Identifying and Avoiding the Risks behind the Headlines

Will there be major economic and financial policy changes in 2017? Should your portfolio be adjusted to reflect those changes? Those questions dominated the recent MoneyShow Orlando.

As I’ve said recently, we are in a period of exceptional uncertainty. A wide range of policy changes is possible, and that means a wide range of economic and market outcomes is possible. We have to be careful about what former Defense Secretary Donald Rumsfeld called the known unknowns and unknown unknowns. We have both a new style and substance in Washington, and that increases uncertainty. Plus, it’s likely most changes that do occur won’t have a direct effect on the economy before 2018.

Let’s focus on what we know and what matters to the markets instead of speculating about future policy changes.

The U.S. economy continues its steady, sustainable growth.

The consumer remains the workhorse of the economy, though households face new headwinds from higher interest rates, energy prices and inflation. Consumer confidence remains near the highest levels of the economic recovery. That’s partly a response to the election and partly because of higher wages and stock and home prices. Likewise, small business optimism soared after the election, with business owners planning more investment and hiring. Larger businesses, especially manufacturers, also are more optimistic.

Some of this optimism already resulted in more economic activity. Retail sales are higher, and businesses are starting to increase investments in equipment. The combination of optimism, retail spending and business investment could spur higher growth even before major policy changes occur. But so far, the higher optimism resulted only in a very modest increase in economic activity.

The optimism did result in much higher stock prices as investors anticipated higher earnings. That gives stocks high valuations. Major U.S. indexes are at historic highs, with smaller company stocks pushing well ahead of the larger company indexes.

The latest surge in stock prices means there isn’t much room for error or disappointment. They already reflect optimistic expectations of earnings and margins from proposed policy changes. While most of the proposed policies will boost corporate earnings and profit margins, there are other factors already in play that could trim earnings and margins. Rising interest rates, wages and commodity prices are the most important factors. A stronger dollar and less financial engineering by corporations also will crimp earnings and margins.

The Consumer Price Index (CPI) has been rising fairly steadily since late 2015. In January it increased the most since February 2013. The CPI over 12 months is 2.5% to mark the highest level since March 2012. I’ve said several times that higher-than-expected inflation is likely to be the biggest surprise of 2017. Markets continue to price in the inflation of under 2% we’ve had since 2008, despite higher economic activity and obvious inflation pressures.

Wages and salaries also are rising faster than a few years ago. That’s good for consumers, but also could give retailers confidence to raise prices.

The Fed’s been tightening monetary policy and indicated more interest rate hikes will occur in 2017. But the Fed lags market action. The markets almost always increase rates before the Fed does. They’ve done that over the last year, and are likely to continue the pattern in 2017. Since last July, longer-term interest rates have risen first and by a greater amount than short-term rates. We want to avoid investments that are sensitive to U.S. interest rates, as we have since last July.

Offsetting the monetary tightening in the United States are the easy money policies of the European Central Bank and the Bank of Japan. They continue to flood their economies with money and credit.

Higher inflation and interest rates might not be the only surprises for investors in 2017. Earnings and profit margins outside the United States are likely to improve more than their U.S. counterparts and more than is priced into the markets. Most reports focus on the economic weaknesses and political problems in Europe and Japan. They overlook the steady improvements that occurred in recent years and the positive effects of central bank easing.

Emerging markets also are benefiting from stabilization in China. Latin American emerging markets are recovering thanks to rising commodity prices and the improving global economy.

While most investors focus on the United States, we continue to maintain globally balanced portfolios. There are high levels of uncertainty and risk in U.S. investments, and a lot of expected good news already is priced into the markets. The global markets also have risks, but the potential good news isn’t reflected in those markets. They offer a higher margin of safety and add needed balance to portfolios.