Building resilience into ETF portfolios

• Economic growth in the U.S. has likely peaked, a trend with implications for all investors.
• Quality stocks have historically outperformed in mid-cycle economies when growth is positive but slowing.
• Recent U.S.-listed ETF flows demonstrate that investors are showing a preference for high-quality companies and assets.

Now may be time for investors to consider the implications of slowing economic growth.

While many COVID-era economic trends remain in place — shoppers are still buying more groceries online, many office workers continue to log in from home — we think that the biggest growth gains are behind us.

Fiscal stimulus and easy monetary policy provided a bridge through the worst of the pandemic, helping ensure that an economic restart happened quickly. The U.S. recession that lasted from March to April 2020 was the shortest on record. But questions about vaccination progress and virus variants are tempering expectations. U.S. real GDP growth this year appears to have peaked at 6.7% in the second quarter, with Bloomberg consensus estimates showing a slide to 5.0% in the third, 5.1% in the fourth, and 4.2% in the first quarter of 2022.¹

We don’t expect a contraction but investors should appreciate that, historically, shares of companies with strong fundamentals, often called “quality” companies (those with high return on equity, stable year-over-year earnings growth, and low financial leverage) have been beneficiaries in similar mid-cycle economic environments.

Peaking growth

A major storyline in markets earlier in the recovery was the outperformance of cyclically oriented “value” stocks, especially smaller ones, which have historically benefitted during periods of higher economic growth.

While lower-but-still-strong growth will continue to support value-oriented companies, we think that some of the early-cycle investment opportunities may have already played out, particularly in the U.S. Our teams have found that during periods of strong-but-declining growth, companies associated with quality fundamentals outperformed more cyclical, value stocks.²

To thread the needle between the two trends, we favor a “barbell” approach to stock investing — pairing value with quality to access companies that may be primed to perform in this mid-cycle environment. A strategic value-quality “barbell” approach to the stock market could offer better risk-adjusted returns and resilience to portfolios at this stage of the economic recovery, in our view. Additionally, we think quality-oriented companies have the pricing power to pass rising input costs through to customers and strong enough balance sheets to weather potentially thinner profit margins.

In the U.S., while value stock ETFs saw record-breaking inflows of $29 billion in Q1 and $20 billion in Q2, the pace slowed in Q3. Meanwhile, quality stock ETFs reversed a Q1 outflow of by bringing in $872 million in Q2 and $6.5 billion Q3 to date as investors sought the relative safety of quality names in the face of persistent inflation and signs of slowing growth.

Flows also demonstrate a bias for quality bias among U.S.-listed bond ETFs:

• Flows into U.S. government bonds turned positive in Q2, adding $5.3 billion after Q1 outflows of $1.2 billion.
• A resurgence in Q2 corporate bond ETF inflows saw investment grade exposures take the lion’s share of assets, taking in nearly double those of high yield ETPs.
• And, In Q1, $8.5 billion flowed into inflation-protected fixed income ETFs setting a new quarterly record, only to be beat by Q2 flows of $9.6 billion.³

In the U.S., year-to-date flows show investors embracing “quality time” in portfolios year to date

The economic restart looks poised to slow in the U.S.. We believe that the current mid-cycle economic environment may be time for investors to consider U.S. quality stock ETFs for potentially added resilience.

Index-based ETFs offer the potential for investors to add quality-oriented stocks in an affordable, diversified and tax-efficient manner.