There are three investment themes that show promise based on secular trends in the economy. The themes of regional banking, biotechnology and manufacturing are familiar forward-thinking ideas. Each has a separate investment thesis. Regional banks stand to benefit from shifts in fiscal policy. Biotechnology stands to benefit from regulatory changes. Manufacturing stands to benefit from the economic cycle. The purpose of this essay is to give a conceptual overview of each theme.
Regional banks stand to benefit from rising interest rates. A steeper yield curve means a wider spread between 2-year and 10-year rates. Last year, in the environment of low interest rates, search for yield had driven SPDR Barclays High-Yield Bond (NYSEARCA:JNK) down to 5%. That figure will rise in a normalized rate environment. Barring a sharp increase in inflation, the 2-year rate should hold steady and the 10-year rate should rise. The difference between the two rates translates to increased profitability. Consumers and small businesses can be charged higher rates for loans.
FDA policies which have not been as restrictive benefit biotechnology. Major players such as Gilead (NASDAQ:GILD) and Amgen (NASDAQ:AMGN) have seen share prices rise. Greater odds of bringing medical technology to market should encourage investment from smaller firms. The capital costs had been prohibitive to all but government-sponsored developers and established biotech outfits. Core products from large-cap biotech firms, like Amgen, are based on technology that was developed decades ago. The major biotechnology firms face patent expirations, the same problem that has been faced by the pharmaceutical drug industry. The loss of core products to patent expirations is a signal that innovation needs to be accelerated.
Manufacturers have high fixed costs. In contrast to variable costs, which are costs that can be reduced in times of slack demand, fixed costs remain even when output falls. Fixed costs include equipment, factories and land. All of these assets require upkeep regardless of the volume of output. It is hard to scale down these assets in the event of a recession. The requirements needed to maintain these assets remain on the books. Assets which are not fully utilized create a drag on profitability in times of slack demand.
Demand for products rise when the economy strengthens. The assets which incur fixed costs can then be more fully utilized. Increased productivity offsets the cost of maintaining the assets. Rising output then directly translates to increased profitability for a manufacturer. Fixed costs become a liability in times of slowing economic growth. Demographics indicate solid performance from manufacturers until 2018. Demand is set to fall in 2018 because the number of people expected to increase spending at age 28, on household formation, is set to fall. This translates to weakness in the economy. The picture brightens again for manufacturers when the spending pattern of Generation Y shifts from consumer staples to large-ticket items.
The best customer for a new car is a 43-year-old male. This indicates that, after 2018, manufacturers will not see demand peak again until 2034. The manufacturing and industrial sectors can be bought in 2025, which is nine years ahead of peak demand. Investors will then begin to see a trend of accelerating demand for those products. The year 2025 also corresponds with the trough in demand for stocks as an investment vehicle from Generation X.
In 2025, the number of people that were born 50 years earlier (beginning in 1975) starts to rise. This means that there will be increased demand for stock as an investment (from Generation X) at the same time as there will be increased demand for large-ticket manufactured goods (from Generation Y). The combination is extremely favorable for the manufacturing and industrial sectors in 2025.
SPDR S&P Regional Banking ETF (NYSEARCA:KRE) is a viable ETF for regional banks, although investors could use fundamental research to find candidates that are likely to outperform the index. Index investing is advisable for biotechnology because the vagaries of test results and FDA approval can cause wide price swings in these stocks. Add the complex science upon which the industry is based and, unless the investor has an advanced degree in medicine, the relative merit and viability of each company is difficult to determine. The ETFs SPDR S&P Biotech ETF (NYSEARCA:XBI) and iShares Nasdaq Biotechnology (NASDAQ:IBB) cover almost all of the publicly traded firms in the sector.
Regional banks and biotechnology firms have seen their fortunes rise in the advancing market since the recession. Both sectors are vulnerable to a correction if there is a decline in the market overall or if the beneficial trends (rising interest rates and less-stringent regulation, respectively) come to an end. As regards manufacturing, weak economic growth beginning in 2018 will make fixed costs a liability. Concerning regional banks, lending after 2018 is likely to remain strong but lower interest rates between then and 2025, caused by declining economic activity, will reduce profitability.
The year 2025 marks the beginning of increased demand for stock from the second half of Generation X. It also marks the beginning of increased consumption from the second half of Generation Y on increased household formation. The year 2025 happens to be 8 years before the year 2033 as well. The year 2033 comes 43 years after the peak in the number of births that happened in 1990. This means that the year 2033 will serve as a marker for the greatest number of people turning 43. Investment can be made in 2025, ahead of peak demand for manufactured goods in 2033.
The year 2018 marks the beginning of reduced demand for consumer staples. The trend is in place until 2025. The period was preceded by declining birthrates from 1990 to 1997. The trend was reversed in 1997. In 2025, the consumer staples sector will strengthen.
The trend favors consumer staples until 2018, at which point demand will fall based on falling household formation from the decline in births which began 28 years earlier in 1990. The trends favor both consumer staples and manufacturing in 2025. The year 2025 is 28 years after birthrates began to climb in 1997. This favors consumer staples. The year 2025 is also eight years ahead of peak demand for manufactured goods in 2033.
The trend of rising demand for consumer staples gives that sector a good chance of outperforming the market average until 2018. Overall, the market is expected to decline until 2018 on falling demand for investment. The fall in demand for investment is from the fall in the number of births 50 years earlier that led to the year 1968. The likelihood of a recession in or around 2018 is high based on the sharp decline in the number of births that began 28 years earlier in 1990. The market is expected to rebound (post-recession) in 2019 and 2020 on higher birthrates from 1969 and 1970.
Strength in the consumer staples sector could cause it to thwart the downward trend in the stock market that is in place until 2018. A recession in 2018 means that all bets are off and declines in all sectors of the market are quite likely. Consumer staples are not expected to outperform the market average post-recession because the trend which favors the sector will have ended. An index fund intended to track the overall market would be a good choice to catch the post-recession bounce into the year 2020.
The bond market looks favorable in 2020 on the reduced inflationary pressure which is expected to last from 2018 to 2025. The reduced inflationary pressure is from falling birthrates 28 years earlier from 1990 to 1997. Manufacturing and consumer staples become favorable in 2025. In 2025, the market will also have an overall tail wind from rising demand for stock as an investment vehicle. This is because the increased number of births that began in 1975 translates to an increasing number of people turning 50 and saving for retirement.
Gronbach, Kenneth W. The Age Curve: How to Profit from the Coming Demographic Storm. New York: American Management Association, 2008. Print.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.