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Does Low Growth Mean Lower Investment Returns?

Why U.S. potential GDP has declined. Investors should lower their expectations of future returns. Low growth comes with both higher opportunity and higher risk too. 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 participation rate and productivity declining, it is 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 over 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 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 FactSet, “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 shares’ prices due to lower expected future growth prospects. A dividend yield of 5% is not advantageous if the 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, 3% to 4%, are much more an aberration than the norm. The good news is that even at a 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 favor. 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 favor of savings and maintain a well-balanced disciplined portfolio approach. Granted nothing worked in 2015 – a traditional 60/40 portfolio using the Vanguard S&P 500 ETF (NYSEARCA: VOO ) and the iShares Core Total U.S. Bond Market ETF (NYSEARCA: 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. The PowerShares QQQ Trust ETF (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 Financial Select Sector SPDR ETF (NYSEARCA: 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.

WisdomTree Going Beyond Hedged International ETFs

WisdomTree Investments (NASDAQ: WETF ), the industry’s fifth largest ETF provider, has a long list of successful products, be it currency hedged, pure domestic or international equity funds. In fact, WisdomTree has been the king in the currency hedged ETF world with blockbuster funds – Europe Hedged Equity Fund (NYSEARCA: HEDJ ) and Japan Hedged Equity Fund (NYSEARCA: DXJ ) – having AUM of $19.4 billion and $16.2 billion, respectively. Encouraged by the incredible success of these two funds, WisdomTree now plans for their unhedged versions. These ETFs will simply provide exposure to the export-oriented dividend-paying European and Japanese stocks excluding the currency derivatives, making them WisdomTree’s first unhedged international ETFs. While a great deal of the key information – such as expense ratio or ticker symbol – was not available in the initial release, other important points were released in the filing. We have highlighted those below for investors, who may be looking for a new income play targeting Europe and Japan from WisdomTree should it pass regulatory hurdles: WisdomTree Europe Equity Fund in Focus The proposed ETF looks to offer exposure to European equity securities, particularly shares of European exporters, which tend to benefit from the falling euro. This could easily be done by the WisdomTree Europe Equity Index, which consists of dividend-paying companies that derive at least 50% of their revenue from countries outside of Europe and have at least $1 billion in market capitalization. Though this planned fund will likely get first mover advantage due to the inclusion of export-oriented, dividend paying companies, it will face stiff competition from FTSE Europe ETF (NYSEARCA: VGK ) and First Trust STOXX European Select Dividend Index Fund (NYSEARCA: FDD ) . VGK is the most popular and liquid ETF in the European space with AUM of over $14.9 billion and tracks the FTSE Developed Europe Index. It charges 12 bps in fees per year from investors. On the other hand, FDD follows the STOXX Europe Select Dividend 30 Index, providing exposure to high-dividend yielding companies across 18 European countries that have a positive five-year dividend-per-share growth rate and a dividend to earnings-per-share ratio of 60% or less. It has amassed $158.7 million in its asset base and has an expense ratio of 0.60%. Further, the success of the proposed ETF depends on European economic prospects, which look bright at present. This is especially true as the economy is on the mend with the rounds of monetary easing. The European Central Bank (ECB) is pumping trillions of euros into the sagging Eurozone economy, courtesy its QE program that began in March and will run through September 2016. Additionally, cheap oil, higher exports, and weak euro are providing a further boost to the region. If the current trends continue, the WisdomTree proposed fund, if approved, will not find it difficult to attract investor attention. WisdomTree Japan Equity Fund in Focus This proposed ETF looks to target export-oriented, dividend-paying Japanese equity securities by tracking the WisdomTree Japan Equity Index. The Index consists of dividend-paying companies incorporated in Japan and traded on the Tokyo Stock Exchange that derive less than 80% of their revenue in Japan. Similar to its Europe counterpart, this fund will also get first mover advantage but iShares MSCI Japan ETF (NYSEARCA: EWJ ) could pose a major threat. EWJ is an ultra-popular fund targeting the Japanese economy with an AUM of over $19.9 billion and charging 48 bps in fees per year. Currently, the Japanese economy is experiencing a slowdown despite the slew of monetary easing measures and the Prime Minister Shinzo Abe’s reform policy popularly referred to as Abenomics. However, earnings of Japanese companies have improved since the launch of Abenomics and a weaker currency is making its exports more competitive leading to higher exports. This lethal combination will drive stock prices higher for exporters, making the proposed ETF a compelling choice, once approved. Original Post

