Getting a Read on Today's Economy

The following is a replay from the 2015 Morningstar Individual Investor Conference.

Jason Stipp: Good morning, and welcome to Morningstar's 2015 Individual Investor Conference. I'm Jason Stipp, site editor for Morningstar.com. If you have attended our conference before, welcome back. If you are new, we are glad to have you today. We have a great lineup for you this Saturday. We have sessions all through the morning, going into the afternoon. We are really looking forward to spending the day with you today.

We love hearing from Morningstar readers, whether it's article comments, or emails directly to us, or just seeing what topics and articles and videos you are interested in on Morningstar.com. We've designed this panel to really key in on some of the critical issues we know are on your mind.

We're starting this morning with Panel 1 to talk about the current market, current state of the economy, valuations, and interest rates. Panel 2 will deal with a topic we know a lot of you are concerned about--that's making your money last in retirement. We've got a great discussion on longevity, withdrawal rates, and other strategies. Panel 3 will be a great presentation from Christine Benz about getting income out of that portfolio in retirement--not so easy these days with interest rates so low. So, you'll definitely want to tune in for that.

This afternoon, we're going to be looking at our best fund picks--how we find the best funds and what some of our fund strategists' best ideas are for the market today. Then, we will be closing out the panel with a very popular topic, dividends. We love them. We know you love them. We are going to help you do dividends right today with a special presentation by Morningstar DividendInvestor editor Josh Peters.

Before we get started, a few notes for you today. This is a live presentation, so we really want to hear from you. We have an "Ask a Question" box to the right of your viewer. We are going to be screening questions, taking questions all day. We'll get to as many of those as we can throughout the day.

Also, there is a chat module. You'll notice that right below the viewer. You can exchange ideas with other viewers. We are going to be posting a few things for you in there as well.

Number three: We expect everything to go smoothly today, but if you encounter a technical glitch or a bump, there is a Help link at the top right of your screen. You can test your system there as well as submit a request for help if you need some technical assistance today.

Lastly, we're going to be taking a few short breaks between each session, about five or 10 minutes, to give you a chance to stretch your legs; but of course, we hope you stick with us all day.

So, no breaks for now. Our first session is on today's market. I'm joined by three really sharp panelists today to talk about interest rates, the Fed, the economy, and corporate America. No shortage of things to discuss today.

Our first panelist is Carl Tannenbaum. Carl is the chief economist for Northern Trust, and he has also worked with the Federal Reserve, with their risk group there.

Carl, thanks for joining me.

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Carl R. Tannenbaum: Good to be with you this morning.

Stipp: Thanks. Susan Schmidt is head of U.S. equities at Mesirow Financial, and Susan is going to be able to talk all about what she is hearing from corporate America and how that's connecting to the economy.

Susan, thanks for being here.

Susan J. Schmidt: Thank you.

Stipp: And, of course, Bob Johnson is director of economic analysis with Morningstar.

Bob, nice to see you again.

Bob Johnson: Great to be here today.

Stipp: So, several things to talk about today. Up first, of course, is the Fed. I thought maybe I'd just say Janet Yellen and let you guys start going. The Fed, of course, this week released its statement. Folks were expecting that the word "patient" was going to come out of the Fed statement. The Fed had said that they are going to be very patient about interest-rate increases for a long time, so folks expected that meant it's not going to happen for a little while. That language came out this week, but in its place, we also got a little bit of haziness about exactly when rate increases might happen.

So, Carl, I'd like to start with you. Obviously, you have a lot of experience with the Fed. How did you interpret that statement and what is the Fed actually going to be looking for when they are deciding when those rates are going to come up?

Tannenbaum: I'm a little bit bitter about the decision because I had thought that they would leave the word patient in the statement. I had bet my associate a muffin on that, and I ended up losing it, of course. And then when you sorted through their forecast in their statement, it really felt as if they were even going to be more patient than they had been when the word was in their statement. They downgraded their outlook for the economy a little bit and, as a result, their own forecasts of where the Fed funds rate was going in the future were made considerably more shallow than they had been in the December iteration.

In addition, inflation, which is their target and they have a target of 2% to reach, has been very, very muted. It has been held down by a lot of things, including the strong dollar and, of course, energy prices. And they are trying to look out into the future and assure themselves that they'll get to 2%.

The last thing, I think, that's holding them back is just being cautious after more than six years of zero-interest-rate policy and a lot of quantitative easing. One never knows exactly how the market and the system are going to react to the beginning of normalization, but it's our view that they'll make that attempt in September, that the increases will be shallow from there, but that eventually the market is going to have to learn to run without training wheels.

Stipp: So, Susan, the market actually liked what the Fed had to say. The market shot up after that statement, even though "patient" came out--

Schmidt: We had a bait-and-switch with the language, is sort of how I saw it. And the market really liked that because I think the market is very insecure. So, institutional investors, they don't like uncertainty. The traders out there, they want to feel like they have the absolute [answer], this is the way it is going to be. And I think, with that language, that gave them a little bit of comfort because we hadn't seen great economic numbers. The market is only going to be satisfied when we have super-strong economic numbers. And then, if the Fed comes out and says, "All right, we're going to raise rates," then the market will be expecting it, and it won't be a shock. I think it will ease in. The likelihood of that happening is very low, and I think the market will continue to be positioning around what Yellen might be saying. And, yes, right now, contrary to what's healthy for us in the long term, the market said, "Great, she is going to keep those supporting [policies] because things aren't going so well."

Stipp: Bob, you have an article on Morningstar.com this morning that says you are just frustrated with all of this hyper-attention on the Fed. What do you think is happening with the market? What do you think the market should be focusing on if not what Janet Yellen is going to do in the next six months?

