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Fiscal Stimulus? Check Your Portfolio’s Inflation Beta

By Vadim Zlotnikov With negative interest rates unlikely to ignite global growth, the debate will soon shift to expansionary fiscal policy. Investors should consider how a potential inflation recovery could impact their portfolios. In the aftermath of the global financial crisis, central banks have boosted liquidity, which has helped markets return to normal and supported asset prices. But end demand hasn’t fully recovered yet, and nominal economic growth is still subdued. As a result, investors are losing confidence in monetary policy as a tool to stimulate growth. We see this as a key source of potential downside for risk assets. A closer look at three key transmission mechanisms sheds light on why quantitative easing (QE) has become less effective over time: QE encourages risk taking . By reducing the supply of financial assets, QE was expected to lower the risk premium investors demanded. But current estimates of the 10-year US Treasury term premium are now negative. That’s a 50-year low, and it suggests there’s limited potential for further declines. Meanwhile, equity valuations have risen above their historical averages and housing prices have regained their pre-crisis highs in most regions. Sure, valuations could expand further, but upside potential appears more limited, and further gains could trigger concerns about asset-price bubbles. Wealth effects haven’t led to more spending . Higher asset valuations have helped reduce household leverage, but households have been reluctant to spend more – despite growing wages and cheap energy. One likely reason: rising asset prices mostly benefit higher-net-worth households, which tend to save more. And even though households have reduced their leverage from post-crisis highs ( Display 1 ), it’s still higher compared to history. Corporations have reacted to tepid end demand by returning cash to shareholders, instead of exploiting higher stock prices and low rates to fund investment. Click to enlarge Currency depreciation is less likely to continue . As currencies have weakened in response to lower interest rates, they’ve been very effective at driving corporate profit margins and equity returns across regions. But if QE becomes less effective at pushing down long-term interest rates, it will also likely be less effective at driving currencies. Supportive Environment for Fiscal Stimulus The deleveraging cycle appears likely to last if consumer and business sentiment don’t improve. We think governments can break this cycle, even though they’re highly leveraged, too. Central bank asset purchase programs are in place, so governments could finance spending initiatives by expanding the money supply. And given low rates, the interest expense burden should be fairly small. In general, it’s hard to gauge how effective fiscal stimulus can be. Academic studies estimate that fiscal spending multipliers on GDP average less than one in a normal interest rate environment. In other words, for every fiscal dollar spent, GDP gets a boost of less than a dollar. But recent research suggests multipliers may be much higher today. When growth is strong and there’s no slack in the economy, public spending raises inflation and interest rates, crowding out private spending. But when output is below potential, like today, and there’s spare economic capacity, increased public spending can have a more direct impact on real economic growth, with a much larger fiscal multiplier ( Display 2 ). Click to enlarge Also, when monetary policy is constrained by zero interest rates, fiscal stimulus raises inflation expectations, causing real interest rates to decline. This decline raises overall demand substantially, which further heightens inflation expectations and depresses real interest rates. This process can help break the deflationary dynamics of zero interest rates. US growth has been strengthening and core inflation has been accelerating, but the settings in Europe and Japan point to the potential for fiscal stimulus to be more effective than normal. Underinvestment Has Created Fiscal Spending Targets Infrastructure spending could be a prime target for that fiscal stimulus, because many developed economies have arguably underinvested in this area. A McKinsey study estimates that in the US and some European countries, spending would need to increase by 0.5-1% to meet infrastructure needs. Fiscal spending directed towards the right infrastructure projects may have a positive structural impact on growth in addition to cyclical benefits. In Japan, given the country’s elevated infrastructure spending, measures to improve consumption (such as the postponement of the consumption tax), labor-force participation (such as elder care and child care), wages and capital spending (including corporate tax incentives) may be more appropriate. Up Next: Helicopter Money? We expect the risk-on, risk-off environment to last for a while – investors and policymakers still don’t have a coherent framework for stimulating economic growth. Monetary policy, including negative interest rates, has failed to bring sustainable growth. We expect to see more discussion of the potential for helicopter money (central banks printing money and funneling it to consumers to stoke demand), or simply tighter integration of monetary and fiscal policy. If this is done in scale, it would likely recharge inflation. But there are political hurdles in large-scale fiscal stimulus, so we expect these initiatives to be delayed until 2017-2018. And they’ll be implemented only if there’s more evidence that monetary policy is becoming less effective. Long-Term Investors: Check Your Portfolio’s Inflation Sensitivity Still, investors with long-term horizons (three to 10 years or longer) have some things to think about – if they’re willing and able to tolerate short-term volatility. We think it makes sense to consider increasing portfolio tilts toward assets that would benefit from an environment of reflation – in other words, inflation recovering to normal trend levels. This means potentially increasing their portfolios’ inflation sensitivity – also known as the inflation beta. Some ideas would be allocating to real assets, such as commodities, and emerging-market-related assets in equity, credit and currency. Value equities in Europe and Japan would be other ideas to consider. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Vadim Zlotnikov, Chief Market Strategist; Co-Head – Multi-Asset Solutions; Chief Investment Officer – Systematic and Index Strategies

