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Cautious optimism expressed by economists

Christian Charest
John Gabriel

Christian Charest: For Morningstar, I'm Christian Charest. We’re at the ETF Invest Conference in Chicago put on by Morningstar and we’re about halfway through the conference so far. We've had three very interesting presentations by three high-profile economists. I'm here with Morningstar ETF analyst, John Gabriel, to chat a little bit about what's been said so far.

John, thanks for being here.

John Gabriel: My pleasure.

Charest: Now, one of the main themes that came up during all three presentations was the prospects for the economy. Everyone seems to agree that the recovery is going to be slow but steady.

Gabriel: Right. One of the main themes or the tone so far, and I think all three of the economists that we've heard so far can agree on, is that of cautious optimism. But, again, the focus has been – it’s been five years since the recession and it was such a deep recession, the worst recession since the Great Depression. A lot of people expected a V-shape recovery, which would be economy to snap back with fast growth. But as we look over the past five years, it's been a pretty slow and steady type recovery. So instead it went from being a V-shape to a U-shape, then some people call it an L-shape. So…

Charest: Which is not really a recovery.

Gabriel: Right, exactly. Now, we wanted to come back up, but – and really there's a few reasons for that too, because the recession was unique, in that it was deleveraging – it was caused by deleveraging and the consumer deleveraging 70% of the economy. What that means is that unlike other recessions in the past the economy doesn't return right away to what it was before. We can’t just keep doing what we were doing before, like what was the case in, say, 1975 or 1982 to 1984. In this case we had the housing bubble; housing was just so overbuilt in the U.S. and that really can't return to those levels.

We’re going to have to normalize, so going from, say – one of the economists mentioned that from 1998 over the next 10 years we grew at about 13.5%. But the first 90 years that we have the data, we’re talking about 40 basis points of growth per year. So he expects us to return something more like that, a slow and steady growth in housing. So as we look at the recovery from here, we can’t return to what we were before. Now the drivers are going to be investment and the shape of the economy is going to change a little bit, in that we’re going to be more reliant on exports to drive growth.

Charest: Let’s talk a little bit more about those drivers. That's one of the points where there were some kind of nuanced points of view from the different economists. Joe Davis from Vanguard was very adamant that innovation and investment are going to be the key drivers, whereas Austan Goolsbee, Professor at The University of Chicago and former advisor to President Obama, seems to think that the demographics in the United States are still favourable. What’s your take on that?

Gabriel: Well, I would have to say that, I think Joe Davis is right on this point here, because investment is going to drive – the demographics point, while it can be a positive, it was more of a relative issue. So we have an aging population in the U.S., but his point is that we’re aging slower than some other countries. So compared to them we’re not as bad. But Austan Goolsbee did say to his credit as well that something – and he was a little embarrassed to say that, well, I don't have numbers to back it up, it’s a softer point, but the U.S. has been characterized as innovative and is known for its entrepreneurship. He thinks that that’s a key to the recovery and what’s going to drive growth.

He did also mention the importance of investment, in that corporate profits are at all-time highs and that can help drive the investments going forward. Also that there is pent-up demand in the system, because through the recession a lot of people, they withheld a lot of their capital outlays, things like cars and other capital goods. There's a lot about – 25-year-old or 20-somethings young professionals still living at home and those going out for household formations and furnishing their apartments and that type of consumer spending that’s still pent up in the system. If that’s 30% of the growth that he expects, that's still to come over the next few years. He was careful to say that this is not a 12 – story over the next 12 months, but over the next few years, which again plays to the slow and steady type recovery.

Charest: The presenters were actually all fairly pessimistic with the near term. The next 12 to 18 months are going to be very volatile, but eventually things are going to get better.

Now, switching gears a little bit, Heidi Richardson of BlackRock mentioned that a new source of risk was going to be the bond market. Bonds have been known as safe havens traditionally, but that's going to stop pretty soon.

Gabriel: Right. Well, she mentioned what we think is safe may not actually be as safe, and she's talking about traditional fixed-income exposure, where the bulk of your risk comes from interest rate risk. So, obviously, we’ve seen as the Fed hinted towards their stopping the tapering and interest rates shot up, it’s been a rough period for fixed income. She expects the interest rates to be trending up as we move forward and that the interest rate risk that comes with your traditional fixed income exposure could be a hidden source of risk that a lot of people aren't used to, because it’s been a great 30-year stretch for bonds and people aren't used to seeing negative returns on their fixed income portfolios.

So with that, she wasn't totally averse to bonds. She said with respect to government issues, I would stay on the short end of the curve, where you’re less sensitive to the interest rate risk, and then where you can, to be tactical with your fixed income exposure.

Charest: She did mention that there were some alternatives, because as you said, the risk is with the traditional bond exposure, but there are different types as well.

Gabriel: Yeah, exactly. So a couple of the things that she mentioned were bank loans, floating rate-type fixed income exposure, where you don't have the interest rate risk.

Charest: Those are becoming very popular in Canada; a lot of new funds and new ETFs are being launched to target that niche.

Gabriel: Yeah, absolutely. Yeah, we have both. In Canada we have the bank loans, floating rate notes as well. She also mentioned global fixed income, and with equities too being that she sees those risks in the bond markets. She thinks stocks are attractive on a relative basis and she thinks that investors can look for income in the equity market. I think dividend strategies in North America have kind of been bid up. They’ve been very popular over the past year and a half or so. So her recommendation, which I think makes sense on a valuation basis, is to look globally for your dividend strategies, where the valuations are still in line and yields are much better than you can find in North America.

Charest: Now, debt levels in the United States are very high. It’s actually at a troubling levels and Joe Davis did mention that this was going to be the major issue facing the country in the near term. However, he and the other presenters, none of them seemed to believe that a default was in the cards.

Gabriel: Right. Unfortunately, this really comes down to a game of politics. Long-term investors, we might look back on this as a nonevent almost, but the reality is that it’s going to affect the markets. We’re going to see increased volatility; up until there is some sort of resolution, we have that deadline looming, October 17. Really it's kind of a stalemate right now with the U.S. government shut down, but everyone seems to agree that the consequences of the U.S. defaulting on its obligations are just so catastrophic or unimaginable or unquantifiable that nobody could be stupid enough to let that happen, to let the politics get into the way of coming to a solution or an agreement to either extend or raise the ceiling. So, yesterday with PIMCO’s Douglas Hodge even, he took the risk almost off the table completely saying there is no way that it could happen. Others won’t go that far, but I think the general consensus is that there will be a resolution, but volatility will be heightened until we get to that resolution, which would probably be at the last minute.

Charest: Thank you very much for sharing your thoughts with us, John.

Gabriel: My pleasure. Great to be here.