Johnson: Well, Carl and I were talking this morning that we are used to periods of much higher interest rates. And certainly, if rates are near zero and we go up 0.5%, it really doesn't change the equation. If you've got a business project that you're working on [that would be greatly impacted by] interest rates going up by 0.5%, that's not a project that you really should be considering anyway. I think that all of this focus on what the Fed is doing [is unnecessary]. I think the Fed is watching the fundamentals. We all need to be watching the fundamentals of the economy, not what the Fed is doing, because the Fed says it's going to be a very data-based decision going forward. I think they are going to have to wait until all the data comes in. Some of the data looks little soft right now, but I think it's a fake-out. I think that we've got another winter lull, and then we are going to turn out to have a stronger second half of the year. That's when we are going to start to see some of the rate increases.

Stipp: Then, Carl, in the long run, does it really matter whether we see the rate increase in June and September? For a long-term investor or someone worried about the long-term health of the economy, there seems to be such hyper-attention on exactly when. We all know it is coming, right?

Tannenbaum: I think there has been so much focus on the launch date and there hasn't been enough focus on the launch angle, which is to say that it may be September, December, or even later; but over the course of time, if you are a long-term investor, you are really interested in what long-term credit conditions are going to look like. I think all the signals that we've gotten from our central bank and, frankly, other central banks around the world is that they recognize that we've come through a very trying period; that the expansion, while it looks pretty good, is still potentially fragile; and they are going to want to take their time to normalize conditions for fear of having to retreat later on.

Stipp: This is another issue that it seems like the markets really aren't thinking about: We might get that initial rate increase, but then there is going to be a trajectory afterward. It doesn't mean that we are going to have necessarily a lot of rate increases all at once. Bob, what do you think the Fed's options might be? A first increase, and then is it going to be a few smaller ones? Do you think we'll see a big one? What are the factors that are at play there?

Johnson: Well, I think one of the things that's on their mind is that, certainly, in the Alan Greenspan years--in "the aughts," if you will--when they raised rates, every meeting it was like clockwork, they'd raise them another 0.25%, then another 0.25%, and that almost got too predictable. And I think the Fed is kind of saying that they don't want to do that this time. They don't want to be on this clockwork pattern where it goes 0.25% every time, because then people bet against us and maybe they are expecting it to be a little bit more data-driven. So, I think this time around, we may have some slow data, and we have a no increase for a couple of meetings. And then things heat up, and then they have a 0.5% increase. So, I think we'll have that as a possibility.

What's a little bit even more interesting to me than what the trajectory is is [the question of] how much does it eventually become. I was kind of surprised with the last four major Fed rate increases. They've been up about 3%. Now, it has happened over two or three years, but we are all sitting here talking about eighths and quarters and maybe halves in terms of rates going up; but the historical pattern is that the first one is kind of just the beginning and that the increases can amount to as much as 2%, 3%, or even 4%. So, I worry a little bit about that, but hopefully we won't get to those high rates unless we have high growth.

Stipp: Susan, the market is obviously very keyed in on this particular event. Everyone knows the rate increase is coming, but we still might see some volatility. As someone who watches the market in response to economic conditions, including the Fed, what are your expectations? What should investors expect to see around these events?

Schmidt: I'm approaching it as a stage where I get to pick my spots of when I want to introduce new money into the market. And if I have a company that I particularly like and I think might be a little expensive right now, or if I feel like something is perhaps undervalued now and I'm willing to take a bit, it might be more undervalued later. It's really about legging in. The market is reacting to [the question of] when the launch date is.

Ultimately, for a long-term investor and for these companies, when the launch date is--whether it's June, September, December, or next year--we don't care. I think what's more important is looking at what the Fed messaging to the market is, which is, "We are here to support and continue to support these businesses as they go forward." And I think they are showing that they are being very prudent about how they are going to roll this out. That, for long-term investors, is the message, because I think it means that we are going to have continued support, a very positive backdrop, for companies operating in the next few years.

Stipp: Given that, though, in the short term, would you say that investors might want to put their seatbelt on because it could get rocky?

Schmidt: No question. It's already rocky. It's already more volatile than last year; that's the only thing we've seen with certainty so far this year. You are going to see a lot of swing, so be prepared. You've forgotten about how that feels because we haven't seen such big swings in the last couple of years. Those are coming back.

Stipp: We've got a question from a reader now asking about the effect of Fed policy on fixed-income investments. We talked about the stock market, obviously. If rates go up, that can have a negative effect on bonds. What's your thinking about how investors should be prepared for a higher-rate environment with respect to fixed income?

Schmidt: Well, fixed income in this environment is very, very tough because we know the rate increase is coming. So, when that happens, we know that the value of the underlying is going to go down. So, fixed income, I think, is dangerous. I think we are at a point in time where things are actually shifting. Fixed income used to be, to me, one of the safest places you could be, because you weren't going to have a lot of volatility. It was a steady ride. It was very positive going forward. I think we are in a new era. Right now, look at the change in the 10-year Treasury just over the past couple of months. The gyrations in that interest rate have been extreme compared with what they have been in the past. So, fixed income gets, I think, much trickier than people realize in that scenario to pay attention to. It's not what you were used to dealing with in the past; it really has changed.

Tannenbaum: The only thing I'd add to that, though, is that the long end of the fixed-income market is quite a bit different these days than the short end. Certainly, both are influenced by the Fed. But the long end certainly has been the recipient of a lot of safe-harbor asset flows, not just here but overseas; even though markets have done well, there is still a caution that persists. There is a trade out of other markets into dollar-based assets, and so we've been the recipient of those flows. And so, I think, frankly, the Fed is going to have difficulty trying to steer that long end of the yield curve to a point that they would want because there is so much capital flowing into it.

