What If the U.S. Economy Surprises Us--To the Upside?

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Investors should be prepared for surprises, either by insulating a portfolio against sudden change or, for those who are a bit braver, heightening their senses to take advantage of what's coming next.

But with European fiscal and economic concerns still swirling, Chinese growth predictions cut, and a few disappointing U.S. economic reports dotting a landscape of mostly improved data, investors may be reluctant to stick their necks out just now. Therein also lurks the risk. What if the next surprise turns out to be a much stronger rate of U.S. economic growth than the positive but sub-par projections floating out there now?

[See Is it Time to Sell Your Stocks and Run for Cover?]

Morningstar's director of economic analysis, Robert Johnson, said in his forecast for 2012: "My overall [view] is for slightly higher growth than the consensus, but not by a lot. However, I think the odds of an upside surprise are substantially higher than a downside surprise. Potential sources of an upside surprise include increased U.S. oil production, a sharper rebound in auto production and aircraft production, and a stronger housing market."

Some forecasts have already been bumped up. The Federal Reserve said April 25 that it now expects U.S. GDP growth to be between 2.4 and 2.9 percent for 2012, higher than the 2.2 to 2.7 percent range it predicted for the year in a January release. The unemployment rate is likely to sit between 7.8 and 8 percent, the Fed said. That's down from the 8.2 to 8.5 percent range in the previous outlook.

Even though the Fed reiterated that it foresaw "exceptionally low levels" for interest rates at least until the end of 2014, only four Fed officials at the April meeting, compared with six in January, said they believe ultra-low interest rates will be appropriate two years from now.

The 2.5 percent GDP growth that Wall Street economists predicted, on average, for this year is nothing special, but it's better than last year's 1.7 percent. As rebounds go, this one still has a lot to prove. For instance, the economy grew 7.2 percent in 1984, coming out of the next-deepest postwar downturn.

What's working in the economy's favor? For one, consumers' debt payments as a percentage of their income are at their lowest levels since 1994, according to Fed data. Now, income will need to spur additional spending as consumers are feeling better about conditions, according to several sentiment indexes. As for the mood overall? Both homebuilder and manufacturing purchasing managers sentiment surveys have been trending up.

[See Why You Need to Pay Attention to Earnings.]

In late-April quarterly earnings reports, large manufacturers, led by 3M (MMM), Illinois Tool Works (ITW), and Parker Hannifin (PH) raised 2012 profit forecasts after reporting stronger-than-expected results.

"The improved outlook for growth is likely to favor stocks in cyclical sectors, especially those with a large portion of sales abroad: energy, consumer discretionary, industrials, materials, and technology," said Brian Gendreau, market strategist with Cetera Financial Group, in a research note.

Cyclicals have helped push major stock averages to four-year highs this year. The broader market's valuation may not qualify as "bargain" status, but current levels suggest that prices may have room to run. The S&P 500 is trading at 13 times this year's expected earnings, according to Thomson Reuters data, below the 22-year average of 16.8.

For investors who want to play the theme rather than sniff out individual stocks, a far-reaching exchange-traded fund (ETF) might make sense.

Consumer Discretionary Select Sector SPDR (XLY) offers investors exposure to firms in the S&P 500 Index that largely depend on discretionary consumer spending. This low-cost, highly liquid exchange-traded fund, which owns 81 companies, is fairly concentrated and owns a variety of names that are tied to consumer spending, including retail companies, restaurants, media companies, apparel and luxury goods companies, automobile manufacturers, and leisure firms, according to a Morningstar analyst report.

XLY has almost 74 percent of its assets invested in companies with economic moats, a designation assigned by Morningstar's equity analysts to firms that possess significant and durable competitive advantages. In addition, eight of the fund's top 10 holdings sport economic moats.

[See Should You Have ETFs in Your Portfolio?]

Investors can also consider Vanguard Consumer Discretionary ETF (VCR). It holds a vast 369 companies, making it a diversified play. Otheroptions include First Trust Consumer Discretionary AlphaDEX (FXD) or the more thinly traded PowerShares Dynamic Consumer Discretionary (PEZ) and Guggenheim S&P Equal Weight Consumer Discretionary (RCD).

The rub? There are factors that could potentially sully the optimists' view, including increased volatility leading up to the presidential election; long-term debt burdens for Europe and the United States; higher oil and gasoline prices, which could eat away at other consumer spending; and a stronger-than-expected pickup in inflation.

Europe's developments continue to be closely monitored (the collapse of the Dutch government over failure to pass an austerity package and a forced French presidential run-off are only the latest wrinkles), but the U.S. economy and the markets are showing some independence from the continent.

"Chances are that a mild, brief recession in Europe won't have a huge impact. Many of the structural factors that are hurting Europe aren't present in the U.S. at the moment," writes Morningstar's markets editor Jeremy Glaser. "No one is worried that the dollar is going to collapse and that each state is about to issue its own currency. U.S. firms and banks have been girding for a European crisis and generally have diversified enough revenue streams to handle a mild downturn in demand."

"If the recession turns out to be much deeper than it is right now, and particularly if Germany gets hit hard, the impact on the U.S. is going to be larger. Investors would be well-served keeping an eye on Europe and making sure a slowdown there isn't throwing off the United States' burgeoning recovery," wrote Glaser.

According to economists at the Royal Bank of Scotland, brighter economic data are masking the bigger picture for now. The greatest threat to the medium-term outlook for U.S. growth remains the changes in fiscal policy slated to take effect in January 2013, they said in a research note. The Bush-era tax cuts are set to expire, along with the payroll tax holiday and extended unemployment benefits. In addition, the first tranche of the $1.2 trillion in automatic spending cuts (evenly distributed over nine years) mandated by the Budget Control Act of 2011 are to be instituted.

Another risk to the bullish scenario: What if China slows more than expected? Big-machinery makers such as Caterpillar (CAT) make a chunk of their profits in China and other developing nations.

As always, diversification is important. "We would not pare back allocations to dividend-paying stocks too much--the dividends may yet prove to be welcome if volatility raises to levels anything like last year's," Cetera's Gendreau added.



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