Managing Today’s Overlooked Risks

Investors and markets have been calm and steady for a while. That’s generating some profits but means some risks are being overlooked or downplayed.

The U.S. economy continues to grow. The low first-quarter gross domestic product (GDP) growth didn’t reflect the real state of the economy. The bulk of the data reported during the quarter indicated growth slowed a bit from the fourth quarter of 2016 but still was higher than the GDP estimate. So far, second-quarter growth appears to be picking up, with housing and manufacturing leading the way and services remaining steady.

Even so, the economy isn’t booming.

There’s a wide gap between the hard economic data on the one hand and the surveys and anecdotal reports on the other hand. The surveys are very positive, while the data is lagging. Usually, improvements in the surveys are followed by similar improvements in the data. That hasn’t happened.

I suspect the gap will persist. That’s because the most optimistic households in the surveys currently are those with lower income and education levels. Those groups are less likely to have sharp income increases or to go on spending surges using savings or debt. People with higher incomes and education levels do most of the discretionary spending, and they are more cautious right now. They aren’t spending and investing aggressively.

Corporate earnings recovered in the first quarter, increasing by 14%, after about two years of poor earnings. But I have doubts about the sustainability of that rate of earnings growth in the United States.

The labor market is very tight. Jobs are being created faster than people are joining the labor force. Employers likely will have to increase wages further to attract and retain quality workers, and employer surveys indicate they expect to pay higher wages over the next year. That will put a dent in earnings. That’s especially true if the decline in productivity isn’t reversed.

Also, business capital investment has been lagging. That has helped profits in the short-term, but it also probably isn’t sustainable. Productivity has been declining partly because businesses aren’t investing in new equipment. I think at some point capital investment has to increase to meet demand, and that is likely to hurt profits in the short term.

Inflation still isn’t something to worry about, but it should rise steadily if wages increase as I expect. Inflation won’t rise a lot above the Fed’s 2% target, but I think it will rise more than is priced into the markets.

Overall, the U.S. economy appears to be maintaining a sustainable, modest growth rate. It should be able to accommodate the interest rate increases planned by the Fed. But the economy also is late in this cycle in many ways. Interest rates, inflation and wages all are rising faster than a few years ago. Profit growth slowed, and productivity is down. This stage of the cycle can continue for a while, but it’s not a time to be heavily weighted to U.S. stocks that already are at high valuations.

Economies and markets outside the United States continue to offer better opportunities.

Politics in Europe capture most of the headlines about that region, obscuring positive news about the economy. Make no mistake that much of Europe’s economy still is at very low levels. But it is improving slowly and steadily. Corporate profit growth is increasing, and earnings have a lot more room to grow than they do in the United States.

Investors gradually are finding this opportunity. That’s one reason the dollar has been declining against the euro and many other currencies in 2017.

Emerging economies also continue to recover from their bear market. Latin American markets were the first to recover, beginning in 2016. Recently, the Asian markets caught up after lagging late last year and earlier this year. The emerging markets also have lower valuations and more growth potential than the United States.

The major risks to investors are from outside the markets, though investors don’t seem worried about them.

The global populist political movement could trigger major changes in economies and markets that, at least in the short run, would cause negative market reactions. The recent French election and polls in Germany eased many fears of decisive wins by populists. But populism still is strong, especially in Europe. Italy and Greece are the next likely flashpoints, but there are other possibilities around the globe.

Central bank and government policies also remain major risks. Both the Fed and the European Central Bank (ECB) appear to recognize that an economic downturn is a much greater risk than inflation. They don’t seem to want make the mistake of tightening policy too much, too fast, but it’s always possible.

The ECB needs to be watched closely. It is committed to maintaining current policies through the end of 2017. Some in Europe, however, want it to scale back its stimulus, and it is likely to run out of securities eligible for its purchase program around the end of the year. I monitor the ECB for indications of how it will adjust policies in late 2017 and early 2018.

Risks are simmering on the back burners, and investors around the globe are complacent about them. This is a good time to be sure each of your investments has a margin of safety and your portfolio has good measures of balance and diversification.