On the same day that the Federal Reserve offered a somewhat sobering view of the U.S. economy, Wilmington Trust forecast a recession later this year or next.

In its latest capital markets forecast, Chief Investment Officer Tony Roth told reporters in New York that the U.S. economy, though currently outperforming the rest of the developed world, is “overdue for a recession… There is certainly one on the horizon.” The last recession, known as the Great Recession, ended in June 2009, more than 6-1/2 years ago. 

“The risk of a U.S. recession has grown since the beginning of the year,” said Roth, citing the decline in housing permits and the continued, volatile stock market, which is down about 8%. “There is a material chance that we have a recession this year,” said Roth.

In the meantime, though, Wilmington Trust expects the Fed will raise interest rates once or twice this year, not the four times suggested by the Fed in December when it raised rates for the first time in almost 10 years.

Dividend-Paying Stocks

Against that backdrop, Wilmington Trust sees limited opportunities for capital gains, which is why income will “become an increasingly important component of portfolios,” said Roth. Income-producing investments will not only provide some return for investors but also cushion any capital losses, said Roth.

To that end, Wilmington Trust recommends that investors own dividend-paying stocks as well as U.S. and international REITs, high yield bonds in select sectors and eventually emerging market stocks.

Dividends will grow 5% to 5.5% over the over the next 10 years, keeping pace with 2.5% inflation rate and 2.5% GDP growth rate, and account for an increasingly larger part of total returns of the stock market, said Cam Albright, head of the firm’s investment strategy.

Dividends accounted for 2.3% of the 15% increase in total return rise in the Russell 1000, which are the 1,000 largest companies of the U.S. equity market, over the past five years and will contribute about one-third of the 7.2% total return over the next 10 years, said Albright.

Albright expects the biggest growth in dividends will come from the tech sector, where companies are maturing, and from financials, as more firms, having met required capital ratios, will be able to return funds to shareholders.

He said the firm has made a “strong strategic allocation in U.S. and global REITs and a smaller allocation to high yield – “a great asset class to date [but] I’m not sure you want to marry it the entire time.”

Emerging Markets: Their Time Will Come

The third and final investment theme of the Wilmington Trust forecast was emerging markets. Although the firm is currently underweight the sector it foresees “a moment sometime in the next year to year and a half when emerging markets become a very attractive” investment, said Roth.

Underlying the appeal are stronger demographics of emerging economies compared to developed ones. Their populations and middle class are growing while populations in developed markets are aging.

Within emerging markets, the market caps of “new economy stocks” such as mobile device makers will supplant old economy stocks” involved in commodities and other industries, said Clem Miller, portfolio manager of International Fund. And as that happens, current risks in those markets will decline.

“Three to four years from now we won’t be as worried about currency and commodity prices affecting emerging markets,” Miller said. “As their consumer-oriented industries rise, those concerns will gradually diminish.”  

The Big Market Risks: Some May Surprise

In the meantime Wilmington Trust is concerned about China, considered by many to be the world’s largest emerging market. More specifically it’s concerned about a “significant uncontrolled devaluation” of China’s currency, which would impact global financial risks.

Another big risk, according to Wilmington Trust, is Europe, which continues to struggle with “economic and political fault lines,” said Roth. He’s particularly concerned about a potential referendum in the U.K. on whether to leave the European Union. It’s not on everybody’s radar but is a “very real risk,” said Roth.

So is the price of oil, “not that it continues to fall but that it spikes higher,” said Roth.  We have “never had a recession since the early ’70s that was not accompanied by or preceded by a significant spike in the price of oil.”

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