Stipp: Well, that's certainly something that we've seen, because everyone has been expecting fixed income to feel some pain for a while and fixed income, of course, has been doing quite well and did quite well last year, as some of these safe-harbor asset started to come in and also as the U.S. dollar and U.S. interest rates suddenly [caused the U.S. to become] a little bit better of a place to be as other countries began to ease their policies.

But I want to talk a little bit about higher rates not necessarily being a bad thing. We've got retirement investors and other folks who are trying to get some current income from relatively safe investments, and we also know that we've been under extraordinary policy here for many years from the Federal Reserve. We want to get back to normal, right, Carl?

Tannenbaum: Ask any pension-fund manager whether they want to get back to normal and they'll say, "As soon as possible." And absolutely, I think we're going to want to find out that the economy can perform without performance-enhancing policy from the Fed or fiscal policy. We've needed what they provided, but maybe it's time to see how we fare without it. Again, normal levels of interest rates will create normal types of asset allocations and more normal conditions for long-term investors to assess the possibilities.

Stipp: Bob, what does the normal look like? What should the 10-year rate be, and what does that signal about the strength of the economy?

Johnson: What happens is you take whatever the underlying rate of inflation is and, usually, the 10-year bond is 1.5% to 3% more than the rate of inflation, with 2% being the average. And it's a range--a range you can drive a truck through. So, if inflation is 1.5% to 2%, then we are looking at a 3.5% or 4% 10-year Treasury. Now, that's not going to happen overnight, and certainly we've mentioned part of the issue is that we're not the only game in town anymore. It used to be that we all watched the Fed, but now you've got to watch the euro, which is every bit as big of an economy as the U.S. You've got Japan who's already in an easing program, and then you've got whatever China might do. So, the U.S. central bank is not the only game in town. That's going to make it hard to control those long-term rates. And I really do think that rates will have to move higher eventually to compensate investors for inflation. And I think that's actually good news for senior citizens and for people who are savers, in general, who have gotten the raw end of the deal here. They've gotten almost this tax increase because it's a forced deal without any vote on it.

Stipp: Susan, I want to talk a little bit about how interest rates progress higher because it seems to be one of the key factors for the economy and for how the market will perform. It's not so much that rates will go higher but how quickly they go higher and if there's an unexpected jump up in rates. As you're thinking about corporate health and corporate markets in the stock market and how rates might move up, what should investors keep in mind about the volatility or the velocity of rate increases?

Schmidt: Well, if you take a really long-term perspective--we get very myopic when we talk about this--but with a long-term perspective, remember that anything under, say, 5%, which is the entire range that we're talking about here, is actually a very low rate for corporations to borrow at. So, if they have that as their base line and they're borrowing against it, that actually can be a very healthy environment for businesses. So, keep that long-term perspective on, recognize that there is volatility in between. If the rates rise more quickly than the market expects, you're going to have a great opportunity to buy because the market is going to jump back with a kneejerk reaction and say, "Oh, we're not prepared."

The market is typically behind in their expectations, and they always think it's going to be a little bit less, a little bit softer, a little bit longer than what the Fed actually does. So, there is going to be a lag; be prepared for it. With the messaging here, I think [Yellen] is trying very hard to set the stage so that the market moves to a gradual acceptance. I think Janet Yellen is doing a very good job of trying to take some control back from the market so that the market is not dictating to her what she has to do. But I would say be prepared for pockets of volatility and recognize that, if you can really look at a five- and 10-year horizon, you have the opportunity to invest in companies that have an 8% or 10% return on invested capital. Even if rates go up to 4%, that's a much better investment for you.

Stipp: To look forward to a potential opportunity to pick up a few bargains is the upside there. Carl, you mentioned earlier that it's not just the U.S.; there are other central banks in action here, and many of them are kind of moving in the opposite direction from the U.S. Federal Reserve. We had a question that's kind of attuned to this, which is asking about some of the consequences of negative interest rates that we're seeing in some parts of Europe. But in general, when you think about the actions that Bank of Japan and the European Central Bank are taking, how does that play into what the Fed is going to do and what the outcomes of all of these different central-bank actions are for the global economy?

Tannenbaum: Well, setting the stage: I've lost count. We're not even at the end of March, and I believe we've had more than 20 major central-bank actions--most of them going in the opposite direction from what we are doing here in the United States. Many central banks in Europe have not only lowered rates but pushed them into negative territory--and, in some cases, deeply so. Others, like the European Central Bank, have initiated a quantitative-easing program that was probably three years too late. But the Japanese are accelerating theirs as an effort to try to get out of what has been a terrible economic malaise.

And Bob mentioned something that I think is very important, which is what are the Chinese going to do? They've been sort of on the sidelines while their economy seems to be moderating perhaps a little bit more than they would want. The issue of negative interest rates is one that we're going to find out a lot more about. It does create some very strange incentives for investors. It may prompt some different asset allocations. It may cause upset in certain financial systems. We're going to be finding out more about that. In Europe, I believe, approximately 50% or 60% of government rates now, across the various yield curves, are in negative territory, and so that's something that we're going to have watch.

