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By Adam Zoll | 09-18-2014 01:00 PM

Kelly: Stiffer Headwinds Up Ahead

Constrained labor force and productivity growth will add up to only 2% real growth for the U.S. economy over the long term, says J.P. Morgan's David Kelly.

Adam Zoll: For Morningstar, I'm Adam Zoll. We're at the Morningstar ETF Conference in Chicago.

My guest today is Dr. David Kelly, chief global strategist for the JPMorgan Funds.

David, thanks for being with us today.

David Kelly: Glad to be here.

Zoll: David, in your speech today you talked about both the short-term, somewhat rosy outlook for the U.S. economy, but also the long-term outlook in which you and others foresee below-historical-average growth for the U.S. economy.

What are some of the headwinds that you foresee for the U.S. economy going forward?

Kelly: The problem is that in the short run we still have a certain amount of slack in the economy, and so it's really about demand, about how fast we absorb that slack.

But in the long run, we are constrained by supply; we are constrained by the number of workers and the output per worker, or productivity of those people. The problem is that the number of workers is not going to be growing fast. The baby boomers are retiring in large numbers. We still don't have immigration reform, and because of that, we're looking at labor force growth of less than 0.5% per year going forward.

Productivity growth has also slowed down. I think a lot of this has to do with a lack of capital spending. We're not investing as much in technology and structures and equipment as we used to. But one of the results of that is that workers don't have more tools to become more productive with. And so it looks like output per worker is probably going to trail below 1.5% per year going forward.

If you add those numbers together, it does look like in the long run, once we get to full employment, the economy is only going to grow by 2% per year in real terms, and that is a good deal slower than the 3% per year that we've seen over the last 50 years.

Zoll: You also mentioned that as far as investment advice going forward, you think a mild overweight to U.S. equities is appropriate, and also an underweight to fixed-income securities.

Let's talk about U.S. equities first. Why do you think a mild overweight is appropriate?

Kelly: There is an old saying that you should make hay while the sun shines, and the sun is still shining on the U.S. economy. I think the next two years will be good in terms of growth. I think they will be good in terms of profits. And because profits have been so good so far, valuations are still actually pretty average in absolute terms, and they are cheap relative to cash and fixed income.

I do think that investors are feeling more optimistic, and they will put money into equities. The equity market will do pretty well over the next year or two, and given a rather difficult [environment] for cash assets over fixed income, I'd still be overweight U.S. equities right now.

Zoll: As far as fixed income goes, are you just concerned about the rising interest rate potential?

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