Monitoring Your Portfolio’s Dollar Sensitivity

By Tripp Zimmerman At WisdomTree, we continue to believe one of the most important themes impacting the global markets has been the strengthening U.S. dollar-and this is a trend we expect to continue for some time. As a result of the recent dollar strength, many U.S. multinationals with global revenue streams have reported currency headwinds as part of their earnings statements over the past year. This has hurt their performance compared to European and Japanese exporters, who have benefited from the weakening of the yen and the euro, respectively, against the U.S. dollar. This relative performance advantage is no surprise to us, because our research shows that these foreign markets actually performed better when their home currencies depreciated than when they appreciated. 1 Given this historical relationship and relative valuations, we continue to advocate for Japanese and eurozone exporters. But how should investors position their U.S. allocations? U.S. Corporations Continue to Warn about Dollar Strength “Sales by U.S. companies were $26.4 billion in the fiscal nine months of 2015, which represented an increase of 0.8% as compared to the prior year,” Johnson & Johnson (NYSE: JNJ ) reported. “Sales by international companies were $25.9 billion, a decline of 13.5%, including operational growth of 1.1%, offset by a negative currency impact of 14.6% as compared to the fiscal nine months sales of 2014.” 2 The Coca-Cola Company (NYSE: KO ) reported that over the most recent three months “fluctuations in foreign currency exchange rates decreased our consolidated net operating revenues by 8 percent. This unfavorable impact was primarily due to a stronger U.S. dollar compared to certain foreign currencies, including the South African rand, euro, U.K. pound sterling, Brazilian real, Mexican peso, Australian dollar and Japanese yen, which had an unfavorable impact on our Eurasia and Africa, Europe, Latin America, Asia Pacific and Bottling Investments operating segments.” 3 Determining Your Dollar Sensitivity WisdomTree believes currency sensitivity is an important factor that will continue to impact returns going forward, so to monitor the performance of this new factor, WisdomTree has created two new rules-based Indexes: The WisdomTree Strong Dollar U.S. Equity Index (WTUSSD) – This Index selects companies that generate more than 80% of their revenue from within the U.S. and then tilts its weight toward stocks whose returns have a higher correlation to the returns of the U.S. dollar. The WisdomTree Weak Dollar U.S. Equity Index (WTUSWD) – This Index selects companies that generate more than 40% of their revenue from outside the U.S. and then tilts its weight toward stocks whose returns have a lower correlation to the returns of the U.S. dollar. Since the inception of these Indexes, the U.S. dollar has strengthened 2.95% against a diversified basket of developed and emerging market currencies, leading to a performance advantage of 1.72% for WTUSSD compared to WTUSWD. 4 To try to understand what is behind this performance difference, we chart the median earnings and sales growth for the most recent quarter compared to the same reporting quarter one year ago, for both Indexes and the median for the entire universe. Year-over-Year Median Earnings and Sales Growth (click to enlarge) Strong Dollar Companies Displayed Higher Growth- The median earnings and sales growth for constituents of WTUSSD was more than 6% and 7% higher, respectively, compared to constituents of WTUSWD. We believe constituents of WTUSSD, or companies that generate more than 80% of their revenue domestically, tend to be less impacted by a strong-dollar environment-they aren’t focused on selling their goods and services abroad, and their import costs decrease with the rising purchasing power of the dollar. How Long Can This Persist? We have recently published a research paper, What a Rising U.S. Dollar Means for U.S. Equities White Paper , in which we illustrated the declining competitiveness of U.S. exports by graphing a ratio of exports of the U.S. economy over imports. As the U.S. dollar strengthened, the ratio of exports over imports weakened. Historically, we found that the impact can have a lag of around 36 months, so if history is any guide, we may not have seen the worst impact on exporters yet. At WisdomTree, our base case is still for a strengthening U.S. dollar, which may provide a continued headwind to U.S. multinationals with global revenue, but, depending on investors’ views, they can use the above Indexes to track the performance of either basket. Sources WisdomTree, Bloomberg. Johnson & Johnson quarterly earnings report, 10/30/15. Johnson & Johnson had a 1.21% weight in the WisdomTree Weak Dollar U.S. Equity Index as of 11/13/15. The Coca-Cola Company quarterly earnings report, 10/28/15. The Coca-Cola Company had a 0.71% weight in the WisdomTree Weak Dollar U.S. Equity Index as of 11/13/15. WisdomTree, Bloomberg, 5/29/15-11/13/15. U.S. dollar performance against a diversified basket of developed and emerging currencies is represented by the Bloomberg Dollar Total Return Index. Important Risks Related to this Article Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Tripp Zimmerman, Research Analyst Tripp Zimmerman began at WisdomTree as a Research Analyst in February 2013. He is involved in creating and communicating WisdomTree’s thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Prior to joining WisdomTree, Tripp worked for TD Ameritrade as a fixed income specialist. Tripp also worked for Wells Fargo Advisors, TIAA-CREF and Evergreen Investments in various investment related roles. Tripp graduated from The University of North Carolina at Chapel Hill with a dual degree in Economics and Philosophy. Tripp is a holder of the Chartered Financial Analyst designation.