Now, to the point on the Fed: There has been a lot of debate as to whether the Fed should focus on its domestic objectives, which are maximum employment and 2% inflation, or whether they should consider some global matrix of objectives. I think it'd be very, very hard for them to take everything into account. However, they are aware that there are a lot of foreigners that have borrowed in dollars and are very sensitive to dollar interest rates, and so a rapid or unexpected rise in interest rates could be very damaging to them. And then a lot of this is a very psychological exercise. What you want to do is steer investor and business and consumer psychology in the right direct. An unpleasant surprise from the Fed would reverberate negatively not just here, but in a lot of world capitals.

Stipp: You mentioned the dollar there. What impacts do you think we're going to see, Bob, on the U.S. dollar? It's obviously been very strong, but that's going to have some knock-on effects as well?

Johnson: I think probably some of the really big moves in the dollar are probably over. I think the markets did a great job of anticipating what would happen. Look at what's happened to the euro versus the dollar--how it's kind of collapsed even before the first bond was bought. So, they've already had their effect, so to speak. So, I don't expect necessarily a lot more change in the dollar from here. But it is something that's impactful. The trade-weighted dollar is up something like 22%, so it's a huge number. It's a number, if you look back over the last 60 or 70 years, we haven't had a move--maybe once that was close to the trade-weighted dollar--that's moved that much. So, we're kind of in a little bit of a new territory. But that said, exports are only 13% of the U.S. economy. They're 25% of Europe's economy. They're 25% of China's economy. So, they're a much bigger deal elsewhere in the world. I think we'll survive, but it will be a headwind to U.S. exports, which has been a pretty big deal.

Stipp: And of course, we know a lot of corporate America has business overseas, and that's going to be headwind for them. We're going to talk about that in just a moment. I'd like to shift gears now and talk about the U.S. economy--the underlying fundamentals of the U.S. economy. Bob, you mentioned this week that we should be focusing on those things instead of so intently watching the Fed. But when you look at the U.S. economy, the signals have been mixed, at best, especially recently. GDP has been pretty volatile over the last few quarter. It feels like, when you look at the data, that the U.S. economy is going through fits and starts. But when you look past some of the noise, Carl, is the strength of the U.S. economy sort of slow and steady or are we seeing booms and busts as this data might suggest?

Tannenbaum: I'm a bit more encouraged than the characterizations we've seen recently. We're in the sixth year of an economic expansion that started awfully slowly. We averaged probably less than 2% after adjusting for inflation. And even with the sluggishness that we had in the fourth quarter, which has carried over to a certain degree so far this year, we've had much better growth results reflected also in the fact that we've created a lot more new jobs.

I think the tailwinds to the American economy include restored incomes on the part of those people who are back at work; the fact that deleveraging at the household level has preceded pretty well, meaning families can take vacations and replace their old jalopies again; we have very strong markets, which result in a wealth effect. If you see that your portfolio is performing well, you are much more likely to spend out of current income. And our government finances are in a lot better shape than they were three or four years ago. So, the belt-tightening at that level is much reduced. So, for all of those reasons, we're sticking to a forecast that we could get close to 3% during the balance of this year.

Stipp: Bob, I know that you have a forecast that had maybe been a little below consensus for the U.S. economy. What's your take on how we're going to do this year?

Johnson: I think we'll be at 2% to 2.5%. It will be very much a consumer-driven economy. I think Carl highlighted very well why the consumer is going to do so well, and that's 70% of the economy. So, that's really the great news. But the bad news is what's going to happen on the export side of the equation, where we're still hurting, and that's an important part of the equation. That's going to make for considerably less good news in 2015. So, that's going to hold us back a little bit.

Housing is off to a slow start, and you need a good housing market to kind of move the whole set of numbers up. Unfortunately, it's a cycle. You've got to look at a house, get a mortgage, and so on. And unfortunately, that's delayed; but some of the stuff may be delayed enough that it doesn't really begin to help the economy as much until 2016. So, a little bit slower housing market than some people are expecting is going to hold the economy back.

I certainly think that those are the key elements of what's going to hold us back. But the auto industry, for example, added a million new units in 2014. They are only going to add 0.5 million units in 2015. It's a good number but only half as good as it used to be. So, I think we're going to have a little bit of a slowing. This will not be as great a year for manufacturing as it was last year. It will still be very good, but it won't be nearly as good as it was last year. So, I think last year we grew at about 2.4%, and I think we're going to be pretty close to that again this year.

Stipp: Susan, a lot of folks have said, "Man, the recovery has been so slow--it really has been lackluster." But it's also lasted quite a while as well.

Schmidt: Right. And I think you have to take the good with the bad. It hasn't been this zoom back, which most people are used to. That's what's happened in our previous recoveries. We've had a very aggressive, rapid return to normalcy and a positive upward market. Right now, yes, it's fits and starts. It's bumpy, but that slower return also means that it's lasting a lot longer.

And so, people are always asking me, "Well, is it over? We're so far into the economic recovery. We should stop investing in stocks. This is not good for businesses anymore." On the contrary, I think I'm very positive on this recovery thinking that this is going to extend, [given] that positive backdrop. That positive environment is going to be there for a couple of more years, at least.

Stipp: Susan, I want to stick with you because we got a good question from a reader that says, "As a strategic long-term investor, why should I worry about forecasts? They are notoriously wrong anyway." Now, present company excluded--it's very hard to forecast the economy and where the economy is going to go. You invest and you also look at the economy. They don't always move in lockstep, as we know

Schmidt: They never move in lockstep. I would say never.

Stipp: How should people think about the forecasts that they hear and their investment plans? Is it more about setting expectations?

Schmidt: I think it's about setting your own personal expectations, because the biggest mistake that investors can make is to jump into something and then hear a forecast that doesn't agree with their long-term view, second guess themselves, and jump back out. They are going to lose all of the momentum in the positive aspects of their investment by doing that in-and-out [move]. I do believe in long-term investing.