Find Businesses That Control Their Destinies

By Frank Caruso, James T. Tierney, Jr. In a volatile world, it often feels like companies are subject to forces beyond their control. Finding companies that can steer their own course is a good way to capture resilient growth through changing market conditions. Not all companies are equally vulnerable to unpredictable market forces. Some exercise a much greater degree of control over their fate by virtue of having fundamentally sounder businesses based on stronger people, better products, superior operating execution and more responsible financial behavior. Searching for companies that command their destinies is one of several ways that active investors can capture excess returns over long time horizons. Balance Sheets Matter Balance sheet health – and low earnings volatility – is a great indicator of resilience. Investors should always scrutinize a company’s balance sheet, but in times of stress, this is even more important. Companies with less debt to service will pay less of a penalty in their financing costs when interest rates rise. Low debt ratios also are good indicators of a company’s flexibility to execute its strategy without relying on banks or credit markets. And businesses that can generate the cash they need to fund and invest in their operations are less beholden to the demands of externally sourced capital, and less vulnerable to a potential tightening of credit markets. Solid balance sheets and sustainable sources of growth are a winning combination. Companies with both are much better equipped to reward shareholders by increasing their dividends or buying back shares – even in tough market conditions. Companies in the top quintile of share repurchases – especially those with attractive valuations – have outperformed the market historically ( Display ). Click to enlarge Focus on Pricing Power Pricing power is another indicator of a company’s ability to deliver sustainable growth. With China and emerging markets slowing down, and with anemic recoveries in countries from the US to Europe, it’s difficult to find sources of new demand. And with inflation stuck at very low levels, it’s not easy for companies to raise prices. So companies that demonstrate pricing power in their industries are better positioned to improve their earnings than are their competitors that lack it. We think there are three keys to pricing power: innovation, competition and cost and inflation dynamics. Innovative products and services are capable of commanding higher prices even in a tough economy and amid low inflation. For example, Apple (NASDAQ: AAPL ) commands premium prices for its smartphones because of its innovative features and an ecosystem that allows all the company’s devices to work together seamlessly. A highly competitive environment makes it much more difficult for companies to raise prices. And in a low-inflation world, cost dynamics are crucial. Given this reality, we believe that companies with strong market positions and relatively fixed cost businesses are better placed to increase revenues while leveraging costs. For example, Visa (NYSE: V ) and MasterCard (NYSE: MA ) are the two largest global card networks. As such, they have had the ability to modestly increase prices over time while competitors have seen price erosion. And the nature of their networks means that additional transactions or volumes are highly profitable from an incremental margin perspective. Understanding these dynamics can help underpin an investing plan for an unpredictable world. Investors in passive equity portfolios may be more exposed to capricious market forces because they will hold many benchmark stocks that are more vulnerable to instability. In contrast, in our view, active equity managers can target companies with clear advantages in confronting erratic headwinds – and controlling their destinies – which can lead to resilient long-term returns. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Frank Caruso, CFA, Chief Investment Officer – US Growth Equities James T. Tierney, Jr., Chief Investment Officer – Concentrated US Growth

