs) are popular vehicles for market participants looking to engage in thematic investing. Thematic investing looks to take advantage of future growth trends, including disruptive technologies. Given that forward-looking approach, stock-picking in the thematic universe is equally as hard, if not harder, than in traditional market segments.
Go back to the late 1990s, before the bursting of the Internet/technology bubble. Back then, investors stood an equal chance of selecting E-Toys over Amazon or some no longer in existence networking equipment maker over Cisco.
“History is littered with examples of prospering industries with no indication of which company will come to dominate the industry,” according to Nasdaq. “This suggests that successful thematic investing is more about selecting baskets of investments rather than single securities.”1
The ALPS Disruptive Technologies ETF (DTEC) provides basket exposure to a broad swath of thematic investments. DTEC features exposure to not just one or two emerging technologies, but 10 such themes on an equal-weight basis.
The 10 themes represented in DTEC are as follows: 3D printing, clean energy, cloud computing, cybersecurity, data and analytics, fintech, healthcare innovation, Internet of Things (IoT), mobile payments and robotics and artificial intelligence (AI).
Generally speaking, fund issuers have been quick to respond to disruptive and transformative technologies, bringing products to market to tap these themes. Prior to DTEC coming to market late last year, there were ETFs devoted exclusively to cloud computing, cybersecurity, robotics and other themes featured in DTEC. However, few use the basket approach to themes employed by DTEC.
February, a rough month for U.S. stocks, highlighted the advantages of DTEC's multi-theme methodology. Seven of the 10 themes found in the fund finished the month lower, but DTEC was able to outperform the S&P 500 on a monthly basis.
Focusing on individual themes can be rewarding over the long-term, but not all investors have the risk tolerance for such a strategy. Consider this: the Indxx Global Robotics & Artificial Intelligence Thematic Index jumped more than 48% in 2017. That type of performance is enough to seduce many investors, but that same benchmark slipped 7.60% in February, generating monthly volatility of 34.10%.2 Said another way, that robotics and AI index's February slide was more than triple the loss experienced by DTEC during the month.
While it probably is not accurate to call the indexes devoted to individual disruptive themes “old,” many use old school weighting methodologies. For example, the two largest components in the ISE Cloud Computing Index are Netflix, Inc. (NFLX) and Amazon.com Inc. (AMZN). Only two members of the S&P 500 have larger market values than Amazon while Netflix currently has a larger market cap than Wal-Mart (WMT) and McDonald's (MCD).
Holdings subject ot change as of 12/31/17
For its part, DTEC not only equally weights its 10 disruptive themes, but its 100 components as well, potentially reducing single stock risk in the process. As the chart below confirms, equally weighting stocks is rewarding across sectors and market capitalization segments.
Past performance does not guarantee future results
Annualized returns for the past 10 years show seven of the 11 S&P 500 sectors, when equally weighted, outperform cap-weighted equivalents, according to S&P. Three of those seven sectors – financial services, healthcare and technology – are prominent parts of DTEC's roster.
1 Source: Nasdaq Dec. 28, 2015 https://www.nasdaq.com/article/what-thematic-investing-is-and-its-strengths-and-risks-cm559209
2 Source: ETF Replay data
An investor should consider the investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus which contain this and other information call 866.675.2639 or visit www.alpsfunds.com. Read the prospectus carefully before investing.
An investment in the ALPS Disruptive Technologies ETF (DTEC) may be subject to substantially greater risk and volatility than investments in larger and more mature technology companies.
There is no assurance that the market developments and sector growth based upon the themes discussed in the article will come to pass.
ALPS Disruptive Technologies ETF shares are not individually redeemable. Investors buy and sell shares of the ALPS Disruptive Technologies ETF on a secondary market. Only market makers or “authorized participants” may trade directly with the Fund, typically in blocks of 50,000 shares.
ALPS Advisors, Inc. (AAI) has engaged IRIS Werks, LLC (IRIS) to produce analysis and commentary on ALPS-advised ETFs. IRIS currently has a compensated business relationship with AAI. AAI is not affiliated with IRIS.
The content and opinions expressed in this article are that of the author and not the views and opinions of AAI. In addition, AAI assumes no responsibility to ensure the accuracy of the content written by the author.
There are risks involved with investing in ETFs including the loss of money. Additional information regarding the risks of this investment is available in the prospectus. Past Performance is not indicative of future results.
The fund is new and has limited operating history.
ALPS Portfolio Solutions Distributor, Inc. is the distributor for the ALPS Disruptive Technologies ETF. AAI is affiliated with ALPS Portfolio Solutions Distributor, Inc.
The author is not an investment professional and this article should not be considered investment advice. While the information and statistical data contained herein are based on sources believed to be reliable, the author takes no responsibility to ensure the accuracy of the content. Additionally, this article should not be relied on or be the basis for an investment decision. Information that is historical is not indicative of future results, and subject to change.
S&P 500®: A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
S&P SmallCap 600®: A capitalization-weighted index that measures the small-cap segment of the U.S. equity market.
S&P MidCap 400®: A capitalization-weighted index that measures the mid-cap segment of the U.S. equity market.
Indxx Global Robotics & Artifical Intelligence Thematic Index: The Indxx Global Robotics & Artificial Intelligence Thematic Index is designed to track the performance of companies listed in developed markets that are expected to benefit from the increased adoption and utilization of robotics and Artificial Intelligence ("AI"), including companies involved in Industrial Robotics and Automation, Non-Industrial Robots, Artificial Intelligence and Unmanned Vehicles.
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