If you have the attitude that you can look out five to 10 years, then I agree that forecasting doesn't really matter. Pay attention to what's going on, but I think this is an economy where if you can have that long-term perspective, they are absolutely right. Good business models in this economy are going to be presented at a value for you to invest in, and you are going to be able to in this market. You are going to get very good value for solid companies to invest in that should do very well over the course of time.

Stipp: Carl, it seems to me that, at the beginning of the recovery, we saw the economy faltering or struggling to get its footing, but the stock market was doing really well in 2009 onward and for several years. Now, it maybe feels like a little bit of a flip; the economy might be getting its footing and doing a little bit better, but the stock market has moved up so much now, do you think that we're going to see a little bit of a disconnect between what we're seeing in the economy and what we're seeing in the stock market, given where the stock market is now?

Tannenbaum: Well, I think Susan did a good job of describing the divorce that exists sometimes between the fundamentals and the stock market in the short run. In the early days of the recovery, corporate profits were doing very, very well, even though GDP growth was pretty modest. I think a lot of the early years of this recovery were characterized by financial repair, as households, as some corporations, as financial institutions, and governments tried to get their balance sheets back to decent health after a significant blow in 2008.

Now that those are largely in the past for most, you are beginning to see progress on the revenue side and not just the profit-margin side. What I'm told--and Susan is the expert here--is that those revenues, those increasing revenues are coming straight to the bottom line. The cost containment is still there. And so as you look at the multiples going forward, with a reasonable outlook for the economy, there certainly isn't an outward sign that the market is too far off-sides.

Stipp: And when we're looking at corporate health, companies did get lean and mean, very efficient afterward.

Schmidt: They did. They got incredibly efficient. CEOs understood that this was a tough, difficult, extremely rigorous environment in 2008-09, and they had to do everything they could to lean themselves out and improve their operations if they wanted to survive. So, I think that the corporations that you look at today that have lived through that did just what they needed to do. They have been very good at their operations, and they have held those improvements. So, we are seeing margins stay at a very healthy level, and we're seeing this extra cash flow drop to the bottom line. When I talk about long-term health in these businesses and being an investor riding along with them, that's a great sign for investors to be a part of that, because now you're investing in a very efficiently run, well-organized company that's had time to think and plot its strategic direction for survival.

Stipp: And we are seeing sales and revenue begin to pick up. There had been a lot of cost-cutting, and then it felt like they truly couldn't cut anymore cost. Now, we need sales and revenue to step in. We're starting to see that.

Schmidt: Right. We're starting to see that. There is a little bit of concern right now because when we look at the macro numbers, people are saying, "Well, gas costs have gone down so much--why aren't we seeing an increase in consumer spending?" There is a lag for that to take place. So, as an investor, I'm not too worried that I'm not seeing a huge spike up in consumer spend right away, really because the price of gas has gone down so that the average consumer has a little bit more in their pocket to spread around.

I'm not too worried about that yet, because I'm already seeing--and I have been seeing--steady signs of top-line growth. So, there are steady signs of revenue growth. And corporations and CEOs are feeling very confident about their business and their business prospects going forward. That's a positive.

Johnson: As a little bit of a contrary point, I think that on the domestic companies you tend to be a little more focused on, that's absolutely true. I'm a little worried that profit margins overall are peaking out right now in businesses. I think that the stronger dollar is going to begin to affect it.

Schmidt: I agree with that on the international front.

Johnson: But, then again, you've got companies that don't have a lot of exports that might be safe. With companies that borrow a lot of money, I think rates are great right now, but sometime over the next two to five years, those are going to go up, and that's been an important part of the margin-improvement story.

And then I believe the labor market is going to tighten up a little bit. Labor is at least a third of most businesses' costs, and I think that's finally going to be a part where we're going to see that go up. We're seeing people like Target (TGT), like Wal-Mart (WMT) drastically raising their minimum wages and having an impact on margin. So, I think, over time, the corporate margins will probably peak. I don't know if there's a disaster and you have to decide which companies are on the wrong side of all of those trends; you can't make a blanket statement. But I do think, overall, corporate profits have probably peaked out, and margins are probably going to go down from here.

Stipp: Bob, we're talking about how consumers should have this extra money because gas prices are down, but we haven't seen necessarily that spending shift over to other areas. People are used to gas prices being somewhat volatile. Do you think that money is going to find its way back into the economy?

Johnson: Well, it will--and maybe in some ways it has. But people kind of forget that lower oil and energy prices are not a one-way street. The strongest housing market in the United States has been the state of Texas, and guess what they are dependent on: oil. They like to say not so much anymore, but certainly we've seen housing starts and different activity in the state of Texas already start to fall off.

People forget, on the business side, that we spend billions and billions of dollars exploring for oil, and it was kind of the secret sauce, if you will, of why the economy has been so strong the last three or four years. It's been amazing, from the shale oil and the quarried sand that goes into that to the tubular steel that goes into all of that. It has really side-benefited a lot of things. And as that has slowed down, I think that's an impact that some people have missed a little bit.

So, I think those things are holding the consumer back a little bit. I think the weather is probably a little bit of a factor. Last year, we saw that it was really extreme, and we kind of pooh-poohed it a bit. It was almost like clockwork: It's terrible in January and February, and then we boomed in the June quarter as we came bounding back. I think we may see a little of that this year. So, I'm not panicked that the consumer isn't going to spend some of the gasoline money. But there are a few reasons the economy won't be as strong as people think.

