Managing the Trade-Offs in Today’s Markets

It is more critical than usual to include two important steps in your investment decision making. Too many investors overlook these steps, causing them to miss opportunities and to take too much risk.

The first step is to focus on the trade-off between risk and return when evaluating investments, whether you are thinking of buying them or already own them. The second step is to determine which economic outcomes already are priced into the markets. If market prices already fully reflect an outcome, that’s a danger sign. After that, when even one economic report hints at a different outcome, many investors will rush to change their portfolios.

These two steps are the keys to risk management. Managing risk is the best way to achieve higher long-term returns while taking less risk.

Most of today’s investment prices indicate investors expect a continuation of the trends of the last few years. They expect interest rates will remain near zero (or even below zero); inflation will continue to fall; and economic growth will stay below the long-term average. In other words, markets are priced for a sustained depression, or close to it.

Those have been the long-term trends, and they will continue until the developed economies no longer have excessive debt levels.

The intermediate economic trends, however, are different, and markets don’t reflect these trends. Investors are likely to be surprised in the coming months as these intermediate trends become stronger.

That’s why we recently eliminated investments that could be hurt by rising interest rates, such as long-term bonds and utility stocks, and shifted our portfolios to favor a few other investments.

Let’s look at the intermediate trends, using the factors that matter to the markets.

Monetary policy around the globe is expansionary. The European Central Bank, Bank of Japan and Bank of England all are doing what they can to stimulate their economies, and they are developing new forms of monetary stimulus. (Negative interest rates aren’t very effective, but other tools could help.) The Federal Reserve tightened monetary policy beginning in 2014, but in 2016 it suspended plans to increase interest rates. Tightening less than expected is a form of stimulus, plus the Fed increased the monetary base early in the year.

Other forms of stimulus are helping the U.S. economy. Rising home and stock prices increase household wealth. Higher wage increases and lower unemployment boost household income. These factors increase consumer confidence and spending. Usually, they lead to more hiring and capital investment by businesses.

The U.S. economy is stronger than many people realize and that was reflected in the second-quarter gross domestic product (GDP) report. The manufacturing sector is recovering. It suffered the last couple of years from a strong dollar, weak overseas growth and the collapse in commodity prices, especially energy prices. Those headwinds have diminished or disappeared, and manufacturing appears to be forming a bottom. The rest of the economy is perking along. It slowed a bit early in the year but is bouncing back to a growth rate of 2% or higher.

Steady economic growth has improved the labor market to the point that wages and salaries are rising at the highest rate of the economic recovery. This is happening just after investors gave up on it occurring.

Higher wages and salaries, plus rising commodity prices, are increasing inflation. Key inflation measures are nearing the Fed’s minimum target for inflation for the first time since 2008. It is likely that inflation will continue to rise. I’m not expecting inflation levels that would be considered high by historic standards, but it is going to be higher than the extreme lows now priced into the markets. That should increase market interest rates. Markets are pricing in such low inflation and interest rates that any increase is going to be a surprise and move markets in the other direction.

U.S. stocks have outperformed other stock markets for a couple of years and recently set new record highs. But the forces that propelled the outperformance of U.S. stocks are winding down. Financial engineering, such as borrowing to buy back stocks or increase dividends, reached a peak and is declining. Also, productivity is decreasing as compensation increases. That means lower profit margins.

I don’t expect a bear market in U.S. stocks soon. But at this point, it is better to focus on selected opportunities through focused mutual funds instead of the broader market.

Soon, U.S. stock returns should lag other markets. European and emerging market stocks have much lower valuations than U.S. counterparts. Emerging economies, especially those that are commodity-based, are recovering from their declines that began in 2011 and their central banks are implementing more expansionary policies. Europe has been slower to respond to its central bank stimulus, but many stocks there are selling at deep discounts relative to the United States and investors are starting to respond. European-based companies that have global markets are especially attractive.

The long-term economic and investment outlook still isn’t an attractive one. Developed countries, including the United States, continue to struggle with high debt levels and are having trouble implementing policies that will increase growth. But we’re in the part of an intermediate-term cycle in which growth and inflation are likely to be higher than markets anticipate. That creates some opportunities we’ve captured in recent months, and we should continue to benefit from for a while longer.