Curb Your Enthusiasm By Edward Talisse



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Curb Your Enthusiasm

By Edward Talisse

Chelsea Global Advisors

January 4th 2016

With little fanfare, the Federal Reserve recently reduced their estimate of the U.S. economy’s long-term potential growth rate. To be sure, the Federal Reserve has a less than enviable record forecasting GDP, or inflation for that matter. In fact, the Fed has systematically overestimated growth for many years now. In six of the past seven years, actual GDP growth has been outside the Fed’s central tendency or forecasted range. For 2015, real GDP is on track to increase at an annual rate of 2%, which is at the lower bound of the Fed’s initial estimate. This should not be a surprise to anyone. After all, forecasting is a tough science and there are few people that can boast of consistent success. We are all left to wonder whether the Fed’s reduction of potential GDP from a range of 2.0% to 2.3% to 1.8% to 2.2% is at all relevant. The cynics can rightfully be excused for believing that Fed’s action to trim potential GDP growth is a cherished signal that real growth is set to break out on the upside.

It may be helpful to recall that GDP is simply a function of changes in two key variables: the employment participation rate and employee productivity. If we accept this premise, then the prospects for future GDP growth are indeed worrying. The civilian labor force participation rate, rather than increasing, has been decreasing at a rate of about 1% since 2008. Similarly, trend productivity, as measured by the Nonfarm Business Sector: Real Output per Hour of All Persons, is downward sloping as shown in the following chart:

With both the employee participate rate and productivity declining, it hard to see real GDP growth returning to the 3.5% to 4.0% range we enjoyed in decades past. Slow growth is now the new normal, which if realized, has broad implications for investment returns of the medium to longer term. First, it should be no surprise that the iShares S&P 500 Growth Index ETF (NYSEARCA: IVW) handily outperformed the iShares S&P 500 Value Index ETF (NYSEARCA: IVE) by 9.24%. In a low growth environment, investors are sure to pay up for growth. Next, in a slow growth environment, companies will increasingly find it difficult to increase dividends, although they should be able to maintain current payouts, unless we face an earnings recession. However, as interest rates rise, as is currently the case, dividend payers will lose their luster relative to less risky alternatives like U.S. Treasury Notes. The two most popular dividend ETFs, the iShares Select Dividend ETF (NYSEARCA: DVY) and the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG) both sport small total return losses for the year. It is interesting to note that according to FACT SET “shareholder distributions for companies in the S&P 500 amounted to $259.8 billion in Q3 (October), which was the highest quarterly total in at least ten years.” Companies are paying out record amounts of cash via dividends or buybacks, yet investors are marking down theses share’s prices due to lower expected future growth prospects. A dividend yield of 5% is not advantageous if company’s stock price drops by 5% too.

Reader of Thomas Piketty’s Capital in the Twenty First Century can take comfort in the fact that slow growth, circa 1.0% to 1.5%, is a much more the normal rate of growth over long periods of time dating back to the 1700s. Elevated GDP growth rates of say, three to four percent, are much more an aberration than the norm. The good news is that even at growth rate of 1.5%, stock market returns should compound up to at least 45% over a generation, defined here by a period of thirty years. The bad news is that most investors are impatient and are unwilling to let the wonders of compounding work in their favour. So they are forced to take on an inordinate amount of risk to generate acceptable returns. That’s OK in my mind, as long as these investors have both the ability and willingness to take on such risk. Problems arise when investors possess a lot of willingness to take on risk but their ability is curtailed due their financial condition. In other words, most investors simply cannot afford to face big drawdowns that come along with upping the risk profile. What is to be done?

The solution for many investors is to simply lower your expectations of returns, defer consumption in favour of savings and maintain a well-balanced disciplined portfolio approach. Granted nothing worked in 2015- a traditional 60/40 portfolio using Vanguard 500 Index Fund (NYSE ARCA: VOO) and iShares Barclays Aggregate Bond Fund (NYSRE ARCA: AGG) barely returned 1% after dividends. Alternative, higher risk portfolios fared much worse and may bounce back- which is fine unless you cannot afford to lose a large amount of money now-which few people can. Of course, higher returns are available with higher risk. Power Shares NASDAQ 100 Index (NASDAQ: QQQ) had a 9.45% total return in 2015 and both European and Japanese equities had high single digit returns, at least in local currency terms. All three alternatives experienced higher volatility (risk) than the S&P 500.

Certain financial institutions, with powerhouse investment banking franchises, should benefit in a low growth environment. It’s no wonder that investment bankers feast on low growth. After all, mature companies with muted growth prospects focus on industry consolidation (M&A), capital structure (buybacks financed with debt) and tax management (inversions). Well-heeled bankers are ideally placed to lend a helping hand and the SPDR U.S. Financial Sector ETF (NYSE ARCA: XLF) is likely to outperform the broader market in 2016.



Slow GDP growth is likely to be an enduring feature of the investment landscape for many years to come. It is not realistic to expect eight to ten percent annual returns when interest rates remain at extraordinarily low levels. Low or negative interest rates are the result of low growth expectations and intense risk aversion, not as popularly believed, an exclusive consequence of muted inflation. Setting accurate investment return goals, based upon current conditions rather than on historical precedent, is the surest way to avoid nagging disappointments.


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