Stipp: Carl, we got a great question from a reader. It's something that we were discussing just before this meeting about long-term demographics and productivity, and the demographic picture doesn't look fantastic for the U.S. That might suggest slower growth rates in the future than what we've seen historically. Do we need to get accustomed to slower growth in the U.S. just because our demographics are different than they were in the '40s, '50s, and 60s?

Tannenbaum: Demographics, I think, are going to be a major issue for world economies over the next generation. Many [economies] have postwar generations that are transitioning into retirement, and as they do, the impact on public budgets has been well discussed. But we're also losing a lot of talent out of our labor force, and we're going to have to try to replace that.

In addition, cultures that remain collectively young are granted more patents. Cultures that are collectively younger are more risk-takers; they are more entrepreneurs. Those are the sorts of things that grow the economy. Now, we're at a bit of an advantage, believe it or not, in the United States, and our demographics, while challenging, are nowhere near as bad as they are in other parts of the world. Japan, China--low birthrates, very low levels of immigration. Southern Europe--the same kinds of things.

Here in the United States, we're having a pretty interesting discussion about immigration. There are really only two ways to stay young, collectively. One is what I call the organic angle, and I've tried to mention to my wife that we need to have more children [for the economy's sake]; she is not entirely enthusiastic just yet. But it's the immigration, which we've done historically quite well, that would be an easy solution. We educate a lot of smart young people in our country who would like to stay, but the H1B visa limit keeps them from staying. We're having a lot of discussion about the undocumenteds, but the business roundtable will tell you that if we were to deport them all immediately, crops would rot and manufacturing lines would be deeply impaired. So, it's one of the things when I go to Washington, [although] there's certainly not a lot of hope for consensus there, this is one that Republicans and Democrats both seem to think has merit. And in order to keep our economy vital in the long run, I think it's something we really need to work on.

Stipp: Bob, long-term expectations for GDP: lower than what we've seen in the past?

Johnson: Absolutely. Not horrific and, again, not all bad, because we're not running around going crazy with booms and busts. Susan has mentioned the greater productivity, and certainly in slower growth, you have the chance to crank things down a little bit because you know where things are going.

But in terms of GDP growth overall, at least in the U.S., one of the interesting things to look at is in the '40s, '50s, and '60s, the U.S. population growth--that's immigration and natural birth--was about 1.8% growth. That kind of supported 3% to 4% GDP growth. Now, population is growing at about 0.7%, less than half of what it used to grow. And so you'd expect that the long-term expectations for GDP growth have to be lower. There are only two things that can really move GDP: One is population growth and the other is productivity. There are a couple of side factors you might add, but those are really the two biggies, and it's going to be hard to fight that demographic [decline to] half of the population growth that we used to see.

Stipp: We talked about consumer, but another area that drives the economy is capital spending from businesses. Are businesses starting to spend again? Are we seeing that piece pick up?

Schmidt: They are. And I think they're doing it because they have to. It's sort of the last thing that they're getting to. Initially, coming out of the recession, they were very concerned--there was no [capital expenditure]. They were battening down the hatches; they were cutting costs in every way possible; and then they started to slowly move forward. We've had a lot of indecision in Washington, and there has been a lot of uncertainty for senior management teams, not understanding how is this new health-care plan going to affect and impact my business. What really is the cost of it?

It's very hard for business leaders to make decisions when they can't quantify the cost of the action that they might take. So, I think that caused companies to back off on that capital-expenditure spend. And now we're finally passed that. We mentioned financial engineering and that companies really went back to look at their balance sheets and how they were leveraged and what makes sense--what's the best operating leverage to have for my business going forward? They have moved through that, and now we have, I think, a little more clarity from Washington. The CEOs are comfortable in what they're going to spend. And it's, right now, the last tool in the toolbox--where now they're going back and saying, "All right, what can we tweak here and make better?" And I think that capital expenditure is actually going to keep going up.

Stipp: Of course, the other way the businesses invest is by hiring new workers, and we've been tracking the employment market. Bob, you and I have been tracking it for a long time. I remember interviewing you back in the days of 2008 when [the Friday job reports] were real nail-biters.

Johnson: Yes.

Stipp: Those first Fridays of the month. You recently wrote, though, that you think we might be facing a labor shortage. Are we there yet, after all these years, where wages might have to come up because there aren't enough workers, or at least enough workers who have the right skills?

Johnson: I think that's absolutely true. And it's good news that we've got some productivity-enhancing equipment coming and more capital spending coming because I think we are going to face a period of labor shortage. We've actually seen a situation now where the number of people in the working-age population--that's between 22 and 62--is actually going to shrink in the U.S., starting this year. As early as the turn of the century, we were adding more than 1 million people a year to the workforce in that age group. And so we're certainly are facing a period where we're going to have a lot of retirees and it's going to be hard to replace them.

I think we're already seeing some of those shortages in some of the job-openings data, which is something Janet Yellen watches very closely. They haven't kept records for a long time, but we are at an all-time record high for the number of job openings. And so right now, that would seem to indicate, with hiring not being quite so hot, that we've got a little bit of a skills mismatch. And as we train people up and as businesses begin to raise their wages to make their work more opportunistic for individuals, maybe more people will join and maybe that will pull things up a little bit.

But certainly, I think we've seen already signs of shortages, as Susan mentioned earlier--and I'll let her talk about truckers if she wants. That's certainly an area of shortage; drywallers is another area; regional airline pilots, where the shortages have already shown up. And then if you look a little longer term, over the next 10 years, it's labor health aids and those types of folks where we're going to see some potentially huge shortages.