ETF Deathwatch For April 2016: 35 Names Added

A whopping 35 ETFs and ETNs joined ETF Deathwatch this month. However, seven came off the list thanks to improved health, and another 11 exited due to their demise and liquidation. The net increase of 17 products pushes the count to an all-time high of 435. Despite the 585 lifetime product closures, 25 of which have occurred this year, the quantity of funds in jeopardy of increasing the death toll continues to grow. The primary reason is that all of the major investment categories are covered. New products coming to market tend to target a narrow niche, or they add a small twist to an existing strategy in an effort to be unique. Most of the 35 products joining the list fit into one of these descriptions. Even though the 331 ETFs on Deathwatch account for 76% of the 435 total, ETNs continue to have the highest representation. There are 204 ETNs listed for trading and 104 are on Deathwatch. That is more than half. Ten years ago, when ETNs first arrived on the scene, they offered exposure to many market segments that ETFs were avoiding. However, ETF offerings continue to evolve and have been encroaching on territories that were once the domain of ETNs. Today, most successful ETNs target MLPs, VIX futures, leveraged commodity futures, leveraged dividend plays or they are customized products for specific asset managers. There are only 33 ETNs with asset levels above $100 million. Actively managed ETFs also have above-average representation with 39 of the 136 (28.7%) actively managed funds finding themselves on Deathwatch. The 145 smart-beta funds on this list equates to 24.4% of that group. Traditional capitalization-weighted index ETFs appear to have the best chance of survival with just 15.8% of them currently in jeopardy. Combined, the 331 ETFs in these three ETF segments says that one in every five (20%) ETFs is on Deathwatch. The average asset level of products on ETF Deathwatch increased from $6.2 million to $6.6 million, and the quantity of products with less than $2 million inched higher from 97 to 98. The average age decreased from 46.6 to 46.4 months, and the number of products more than five years old increased from 138 to 148. The fact that sponsors have continued to subsidize 148 unprofitable funds for more than five years indicates they are either extremely patient or in denial. ETF Deathwatch is not just about closure risk. Liquidity risk should be a primary concern if you are considering any of these funds. On the last day of March, 277 ETFs posted zero volume, and 23 went the entire month without a single trade. Being lucky enough to get your purchase order filled within a reasonable bid/ask spread is one thing. Finding a buyer when you are ready to sell can be quite another. The 35 ETFs and ETNs added to ETF Deathwatch for April Cambria Value and Momentum (NYSEARCA: VAMO ) DB Agriculture Double Long ETN (NYSEARCA: DAG ) Direxion Daily Cyber Security Bear 2x (NYSEARCA: HAKD ) Direxion Daily Cyber Security Bull 2x (NYSEARCA: HAKK ) Direxion Daily Pharmaceutical & Medical Bear 2x (PILS) Direxion Daily Pharmaceutical & Medical Bull 2x (PILL) Direxion S&P 500 RC Volatility Response (NYSEARCA: VSPY ) EGShares EM Core ex-China (NYSEARCA: XCEM ) First Trust China AlphaDEX (NASDAQ: FCA ) First Trust Strategic Income (NASDAQ: FDIV ) First Trust Taiwan AlphaDEX (NASDAQ: FTW ) FlexShares Credit-Scored US Long Corp Bond (NASDAQ: LKOR ) FlexShares US Quality Large Cap (NASDAQ: QLC ) iPath S&P 500 Dynamic VIX ETN (NYSEARCA: XVZ ) IQ Hedge Strategy Macro Tracker (NYSEARCA: MCRO ) IQ Leaders GTAA Tracker (NYSEARCA: QGTA ) iShares Currency Hedged International High Yield Bond (NYSEARCA: HHYX ) iShares MSCI Saudi Arabia Capped (NYSEARCA: KSA ) John Hancock Multifactor Consumer Discretionary (NYSEARCA: JHMC ) John Hancock Multifactor Financials (NYSEARCA: JHMF ) John Hancock Multifactor Mid Cap (NYSEARCA: JHMM ) John Hancock Multifactor Technology (NYSEARCA: JHMT ) KraneShares Bosera MSCI China A (NYSEARCA: KBA ) ProShares Hedged FTSE Japan (NYSEARCA: HGJP ) ProShares MSCI Europe Dividend Growers (NYSEARCA: EUDV ) ProShares S&P 500 Ex-Financials (NYSEARCA: SPXN ) ProShares S&P 500 Ex-Health Care (NYSEARCA: SPXV ) ProShares S&P 500 Ex-Technology (NYSEARCA: SPXT ) PureFunds ISE Mobile Payments ( IPAY ) Recon Capital DAX Germany (NASDAQ: DAX ) Renaissance IPO (NYSEARCA: IPO ) SPDR S&P International Dividend Currency Hedged (NYSEARCA: HDWX ) SPDR MSCI International Real Estate Currency Hedged (NYSEARCA: HREX ) WisdomTree Global Natural Resources (NYSEARCA: GNAT ) WisdomTree Middle East Dividend (NASDAQ: GULF ) The 7 ETPs removed from ETF Deathwatch due to improved health: AdvisorShares Madrona International (NYSEARCA: FWDI ) AdvisorShares WCM/BNY Mellon Focused Growth ADR (NYSEARCA: AADR ) ALPS Emerging Sector Dividend Dogs (NYSEARCA: EDOG ) iPath Pure Beta Crude Oil ETN (NYSEARCA: OLEM ) ProShares S&P MidCap 400 Dividend Aristocrats (NYSEARCA: REGL ) ProShares Short Basic Materials (NYSEARCA: SBM ) ValueShares International Quantitative Value (BATS: IVAL ) The 11 ETFs removed from ETF Deathwatch due to delisting: ETFS Physical White Metal Basket Shares (NYSEARCA: WITE ) Recon Capital FTSE 100 (NASDAQ: UK ) PowerShares China A-Share (NYSEARCA: CHNA ) PowerShares Fundamental Emerging Markets Local Debt (NYSEARCA: PFEM ) PowerShares KBW Insurance (NYSEARCA: KBWI ) Direxion Value Line Conservative Equity (NYSEARCA: VLLV ) Direxion Value Line Mid- and Large-Cap High Dividend (NYSEARCA: VLML ) Direxion Value Line Small- and Mid-Cap High Dividend (NYSEARCA: VLSM ) ALPS Sector Leaders (NYSEARCA: SLDR ) ALPS Sector Low Volatility (NYSEARCA: SLOW ) ALPS STOXX Europe 600 (NYSEARCA: STXX ) ETF Deathwatch Archives Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.