Kelly: Stiffer Headwinds Up Ahead

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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Kelly: The problem is twofold. Rates are already very low, so you're not getting paid for taking the risk in fixed income. And the Federal Reserve is gradually adjusting itself to the fact that we're running out of capacity. The economy is doing better. That's a good thing. Wages are beginning to rise. That's a good thing also.

But if these things are happening, we need to get back to a normal monetary policy. If you're holding bonds, that's a little bit tricky, because bonds are being underpinned by an abnormal monetary policy. So, when the Federal Reserve moves back to normality, and they push the federal funds rate, say, over the next three years back up to about 3.75%, which is what they expect, I do expect long-term interest rates will rise. And of course when interest rates rise, bond prices fall.

Zoll: Let's talk about equities outside the U.S. What do you foresee for the global economy?

Kelly: The global economy is doing a lot better than people realize. One of the tragedies of being an American investor in just trying to get a perspective is that the world is always portrayed as being in flames. You only ever see the terrible things going on around the world.

In fact, the world economy is doing quite well right now. The U.S. is growing; we know that. But also Canada is growing. The U.K. is growing. The Eurozone is growing; it is recovering from its recession in 2010. China is growing--not very fast by its standards, but it's growing. India is growing. Japan is recovering from its sales tax increase. In fact, if you look at the four largest economies in the world, they are all growing. That's the first thing.

The second thing is, they have more potential to grow. As I say, we're running into this capacity constraint in the United States; I think that's also true in Japan. But in Europe the unemployment rate is still very high. I think they've got years of recovery ahead of them in which profits can grow. And in emerging markets, they just have more capital growth and more labor growth because of a young population. They are going to beat the developed world's growth for many years to come, and it's important that people take advantage of that and invest some money in things that have better economic growth potential going forward.

Zoll: Finally, are there any particular pockets of opportunity that you foresee on either of the equity or fixed-income side right now?

Kelly: On the equity side, I think we should position portfolios for rising interest rates, and that actually means cyclical stocks over defensive stocks. Things like consumer discretionary, technology stocks, also financial stocks tend to do relatively well when interest rates rise. I think people should focus on that rather than things like utilities, telecom, and REITs, which are being bought for yield.

On the fixed-income side, I do think people should be underweight fixed income. But within fixed income, if you've got an improving global economy, I think high-yield bonds will still give you a positive total return over the next two years. I think floating rate bonds won't give you much of a return, but it won't cost you money in an improving economy.

I think there is also an opportunity in local currency emerging-markets debt. You've got countries like India and Indonesia and Brazil, the central banks are very strong, and they are fighting hard to dampen local inflation. They want to make sure their currencies stay solid, and if those currencies are unchanged against the U.S. dollar, if they can keep them flat against the U.S. dollar, and they have local interest rates at 8% or 9% or 10% to combat inflation, that's actually a pretty good opportunity for a U.S. investor in emerging-markets debt.

Zoll: Thank you so much for your time today, David.

Kelly: Very happy to help.

Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.