State Street Global Advisors
Get ready to say goodbye to slow growth, low interest rates and benign inflation. Be prepared for the decline of monetary policy as defined by central banks and global institutions. Bid adieu to the embrace of globalization.
And say hello to the new abnormal, says Michael Arone, chief investment strategist at State Street Global Advisors. Going forward, the policies of the World Bank, International Monetary Fund, United Nations and similar institutions will be questioned and, possibly, ignored. Monetary policy is likely to be replaced by fiscal policy, including infrastructure spending and tax reform.
“Call it the end of fiscal austerity,” Arone says. The relatively free movement across borders that people and labor have enjoyed over the past 20 years will start to reverse course. And trade deals will be abandoned or renegotiated.
What does this mean for investors? They would be wise to consider the contradictory forces at play. In late 2017 and early 2018, fiscal stimulus, infrastructure spending and tax reform in the U.S. are likely to boost economic growth, and push inflation and interest rates higher.
Meanwhile, tougher immigration policy, trade restrictions and possibly tariffs, a strengthening dollar and widening budget and trade deficits will exert downward pressure on economic growth, interest rates and inflation. “Those contradictions are likely to result in an upward bias toward interest rates and growth but a cap to how high they can get,” Arone says.
For State Street, those contradictions suggest three investment themes: generating income at reasonable risk, positioning portfolios for an inflationary environment, and protecting against rising volatility. Here’s a closer look at how to implement each theme in an investment portfolio:
Generating income at reasonable risk. There are a couple of strategies for achieving this goal. One is to invest in bank loans, which provide income and credit exposure—but at acceptable risk, Arone says.
“You’ve moved up the capital structure and you have a floating structure in case rates rise more than anticipated,” he says. The second tactic is to consider companies that consistently increase their dividend yield. “Dividend growers are what you want to own, not necessarily high-yielders,” he says. “High-yield payers come with more risk. They tend to be concentrated in things like utilities and staples.”
For example, each of the holdings in State Street’s SPDR S&P Dividend ETF (SDY) has increased its dividends for 20 consecutive years. These companies tend to have low debt, low leverage and high amounts of cash flow. “From our perspective, these are the types of companies you want to own in today’s environment,” Arone says.
Positioning portfolios for an inflationary environment. Given expectations for increased government spending via infrastructure outlays and tax reform, combined with the likelihood of wage acceleration given the tight labor market, higher inflation is likely in 2017 and beyond. But plenty of investors still are overallocated to longer-maturity fixed-income investments and to high-yield dividend payers. While it doesn’t make sense to abandon such allocations, it may be prudent to start to shift those positions that have done well to sectors that would benefit from higher inflation. Global natural resources is one such area.
For its part, State Street offers a Multi-Asset Real Return ETF (RLY), an actively managed ETF which invests in natural resources, commodities, TIPS and REITs, four sectors that “are likely to benefit in an inflationary environment, which we haven’t seen in a while,” Arone says. “Oftentimes, financial advisers, when they think about a real-asset portfolio they may buy TIPS, they may buy real estate, but they don’t think about it is a holistic solution.”
Protecting against rising volatility. In the new abnormal, there will be bumps along the way, Arone says. Not only is President Trump a polarizing figure, but Washington itself increasingly is polarized and, even absent polarization, under any new administration, mistakes are made—all of which tends to lead to volatility. Plus, several European countries are having elections next year (the Netherlands, Germany, France). Given these prospects, consider gold.
“Any time you have bouts of volatility—9/11, the Gulf War, China devaluing its currency unexpectedly—gold does well,” he says. That is, it doesn’t necessarily rise but it maintains its value when other assets are declining. Plus, unlike many liquid alternative investments, gold has a negative correlation to equities.
Some might ask:
What about low-volatility funds? Keep in mind that such products present interest-rate risk. “Low-volatility funds tend to have high correlation to interest rates because they own a lot of those bond proxies, consumer staples, utilities, REITs,” Arone says. Rather than a single-minded search for low volatility, State Street prefers a multi-factor approach such as its MSCI EAFE StrategicFactors ETF (QEFA), which focuses on international developed markets, offering value and high quality along with lower volatility.
Finally, there’s another risk to consider in 2017: The rise of the U.S. dollar. U.S. companies generate about 40% of their profits in other countries. A strengthening dollar pressures those profits. A stronger dollar also could hinder the new administration’s plans to boost manufacturing, because exports will become more expensive.
Finally, dollar-denominated debt in developing markets has increased dramatically. If the dollar continues to strengthen, paying back that debt would become more difficult for many of those countries. Given that emerging markets make up close to 40% of global GDP, a debt crisis in those countries could be contagious to the rest of global growth.
“The dollar is an interesting risk to keep an eye on in 2017,” Arone says.
State Street Global Advisors is a Boston, Mass.-based investment-management firm and provider of index and actively managed ETFs, including the SPDR funds.
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