The rising US market and heightened risks

The stock market has continued to reach new highs in the United States, troubled only fleetingly by rising interest rates, sluggish corporate earnings and new and uncomfortable political realities.

Monetary policy is tightening, government spending is expected to expand substantially, and, as the US presidential election and the vote in Britain to leave the European Union show, trade relations and other ties among nations may be fraying. How those trends progress sho­uld go a long way to determining the performan­ce of stocks and bonds as the year moves along.

These aren’t the only issues for investors to contend with, either. Economic indicators have perked up — unemployment in December, reported on January 6, was 4.7%, and consumer confidence is near multiyear highs — but the earnings outlook remains subdued, stock valuations remain high and bond yields are low but rising. Under these circumstances, many investment advisers recommend taking only minimal, reasonably priced risks.

“I’m hard pressed to locate any investment where you can make a strong argument that it’s undervalued,” said Joe Davis, global chief economist at Vanguard and head of the firm’s Investment Strategy Group. “Just as the economic environment seems to be improving, the investment environment is more challenging. Investors have more risk in their portfolios than at any time since 1999.” Ben Inker, co-head of asset allocation at the GMO investment firm, likewise finds “plenty of things to worry about.”

The Standard & Poor’s 500-stock index early this month traded at about 26 times the earnings that the constituent companies reported in the previous year, higher than at almost any time in history. One reason investors are willing to pay so much is that they see even less value in other assets.

“The rest of the world looks scarier than the US,” Inker said. “Who would want to touch Europe? Who would want to touch emerging markets?” As scary as they may appear, he recommends investing in emerging stock markets as the best of a series of difficult choices. “It’s not that we have high hopes for the emerging world this year,” he said, “but they’re priced for a really bad outcome. The US is priced for a really good outcome.”

American stocks had a really good outcome in 2016. The S&P 500 rose 9.5% to 2,238.83, including a 3.3% gain in the fourth quarter. The average domestic stock fund in Morningstar’s database rose 3.3% in the quarter and 10.9% on the year. Leading the way in the quarter, with double-digit gains, were portfolios that focused on financial services, smaller companies, energy and industrials.

Whether managers make the most of it, David Kelly, chief global strategist at JP Morgan Asset Management, finds solid prospects in US stocks this year, more than many of his peers do. He favours sectors most sensitive to rising growth, such as financial services, technology and consumer discretionary stocks. “The general trend of government policy will be pretty pro-business and much more friendly to the US corporate sector than it has been,” he said. But he said that “the Republicans may get sidetracked by antitrade rhetoric.”

President-elect Donald Trump has proposed raising tariffs on imported goods, and some Republicans in Congress have proposed changing corporate tax rules to reward exporters and punish importers. Economists generally agree that higher tariffs reduce competitiveness and drive up prices of imported goods, including parts supplied to US manufacturers.

Kelly is also wary of Trump’s pledges to incre­ase government spending on infrastructure projects. “There isn’t actually any money in the budget to fulfil his agenda. Congress may decide not to worry about it and push up the debt, and we’ll end up with more debt and inflation,” he said.

And we may have higher interest rates, too. The Federal Reserve raised rates in December, only the second time in a decade. Kelly expects three, possibly four, increases this year. The more forbidding rate environment may account for much of the run-up in bond yields last year. Yields on 10-year Treasury issues rose to 2.44% at the end of December from 1.36% in early July, with most of the increase occurring just after Election Day, according to Bloomberg.

Bond funds lost 1% in the fourth quarter, depressed by the 11.8% plunge in portfolios that specialise in long-term government issues. For the full year, according to Morningstar, the average bond fund was up 5.9%, helped by double-digit gains in riskier categories like high-yield and emerging market debt.

Laird Landmann, co-director of fixed income at the TCW fund-management company, said he saw little to recommend to investors because “asset prices are getting out of whack with the economy.” Inflation is likely to keep rising, he predicted, perhaps exceeding 2.5% this year. His advice is to play it safe and stick with Treasury bonds, certain mortgage-backed securities not issued or guaranteed by the federal government, and bonds issued by US banks. “It’s hard to buy things after eight years of a credit cycle,” Landmann said. “Wait for it to turn; that’s the discipline of being a value investor.”

Worst-performing markets
When considering any benefits of spending measures introduced by Trump and Congress, it’s important to remember that they wouldn’t be spread far and wide.

Hope that the global recovery might at last get some legs helped the emerging stock markets last year, but they gave back about seven months’ worth of gains in the week after the election, as investors weighed the prospect of Trump’s protectionist campaign language being translated into action.

The average emerging market stock fund lost 5.5% in the fourth quarter but still gained 9% for the year. International stock funds overall fell 2.8% in the quarter and rose 4.9% on the year. Some of the worst-performing stock markets were in countries on which Trump has focused. Mexico lost 8% in 2016, and the Shanghai Composite Index in China was down more than 12%, although funds concentrating on China and its surroundings rose 0.7%.

The president-elect’s outlook “is clearly anti-globalisation,” said Rick Schmidt, co-manager of the Harding Loevner Emerging Markets Fund. “Trade is going to have a bigger impact on some markets than others,” he said. Whether he can implement” his agenda “is one thing, but you have to assume he means it,” he added. “It would be dangerous not to take him at his word.”

Just as Inker prefers emerging markets because the risk they entail comes at the right price, Schmidt sees some of the best opportunities this year in beaten-down markets like Mexico. Elsewhere, he finds India overpriced, and he is avoiding utilities and Chinese banks, although he likes banks in other countries.

While emerging markets are appealing to many based on their valuations, Landmann warned that they may be particularly vulnerable to potential missteps in a Trump presidency. “Markets are not going to crash necessarily, but you could see crashes in more fragile areas like China,” he said.