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By Jeremy Glaser | 07-16-2014 01:00 PM

Finding Value in a Challenging Market Environment

In this special one-hour presentation, Morningstar experts share their takes on how investors can navigate a world with slightly overvalued stocks, an uncertain interest-rate environment, and a slow-growing economy.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. The first half of 2014 did not turn out quite as many investors had expected. Going into the year there were hopes that growth was ready to take off, thoughts that interest rates were almost certain to rise, and an expectation that stocks might take a bit of a breather after 2013’s big gains.

However, in reality the cold weather put a chill on economic growth, interest rates actually fell, and stocks continued to rally to new record highs.

This has created a vexing problem for investors. With stocks looking overvalued, bonds potentially at risk from rising rates, and with cash providing zero return, investors just don’t know what to do with their money.

To shed some light on what is happening in the markets and the broader economy, where investors can find value today, and how fund managers are handling this environment, we spoke to several Morningstar experts.

First up was Bob Johnson, our director of economic analysis. We asked him how the economy has performed so far in 2014 and if it has led him to change his forecast.

Bob Johnson: Starting the year, my forecast was 2%- 2.5% [for GDP growth], the same forecast I have had for the last three years, and I'm still sticking with that. But it will be at the low end of that range. We obviously had a disappointing first quarter that was actually down 2.9%, which will make it hard to get to the 2.5% growth, but it could still happen. But I really do still think we'll get 2%. I think there will be some inventory-adjustment things that come through and some improvements that we are already seeing in the second quarter. I really do think we'll be able to get to the 2% growth. But now that's kind of the top limit of where we can be, and not the 2.5%. It's a small change.

Glaser: What's driving some of this underperformance? Is it weather-related? Is it just timing, or are there some real fundamental influences?

Johnson: There are two things. Obviously housing has been a little bit fundamentally weak which has kind of impacted a lot of things across the board. But really the big negative number was probably very much related to weather and uncertainty relative to the Affordable Care Act and exactly how that would fit in the numbers scheme in the year ahead.

Glaser: Looking across as major drivers, what has surprised you the most in terms of the upside?

Johnson: Absolutely by far is that manufacturing is doing very well and has now for kind of three, four months in a row. And again the sad news is it's not a bigger part of the U.S. economy; [it accounts for less than] 10% of U.S. employment. So it's not that big a sector. On the other hand it's really done well, as the auto industry has kind of come back from the middle of the winter when things looked so bad. The industry really kept production up, and I was very scared about that for a while.

Now we've had a strong spring selling season in autos and the manufacturing now looks justified. And I think probably Boeing is doing pretty well, and just kind of a broader range of the manufacturing industry is finally beginning to do a little better. Maybe a little bit more [production is returning to the U.S.] and so forth. So we've had some nice manufacturing numbers. That's the nice upside surprise.

Probably the big downside was housing, as I've alluded to before, in the first quarter as in the fourth quarter. It was actually detraction from the GDP calculation, which hasn't happened for long, long time.

So it's good to see that it's finally looking, in the last few weeks' worth of data, that housing has kind of the turned the corner again. And I am not worried housing will get back, but it may not be as totally robust as we all thought it might be.

Glaser: Consumers are obviously a big part of that pie. In terms of GDP what does consumer spending looks like. Are people scared?

Johnson: They are not. We've had a couple of bad numbers here and there, but when you look at three months averaged together and appearing year over year, you can lay a ruler down. It's been 2% [growth in consumer spending] for the last three years, and that number continues. The consumer seems to have a rock-solid number that they kind of want to spend toward when gasoline prices go up or something and then they cut back in something else, or maybe they dip into savings a little bit. And then when times get good, they restock the savings a little bit. But really they've done a very good job of smoothing their consumption numbers.

Incomes have been a little bit more volatile because of inflation. But on the other hand the consumption number has really been solid, and I feel very good that it will stay in that range.

Glaser: Let's dive into inflation a little bit then. Are you worried that we are at the beginning of a big uptick in prices, or are things going to stay stable.

Johnson: I think we are going to be in a relatively narrow range. I think we have a few things going on. I think some of the commodity issues are pushing inflation up in the short run. We've got a drought in Texas, which has hurt cattle in the past several years, so beef prices are at a new record high. We've had droughts in California which are affecting fruits, vegetables, and eventually, this fall, nuts. So those will be impacted. And then we've got droughts in Brazil which are affecting coffee prices.

So you've got this trifecta things that are affecting food prices. Then there are the problems in Ukraine, and then you pile in the Iraq situation, and now you've got a situation where you've got oil prices higher than we thought they were going to be. We thought they might come in a little bit with the greater discoveries here in the U.S., but, no, that doesn't appear to be the case right now. So that's pushed oil prices up.

If there is one thing that changed in my forecast; I was saying 1.5% to 1.8% in terms of inflation. Now it looks like the numbers will be 1.8% to 2.0% for inflation this year. That's probably even a little bit optimistic; that assumes that maybe some of the things settle down in Iraq just a little bit.

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