Stipp: Carl, a lot of folks are looking at the number of jobs added each month. But some other folks are also looking at the participation rate and also long-term unemployed. When you think about the structural issues of the skills that we have, the skills that employers need, will there be some trouble in the employment market because we have a lot of folks who don't have the skills who've been unemployed for a long time and have dropped out? And we have now some companies that can't find the workers that they need.

Tannenbaum: So, I'm going to be a little bit more sanguine than Bob. I'll start by scaring everybody a little bit more and then hopefully reassuring them. Bob mentioned the population trends, and if you take that a step further and think about what's going on with the total size of our labor force as people transition into their elder years, it's projected that the American labor force might struggle to grow at all over the next 20 years. However, there are adaptations already under way.

First, people above the age of 55 are already increasing the rate at which they participate in the labor force. And I think that's partly out of necessity because their retirement situations are not as firm as they were prior to the crisis. And secondly, people want to work longer as a means of staying sharp and fresh--and they can because they're healthier.

And with regard to the skills mismatches, what you see--and we were talking about this beforehand--is that if firms have an appetite for those workers, you can take a midcareer professional in many cases and give them new skills that prepare them for the jobs that are open, and America's community colleges are doing a great job of that right now. The question of who pays for it is becoming less of a problem, because the student certainly would see the opportunity that sometimes the employer is willing to pay for that. And then finally, as a society, in order to get that person back to work and perhaps off benefit rolls and on to payrolls, that should be something we find room for in our budgets.

Stipp: Susan, when you're looking at corporate America and who is going to be doing the hiring, where do you think we're going to see a lot of these jobs coming from?

Schmidt: I think you see them at all different ranges, and they are adjusting specialties. Bob mentioned that we had this big discussion prior to the program on trucking; there is a severe shortage of truck drivers right now. So, trucking companies, which have had a very good run and have done very well with their own economics and in operating more efficiently in the last couple of years, are short of drivers. They can't find people who are willing to take that overnight 600-mile journey on a truck. So, that's an area. Drywallers, as we talked about: Despite the fact that we're hearing about malaise within the energy complex, I'm hearing CEOs talk about how they can't find the right engineers to come in and help them with big petrochemical projects, which may have slowed but in the next couple of decades are clearly still going to be around.

And then at the same time, I have CEOs who are complaining and saying they just can't find the right set of people for line workers. So, at all levels, I'm hearing about some shortages or some seeking, but to Carl's point, I think that companies are getting much more creative in finding that pocket of labor that they need. And while we've gone through this temporary mismatch postrecession, we're starting to come back into alignment where I think we are hopefully the labor that's out there is finding a way to move into a position where it's appropriate for the company that's looking.

Johnson: But it could be a real shock to companies that aren't on top of this. People that find ways to retain the 55-year-old, companies that actually go out and work with community colleges and say, "Let us help you set up this program"--those guys are going to win. The people that have just been picking up employees that have been laid off--

Schmidt: They are in a tough spot.

Johnson: [Companies that] haven't had any training programs, no HR program whatsoever, those kinds of companies--and [on top of that] if they are labor-intensive--are going to be in a world of hurt.

Schmidt: Yes.

Stipp: Last big topic on the economy I want to talk about--and it's obviously related to the employment market and also related to wages and wage growth--is inflation. Now, inflation has not been on the radar for a lot of folks for a little while. We had some pockets of it here and there--in food, among a few other areas. But especially with energy prices so low, it's not really on the radar as an issue, and we're seeing that inflation-protected investments haven't been performing quite as well. Carl, your expectation for inflation is that now is the time to worry about it because nobody's worrying about it.

Tannenbaum: When the Federal Reserve started its quantitative-easing program, my old colleagues and friends at the University of Chicago were screaming bloody murder, because that sort of increase in the monetary base is typically associated with a very rapid increase in inflation. That hasn't happened, and it hasn't happened because growth and credit have not been flowing the way that they might normally flow.

At the moment, in addition, we have what Janet Yellen referred to as "transitory factors" of the dollar. And energy prices, while they've been under pressure, it's unlikely they will continue downward at the same pace. So, we'll get a true read on long-term inflation before too long, and there you're going to see the impact of things like wages beginning to firm and move up. Rents, which are the biggest part of the CPI and the PCE deflator, which is the Fed's favorite measure, are also moving up recently rapidly as are service prices.

And so, I do have confidence in the Fed's outlook that they will get back to that 2% rate of inflation. In addition, I think that they are still very dedicated to maintaining inflation at the target. I know investors have wondered whether they've lost track of controlling inflation. I don't think that's the case at all. Janet Yellen herself, when she was on the Fed Board earlier in the 1990s, was very hawkish about keeping a lid on inflation. I think if it ended up being a problem, she'd do the same thing this time around.

Stipp: Is inflation on your worry list at all, Susan?

Schmidt: No, not at all. That encapsulates everything. No. The market is not worried about inflation, and I understand that we have issues we talked about: wage growth, we've talked about some of the increasing expenses for companies. But they are managing to accommodate that and keep their margins. And so they are still operating profitably. We're not seeing any signs of [out-of-control inflation]. Good inflation is healthy, and a steadily rising interest rate is actually very healthy in a great environment where stocks have appreciated. So, as long as we see a little bit of inflation, the market is not going to be shaken by that. When inflation spikes suddenly--big, mid-single-digit numbers are coming out--then the market will get worried.

We are not seeing any sign of that pressure when we talk to corporations and in these business models. So, until we start seeing signs of pressure, the market is going to ignore it. I think Janet Yellen is very much on top of the inflation issue. It is not a concern. That's not one of the problems I have to think about right now.

