4 Worries From Morningstar's ETF Invest Conference

Caution reigned over this year's Morningstar ETF Invest conference. As Morningstar's Scott Burns put it to kick off the event, many of the big investor worries in 2011 still remain in 2012. Despite some kicking the can down the road, underlying problems with the U.S. fiscal picture and the eurozone remained unsolved. There was still some optimism in the air. Many were hopeful about the slow but resilient U.S. recovery, recent equity returns, and the growth of the exchange-traded fund industry into new asset classes. But there were plenty of concerns voiced, too. Here are four big worries from the conference.

Fiscal Cliff
The fiscal cliff was one of the hottest topics of conversation at the conference. There was little disagreement that if current law isn't changed, the U.S. economy is set to fall into at least a mild recession in 2013. The currently slow recovery just couldn't withstand the drag from higher taxes and big cuts in spending. Add in the potential investment pullback from the already-cautious corporate sector as it waits to see what the damage is, and the economy could be in real trouble.

There was disagreement, however, about whether the fiscal cliff would be fixed before Jan. 1.  Charles Schwab (SCHW) senior vice president and chief investment strategist Liz Ann Sonders believes that at least half of the impact will be muted by policy changes. Although the exact changes will be determined by the outcomes of the presidential and congressional races, she believes that politicians will be able to use the lame-duck session to get something done even if it is not perfect. Russ Koesterich, global chief investment strategist at iShares, had a slightly different take. He thinks it is certainly possible that a fix will be passed, but cautions that the market is being too complacent in assuming it is going to happen. Congress and President Obama might just find it too difficult to come to a agreement in a few short weeks before year-end. Koesterich pointed out that nearly all academic and business economists aren't modeling in the chance of a near-term recession, and the market might not be accurately pricing in the chance that nothing gets done. There could be a serious downside risk that policymakers mess this one up.

Entitlements
The problem of entitlements in the United States was also top-of-mind across a number of sessions. Everyone was concerned with what impact the expanding U.S. deficit was going to have on the global financial markets. And though no one was predicating that bond vigilantes were going to be driving up U.S. Treasury rates anytime soon, there was a keen sense that the problems won't be easy to solve and that no grand solution was in the works. Koesterich laid out the historical case that until politicians' hands are forced by the bond market and they are given an electoral mandate to make big changes, no major structural reforms can happen. Given that the political polarization in the U.S. is decreasing the chance that any one set of policies have enough popular support to stick, the chances of a grand bargain that will right the ship could be a distant possibility.

Instead, what is happening is what PIMCO's Vineer Bhansali termed "financial repression." The Federal Reserve is holding rates artificially low in order to combat the threat of deflation. This obscures potential bond market signals and reduces the total real debt burden by pushing inflation higher. But covering up the structural problems is far from a real solution. The Fed can only keep expanding its balance sheet too far before inflation becomes too big of a problem or asset bubbles begin popping up everywhere. And given that health-care costs look poised to blow out the primary budget deficit even more in the coming decades, the deficit problem is going to keep getting worse even with some mild inflation.

Fixed Income
The Fed's policy has also created a number of difficulties for fixed-income investors. As Bhansali put it, investing alongside large noneconomic actors is extremely challenging. Anyone who has looked for yield recently can readily confirm this. It is hard to find income, particularly when you are indexing as many of the major core bond indexes are predominately made up of Treasures and agency-backed mortgage bonds which are essentially government securities, as well. Investors are faced with low yields today, and then when rates start to rise the value of their bonds will fall. The hard part is that there is no easy solution to the problems of the fixed-income market. Bhansali suggested that good security selection is one way to improve your returns. Shunning the parts of the index that are being held down by fiat and looking at other more appealing market segments can help create outperformance.

Kevin Petrovcik from Invesco PowerShares, Rick Harper from WisdomTree and Matt Duda of Western Asset encouraged investors to look beyond the traditional fixed-income categories. In particular, they believe that investors are underexposed to bank loans, emerging-markets sovereign and corporate debt, and currencies. They see a better risk/reward trade-off in these markets in the years to come as emerging markets have been cleaning up their sovereign balance sheets for sometime now and have greatly reduced some of the risks that traditionally have accompanied investing in emerging-markets debt.

China
One emerging market in particular was a hot topic of conversation, and that unsurprisingly was China. Everyone agreed that China was slowing. The controversy was over how much, and what impact it would have on the rest of the world. Morningstar's Dan Rohr and Baochuan Capital Management's Kevin Carter debated the future of Chinese growth in a dedicated panel. Rohr sees growth slowing considerably as the country gets over its fixed-investment hangover. He says too much has been spent on building new highways, apartment buildings, and infrastructure, and that it will take a long time for China to grow enough to justify even more spending. Carter thinks the country will have an easier time adjusting. He sees continued urbanization, increasing consumer spending, and the policy levers the government still has as providing a way to ease down on to a lower, but still high, growth trajectory.

What impact will a slowing China have on the rest of the global economy? There was a consensus that developed countries such as Australia, New Zealand, and Canada, which depend on Chinese demand for minerals to keep their economies growing strongly, could see a squeeze. Duda thinks other emerging markets might actually fare better as their domestic demand can create some cushion, and emerging-markets business leaders have been preparing their firms for a slowdown. Still, a slowdown in China, no matter what the magnitude, is hardly welcome when the fiscal cliff is looming in the U.S. and a recession is already under way in Europe.