Preparing for the Likely Risks and Opportunities to Come

Investors were surprised in 2016, and they’re likely to be surprised again in 2017.

There’s remarkable consensus among analysts about what 2017 will be like, and periods of high consensus tend to be followed by surprises and high market volatility. Several commentators recently reminded us of the quote from Bob Farrell, once a widely followed market analyst at Merrill Lynch who retired in 1992, “When all the forecasters and experts agree, something else is going to happen.”

The consensus is that we’ll have modest economic growth, accompanied by a small increase in inflation and a modest rise in interest rates.

There are many ways the consensus could be wrong. Experts, especially economists, tend to miss turning points, and we are likely to be nearing one.

There are unique factors today that could push growth and inflation either higher or lower, depending on which factors dominate. The long-term debt cycle has been pushing us toward deflation and low growth (or worse) since 2007. But in the shorter-term cycle in the United States, we developed sustainable growth that is at the point when inflation starts to rise and the central bank raises interest rates.

At the same time, we have a new administration that plans to stimulate growth through fiscal policy but also promises to change trade and immigration policies in ways that usually reduce growth.

These contradictory forces increase uncertainty. I think the likelihood is that the forces pushing growth higher will prevail and inflation will rise more than markets anticipate.

But there’s a risk that other factors, especially policy mistakes, will squelch growth. Fortunately, forecasts are not the primary basis of our investment decisions. We review the factors that matter to the markets and follow what they’re saying. Here’s what the factors say now.

Growth: The United States entered 2017 with positive economic momentum, though some sectors slowed a bit the last few months. The best news is that manufacturing is generating its first positive data in about two years. Unnoticed by many ob- servers is that growth also has been picking up in Europe, Japan and China.

There’s also a sharp rise in optimism in all sentiment surveys of both households and businesses, especially

in the United States, but also internationally. This often leads to higher growth. If the new administration quickly loosens regulations and reforms taxes, that would increase the momentum for economic growth.

Inflation: Prices rose higher than people expected through most of 2016, but inflation slowed at the end of the year. That looks like only a pause. Because of the strength of the labor market, faster wage increases are likely in 2017, and that should lead to higher inflation. The inflation measures also won’t be restrained by the commodity depression the way they were the last few years. The most likely surprise is higher inflation than the markets expect.

Monetary policy: The Fed has been tightening policy since 2014, but that’s been offset by easy monetary policy in Europe and Japan. The stronger U.S. economy has attracted money from across the globe, which acts as monetary stimulus. Yet, central banks bear close watching. A great risk is the central banks could tighten too much, too soon, or run out of effective tools.

Earnings: The U.S. stock surge at the end of 2016 was based on expectations of higher earnings after an 18-month earnings recession. Steadily higher earnings and cash flow will be needed to push U.S. stock prices much higher in 2017. Economic growth in 2017 has to be strong enough to offset earnings headwinds such as higher wages and commodity prices, a strong dollar and higher interest rates. Outside the United States, however, I think investors are expecting lower earn- ings growth than is likely. If growth from the United States continues to spill over to Europe, Japan and emerging economies, stocks in those countries should have higher returns. I believe that is the most likely positive surprise for the year.

Valuations: U.S. stocks have high valuations that reflect recent growth rates and perhaps higher growth. Stocks outside of the United States have more attractive valuations. Valuations aren’t a good short-term indicator but are useful when combined with the other factors we’re assessing. Most bonds and interest-sensitive investments are highly valued and at risk from rising interest rates, especially if inflation increases.

Momentum: U.S. stocks continue to have strong upward momentum. Most international markets lost momentum late in 2016 but are starting to rebuild positive momentum. Bonds and most other inter- est-sensitive investments have negative momentum and should be avoided.