Changing Landscape Creates New Investment Opportunities
Oct. 19, 2009

Juliet Ellis, CFA
Chief Investment Officer, Invesco Aim Growth Complex; Senior Portfolio Manager

While we may be emerging from one of the worst recessions on record, a number of mixed data points lead us to believe that uncertainty may persist for some time. Positive data points include:

• An improving economy that should continue to benefit from significant fiscal and monetary stimulus
• Inflation that remains in check
• A stock market that appears to have gone through a bottoming process.

However, a number of negative data points are creating strong headwinds for a sustained recovery, including:

• An overleveraged consumer
• The increasing likelihood of higher taxes
• Potential problems in the commercial real estate market.

Additionally, while credit markets have improved, banks remain much more reluctant to lend money than before the credit crisis. Given these strong economic crosscurrents, we believe uncertainty is likely to persist. But we see opportunity amid the uncertainty of the changing landscape.

New trends and investment opportunities

New trends often emerge at significant inflection points. Consider for example how spending patterns have changed over the last two decades. During the 1990s, software and computer hardware spending led the economy, growing between 10% and 12% annually. Fast forward a decade, when spending on computer hardware actually fell 1.3% per year and spending on gasoline led the economy with growth of nearly 10% per year.¹ These spending pattern changes eventually lead to the emergence of new trends. While it's not our job to predict emerging trends, it is imperative that we be nimble enough to respond to these changes so we can identify the most compelling investment opportunities resulting from economic trends.

GDP: a key to trend analysis
Gross domestic product (GDP) is a useful framework for closer analysis of emerging trends and the related investment opportunities they produce. GDP — a measure of the total value of goods and services produced by a domestic economy — comprises four components:

GDP = C + I + G + (x-m)

C = consumer consumption expenditures
I = fixed or business investment
G = government spending
(x-m) = Net Exports

For simplicity's sake, we will focus our analysis on three of the four major components of GDP: Consumer Consumption(C), Fixed Investment (I) and Government Spending (G). As you can see from the pie graph below, consumer consumption represents over two-thirds of GDP.

Note that total does not equal 100% due to the Net Exports component, which was -2%.
Source: U.S. Department of Commerce, Bureau of Economic Analysis
Data as of June 30, 2009

Consumer consumption trends (C) and investment opportunities

After remaining mostly flat from 1950 through 1985, consumer consumption — the "C" component of GDP — has steadily increased, moving from 64% of GDP in 1985 to today's 71%.¹ This steady increase was driven by several events, including:

• The dramatic fall of interest rates, which allowed consumers to take on more debt while maintaining the same monthly payment. As a result, consumer savings rates fell to close to zero, and debt levels increased sharply.
• Rising home prices led many consumers to withdraw equity from their homes and spend it on items such as vacations, luxury vehicles and home electronics.
• The baby boomer generation entered peak spending years during this period.

We're skeptical, however, that this consumer spending growth trajectory can continue. In fact, it's reasonable to assume that consumer consumption levels as a percentage of GDP have peaked because the severity of the current economic crisis may have finally convinced consumers to save more and spend less. Additionally, home prices have fallen dramatically, reducing the ability of homeowners to pull equity out of their homes to finance other spending. Finally, aging baby boomers have started to exit their peak spending years.

Let's see where consumer spending has been focused and try to project where it might be moving so we can identify new investment opportunities. If we examine consumer consumption data back to 1987, we find that health care and recreation have been the fastest growing components of consumer spending, which has slowed spending on food, clothing and automobiles.¹ However, with the current administration's priority on health care reform, we will likely see a sizable reduction in consumer spending on health care and a corresponding increase in spending in other discretionary areas. As the chart below illustrates, we believe this shift may present new investment opportunities in areas such as restaurants, retailing, automobiles and recreation.

Consumer

Fixed investment trends and investment opportunities

Fixed investment — the "I" component of GDP — includes spending on hard assets, such as commercial and residential real estate, inventories, technology equipment and software and manufacturing equipment. The fixed investment component, which is very cyclical, recently reached a new low of 11.2% of GDP.¹ Let's examine some of the trends and related investment opportunities within the fixed investment area.

While commercial real estate appears to be in the early stages of a downturn, residential real estate — in decline since 2006 — has finally started to show signs of reaching bottom in some geographic regions.

A massive inventory drawdown has been a drag on the GDP for the last six quarters — one of the longest and most severe inventory reductions since the 1981 recession. Why is that important? When a manufacturer sells a product out of inventory and doesn't reorder to replace that inventory, suppliers slow down their manufacturing. This lower utilization ripples through the supply chain until it reaches raw material suppliers. Lower sales lead to lower profits throughout the supply chain, and companies must eventually make cutbacks, often resulting in workforce reductions. The silver lining is that once inventories are depleted, a modest uptick in demand occurs to kick-start production, and utilization begins to rise to more normal levels. Once that recovery starts, the inventory rebuilding process frequently lasts much longer than expected, often creating investment opportunities.

We believe the technology sector offers significant investment opportunities. Leading up to 2000, technology spending accounted for an increasing share of GDP as companies prepared for the Y2K transition. However, technology spending was much more subdued in the most recent up cycle and has contracted dramatically through the current recession. As a result, we believe there is strong potential for pent-up demand because information technology (IT) departments delayed normal buying patterns to cut spending during the recession. Additionally, we are optimistic about a replacement cycle for technology equipment purchased before 2000. These emerging trends should create investment opportunities in several areas, including enterprise hardware. We are also optimistic about semiconductor company opportunities driven by growth in demand for Netbooks and notebook computers and smart phones.

Lastly, we believe there are investment opportunities in manufacturing equipment for companies focused on industrial maintenance and repair. The chart below offers a snapshot of our view on fixed investment trends and opportunities.

Fixed Investment

Government trends and investment opportunities

Government spending — the "G" component of GDP - includes expenditures on national defense, public infrastructure, health, entitlements and education. Government spending dropped from a high of 23% in 1950 to a low of 18% in 2000, and it has steadily moved up to the current level of 20.7%.¹

Where are we headed from here? While we believe government spending levels will continue to increase, we don't think it will be limitless growth. We've already seen a significant spike in the federal debt, driven largely by the government's efforts to rescue the economy from the credit crisis. Debt levels have also been driven by short-term programs such as "Cash for Clunkers" and tax credits for first-time home buyers.

Additionally, as previously mentioned, health care reform is clearly a top priority of the current administration. While it's impossible to gauge how much health care reform will cost, we believe it should create compelling investment opportunities. For example, the government's push toward an electronic medical records system potentially drives large IT investments in the health care industry.

We also believe there will be increased spending in areas such as road and school infrastructure, alternative energy and cyber security. This spending may potentially result in investment opportunities in companies that focus on these areas. The chart below capsulizes our view of government spending trends and opportunities.

Government

Tracking trends opens up opportunity

In this piece, we have identified a number of the most significant economic trends and corresponding investment opportunities as they relate to consumer consumption, fixed investment and government spending. New trends will continue to emerge as the economic environment evolves, and we believe our growth investment teams are uniquely positioned to identify the most compelling investment opportunities for our shareholders.

1 Source: U.S. Department of Commerce, Bureau of Economic Analysis

The Chartered Financial Analyst^® (CFA^®) designation is globally recognized and attests to a charterholder's success in a rigorous and comprehensive study program in the field of investment management and research analysis.

Invesco Aim is the source for all data unless otherwise noted.

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