This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, CFA, chief strategist of Omaha, Nebraska-based CLS Investments.
Donald Trump’s narrow presidential victory, Brexit and stronger nationalist tendencies in Europe and Asia indicate an underlying shift in the emphasis of consumers and government policy.
While it may continue to cause some volatility, the shift will benefit economic growth through a few key changes in behavior:
Greater consumer optimism fuels increased consumption
Expansionary fiscal policies support infrastructure projects
Regulatory reform increases potential business investment
Economic trends show this transition is already in motion. Research originally conducted by MSCI and updated by CLS separates economic regimes into the four different quadrants seen in the chart below. This chart shows the global economy has moved from the slow-growth quadrant to the heating-up quadrant. The heating-up quadrant is associated with stronger economic growth and increasing inflation.
For a larger view, please click on the image above.
This shift will create opportunities for the patient investor in the coming years. There will be numerous ways to tilt portfolios toward these themes. This article briefly summarizes three opportunities CLS sees in the current environment.
Value Over Growth
All three of the key changes noted above should boost value stocks relative to growth stocks. Rising consumption broadens sales growth, infrastructure projects increase demand for physical goods, and a more favorable regulatory environment benefits energy and materials stocks. All of those trends should boost interest rates and loan demand, supporting financials as well.
Prior to 2016, value had lagged growth in six of the previous nine years, and had never outperformed by more than 2.3%. In the six years growth outperformed, three of them (2007, 2009 and 2015) did so by 9.5% or more.
Cumulatively, growth outpaced value by more than 50% from 2007 to 2015. Last year, value picked up more than 10% on growth in the U.S. (see chart above). While value did well last year, we expect the trend to continue to favor value stocks over the intermediate term. Two ETFs that offer exposure to this trend are:
While this economic recovery has been very long by historical standards, it has also been slow. Only in recent periods have we seen wage pressures starting to break through after a long wintry economic recovery.
Global supply chains have helped keep wages low by allowing firms to transfer production to cheaper areas. The new nationalists will pressure companies to keep more production in the home country. That in turn will push up prices, inflation and interest rates.
If the economic trend continues, we expect new quarterly inflation data to continue to be above the past quarter’s data. Based on our higher expectations for inflation, we believe TIPS will outperform nominal U.S. Treasury bonds of similar duration. Bank loans also look attractive in a scenario where credit risk is dropping because of good economic growth and increasing yields. In these bond segments, some holdings include:
The financial crisis has provided the dominant market narrative for investment results since 2007. Any narrative that lasts that long begins to creep into capitalization-weighted indexes.
With a new narrative of economic populism usurping the financial crisis as the defining trend in global economics, investors should expect shifts in leadership around the world.
If this trend-shift proves to be lasting, cap-weighted indexes will be overexposed to the beneficiaries of recent years and underexposed to value stocks, especially financial stocks. Smart-beta alternatives seem more likely than normal to outperform during a period of rapid change.
Here is a sample of smart-beta ETFs, excluding the value ETFs mentioned above:
At the time of this writing, CLS Investments invests in all of the securities mentioned above for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using ETFs. Contact CLS' Chief Strategist Scott Kubie, CFA, at 402-896-7406 or at email@example.com. Please click here for a complete list of relevant disclosures and definitions.