Stipp: Bob, any worry signs on the inflation front from your perspective?

Johnson: I'm actually very worried about inflation, and I think now is actually the time to be worried about inflation. And I think that, again, for all the short-term factors that everybody has mentioned--and everybody on the panel, by the way, is right--I think over the next year or two, maybe even three years, we're probably just fine relative to inflation. But one of my absolute key metrics that has been invaluable in tracking what's going to happen with inflation is the output gap--the gap between where theoretically the economy can produce and where GDP is actually today.

In the depths of the recession, that gap got as wide as 6%. And that kept us thinking, even when the Fed was doing QE, when grain prices were going to roof, that inflation was not a worry; that was our take. Well now, that gap of 6% has turned into a gap of only 2%. And if we keep growing the way we're growing right now, the output gap will disappear completely sometime in 2017. We can argue whether it'll be late in 2016 or maybe it'll be 2018, but it will happen in that time range. And at that time, when output meshes with the capacity, inflation almost always goes up--and always a little bit more than we expect. And I think we're going to hit that period in 2017-18.

Now, here is a conundrum for the Fed: The Fed doesn't like to raise rates more than a quarter or a half at a time, and how many meetings do we have left now between now and 2017? That's why I think they have to begin raising rates now before we get to 2017 and say, "Oops, it's 4% inflation, and now we have to raise rates 1% at a time instead of 0.25% at a time." That's why I'm a little worried that they've put the rate decision off.

Tannenbaum: So, the only thing I'd add to that is that output gaps should, I think, be viewed globally. If we are running at our capacity here, there are businesses--as I'm sure Susan will tell you--that are very resourceful about finding capacity elsewhere. And so, I think one of the things that, over the last 30 years, we've had to focus on is that when we think of inflation or labor markets or capacity, it certainly has to be beyond the boundaries of the United States. That might also help keep a lid on things.

Johnson: And that's true. Unfortunately, I guess, some of the demographic trends that we're seeing here are just as bad elsewhere in the world--even worse in China in a few years when [they start to feel the effects of the] one-child policy in their economy.

Stipp: A reader just asked if we're not necessarily too worried--some of us, anyway--about inflation, what about deflation? Is deflation something that should be on the radar? That's something that's a lot harder for the Federal Reserve, obviously, to fix. Susan, you are not worried about inflation--

Schmidt: I'm not, and deflation would scare me. So, deflation is a much bigger problem for businesses, and that is a scary environment. And I think, as the business person looking at what Janet Yellen is messaging to me and how I am perceiving is, I think she is really protecting us against that slow growth, low growth--all good for a business. So, that's great for an investor; deflation is a little scary, because that could make your revenue just fall apart, and then your business model, you're just left holding an empty bag of air. There is nothing there. If I can't sell a product, the economy just pulls back and it's very hard to restart.

Our economists here will have much more technical terms around it and why; but as a business leader, that frightens me. What's been good about this slow, steady--sometimes lumpy--crawl out of the recession is that I haven't seen that. And so I am comforted that I don't have to worry about that. I feel like I'm right in the middle where it's actually OK.

Stipp: I want to stick with you, Susan, as we're almost short on time. But I want to tie this back to the markets and to investing. We've talked about a lot of topics: slow-growth economy, we talked about monetary policy. But let's take a look at the markets, the market-valuation levels, and where you are seeing some opportunities today. As investors are looking out there, what should they be keeping their eye on besides maybe the chance to buy in the future? What should they do with their money now?

Schmidt: They should recognize that there is going to be a lot of volatility. So, I think that's perhaps a new emotional stage for you to adopt as you go into the market in the coming year; you are going to see more big swings up and down. And they may only last a couple of days, but I think that there is more volatility in the market, overall. And so individual investors have to get comfortable with that, because you are going to have to remember that you are riding it out and that you are in it for the long term. And I think that if you look at the economy, there are pockets of strengths.

So, I still am very positive on the consumer; I don't think we've seen the complete flow-through of the advantage of lower energy prices. So, I think we're going to see that later in the year. I think low interest rates--Bob touched on it briefly--but we forget that that is still very supportive of the housing market, and we are moving past the fear factor. We're getting to the point where people are more comfortable, saying, "I think it will be OK. Maybe I'll go out and look. I'm not going to live with my parents anymore; maybe I'll go look at that starter home." And you are starting to see the pressures on the homebuilders now going, "Wow, we have to build more starter homes; we've been building for the empty-nesters."

So, I think there are pockets out there. What I would say most about the market this year and next year is that, in the past, we've seen a lot of correlation and you could say, "OK, I am going to be in energy; I am going to be out of energy; I am going to be in consumer." That's not the case anymore. I think it's very dangerous to make just broad sector bets. I really think it has become a stock-pickers' market in that you have to look at that individual company story and that profitability and the profitability profile going forward. That's where you need to think about investing. And that's a shift from where we've been the last couple of years, where just general exposure was good. I don't think that's the case anymore. So, you have pockets of opportunity, but then dig down into pockets or themes that you think are good and find individual companies that you like or find managers who are picking those individual companies and really working with that.

Stipp: All right. We're going to have to close there. I'm so lucky to have such sharp panelists today to talk about these very important issues. Carl Tannenbaum, Susan Schmidt, Bob Johnson, thanks so much for joining me today and for your insights.

Schmidt: Thank you.

Johnson: Thank you.

Tannenbaum: Glad to be here.

Stipp: Please stay tuned for our next session about making money last in retirement with Christine Benz and Mark Miller and financial planner Mark Balasa.

I'm Jason Stipp for Morningstar. Thanks for tuning in.