Early in his keynote presentation Wednesday afternoon, Russ Koesterich asked a simple question. Does anybody here believe that over the next 10 years the U.S. economy will grow at the postwar average rate of 3.5% annually?
Nobody in the audience at the fifth annual Morningstar ETF conference could bring themselves to say yes to the BlackRock and iShares’ chief investment strategist. Then Koesterich explored the three “structural headwinds” that are keeping the U.S. economy from growing at that 3.5% annual rate.
“We see jobs being created but nobody’s getting a raise,” he said: wage stagnation is one of those headwinds, along with debt and demographics.
Koesterich says that the global economy is “relatively stable,” the U.S. economy is “shaking off a weather-induced contraction in the first quarter,” and while Japan and Europe are still struggling, most U.S. indicators are “pointing in the right direction.”
Yes, he said, the United States is “definitely in a cyclical upswing,” but what’s missing from that recovery is “wages; people are not coming back to work.” Those who are working, he said, are not seeing their wages increase, which is a big issue in an economy that is 70% driven by consumer spending.
This is not a new phenomenon created by the financial crisis, Koesterich pointed out. “Slow wage growth has been with us for some time,” he said, and “household real adjusted income peaked about 16 years ago.” However, “the really scary news is that if you look at working-age men, their inflation-adjusted income peaked in 1974.”
The paucity of jobs and the lack of wage growth is a trend, Koesterich said, that not only won’t change but will accelerate. “We’re still in an environment where secular forces are holding down wages,” he said. So how has the economy done as well as it has if consumers have less income to spend? It’s been helped by “tricks,” Koesterich said, including a declining savings rate, higher consumer debt and taking on more credit. Finally, “women entering the work force in large numbers is the third reason” consumer spending hasn’t slowed precipitously, but “now we’ve seen a plateau” in women’s earnings as well.
The second structural headwind Koesterich sees for the U.S. economy is the persistently high level of corporate debt. While there has been much talk of corporate America deleveraging since the financial crisis, he said that only one sector has seriously deleveraged: the financial sector. Overall nonfinancial corporate debt has risen by $9 trillion since 2007; even adjusted for a bigger economy, the nonfinancial debt-to-GDP ratio, he said, is 25 to 30 percentage points higher than it was in 2007.
The third headwind is demographics, which he joked is one of the few areas where strategists like himself find it “easy to project; it’s the only thing we know for certain.” Population growth is slowing throughout the world, especially in developed markets, and while the U.S. has better demographics than Germany or Japan, still “our work force did not grow last year.” That’s a big problem, Koesterich said, because basic economics “tells you growth happens because of employment growth or productivity growth.” Like wage stagnation, the drop in the labor force has been going on since before the financial crisis, he said, in fact for 14 years.
The Shorter Term
While he sees U.S. economic growth being slower long term, Koesterich doesn’t expect these headwinds to affect the next two to three quarters, but especially “as long as we’re in a restrained wage environment, growth will be slow.”
So what’s an investor to do?
“Is there anything left in the world that’s still cheap?” wondered Koesterich.
There’s not much that’s cheap, perhaps Japanese equities, he said, but most stocks otherwise are trading at or above their average valuation, though they’re still cheaper than bonds, thanks to “price insensitive” central banks that have been buying those expensive bonds. After an “unexpected drop in the first half,” BlackRock expects interest rates to head back to their 2013 highs, but “not as quickly as many people think.” Then, in 2015 and 2016, Koesterich said “we’re looking at a flat yield curve.”
The financial markets “appear complacent about policy risks” because of the Fed’s stance and actions, he said.
“We’re in the 8th or 9th inning of quantitative easing in the U.S. and U.K.” While the BlackRock consensus is that “we won’t see a return to high volatility,” Koeterich expects the VIX to head back to the high teens — “18 or so, rather than bouncing around in the 10-12” range.
On equities, he said, “Japan is about the only equities that are cheaper than they were a year ago.” So move to cash? “I don’t think so. Stocks are expensive but not at levels seen at previous market tops.”
While U.S. stocks may be “the most expensive market now in the developed world — some of which is justified,” he suggested these three ways to be selective in where you invest.
- Larger is cheaper than smaller. Large caps and megacaps are much less expensive than small caps, which historically have been the most sensitive to Fed actions on moneatary policy.
- Favor cyclical companies. Don’t buy defensive stocks like small caps and utilities, which are trading at par and even at a premium. BlackRock prefers technology, some energy stocks and some financials
- Look outside U.S. borders. Koesterich recommended bringing up your international allocations if you’re overweight U.S. stocks in the portfolio, but pointed out that “you get a better dividend at a lower price overseas,” including Japan.
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