Outlook 2017: Better Growth and Higher Uncertainty

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As the new Trump administration and Congress take office in January, proposed changes in government policies dominate the outlook for 2017. Stock prices, interest rates and the value of the U.S. dollar have risen since the election due to optimism about likely pro-growth policies. But most changes don’t happen overnight – and the priorities aren’t clear. Don’t mix politics and investing – instead, stick to the approach customized for you, and position your investments for likely changes as well as greater uncertainty ahead.

Be patient – changes take time

We think the economy is well-positioned to keep growing between 2% and 2.5% in 2017, faster in the second half of the year. Modest job growth should continue to support solid consumer spending, helped later in the year by efforts to reduce taxes, a boost to federal spending concentrated on infrastructure, and many deregulatory proposals that affect financial services and health care.

The impact on specific sectors of the economy and stocks depends on the details – and while hopes for favorable changes have soared, the earliest effects probably won’t begin until the second half of the year. To help weather policy uncertainty, use time-tested principles, stay diversified, and expand the types of investments you own to create a solid foundation.

Brighter economic outlook favors stocks

Rising consumer spending has been the backbone of the long-running bull market. We expect better growth and higher company earnings to support rising stock prices over time. In late 2016, large-cap U.S. stocks lagged mid- and small-cap stocks due to their potential benefits from lower tax rates and less exposure to changes in the value of the dollar, but both have the support of better earnings and growth. We think the risks and opportunities remain balanced.

Rates still low but rising slowly

Expectations for faster economic growth have also led to forecasts of higher inflation and rising interest rates. The Federal Reserve (Fed) has already signaled it intends to raise short-term interest rates if economic growth continues at a solid pace with further improvements in the job market. Wage growth has accelerated to about 2.5% annually, but we expect inflation to rebound to around 2% as falling prices from the rest of the world partly offset rising wages here. While rising inflation could prompt faster-than-expected rate hikes, the Fed should still be patient and slow. That means long-term interest rates and the dollar move modestly higher.

We recommend that you have an appropriate mix of stocks and bonds based on your comfort with volatility and long-term financial goals. Stock and bond prices frequently move in opposite directions. When stocks drop, bonds can play an important role in your portfolio because they tend to rise, helping to stabilize portfolio values. But long-term bond prices have typically dropped more than short-term bond prices when interest rates rise, and that’s why we suggest a small allocation to long-term bonds.

High-yield bonds tend to be closely tied to economic growth, and thus still look attractive. And make sure you have enough in cash and short-term fixed income to cover current spending and take advantage of opportunities during stock market pullbacks.

Stronger dollar hurt international equities

Rising interest rates have also increased the U.S. dollar, reducing the returns on international investments. When the dollar reverses, international investments are helped, and that’s one reason we think international stocks are an opportunity for long-term investors. While U.S. stocks are near record highs, international stocks have lagged and are attractive in our view, balancing higher political risks and still-slow international growth.

  • Today’s strong dollar and better U.S. economic growth could help boost foreign economic growth due to stronger exports, combined with higher government spending and still-expansionary monetary policies in Europe and Japan.
  • Although past performance is not a guarantee of what will happen in the future, international equity investments have outperformed after past times when they’ve lagged behind U.S. stocks.* They can help diversify your portfolio and may outperform if global growth rebounds.

chart

Source: Morningstar Direct; 1/1/1976 – 12/31/2015. U.S. large-cap stocks represented by the S&P 500 Total Return Index; international stocks represented by the MSCI EAFE NR Index; bonds represented by the Barclays U.S. Aggregate Bond Index. The hypothetical portfolio is for illustrative purposes only. Results may vary for an individual portfolio with similar holdings. Indexes are unmanaged and are not available for direct investment. Past performance is not a guarantee of future results. Investing involves risk. The value of your investments will fluctuate, and you may lose principal.

As the chart shows, a portfolio with 65% invested in U.S. and international stocks and 35% in fixed income has not had a negative five-year return when rebalanced annually. Don’t let recent performance lead you to neglect diversifying your portfolio internationally.

5 strategies to help address policy uncertainty

Investors are rightly optimistic about the possibility of more pro-growth policies worldwide in 2017. And many powerful trends continue to be positive for investors. But risks abound, increasing uncertainty, so we also expect a return to normal volatility in 2017, with at least one 10% stock market correction as well as several smaller pullbacks.

You can help position your portfolio for growth with these five strategies:

  1. Rebalancing to an appropriate mix of stocks, bonds and international investments based on your comfort with market volatility and long-term financial goals. That mix can help reduce the swings in your portfolio and help you stay invested during stock market pullbacks.
  2. Adding mid-cap and small-cap stocks that appear well-positioned to benefit from the possibility of lower tax rates and rising international tensions.
  3. Sticking with international stocks, which have lagged repeatedly. A rising dollar could hurt their performance short-term, but better-growth policies could finally produce better international performance.
  4. Adjusting your fixed-income portfolio to increase short-term and cash investments and reduce long-term fixed income if appropriate.
  5. Staying patient and disciplined. Your investment portfolio is designed for your situation, and the expected changes aren’t certain and will take time. Patience and discipline can help you adjust appropriately when needed, without overreacting.

Don’t let short-term predictions or political uncertainty determine your long-term investment success. Instead, stay flexible and keep a long-term perspective by working with your financial advisor to stick to an investment strategy designed for your circumstances.

important Information:

*Source: Morningstar Direct, 9/30/2016. U.S. stocks represented by the S&P 500 Index. International stocks represented by the MSCI EAFE Index. Indexes are unmanaged and are not available for direct investment.

Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal. Small- and mid-cap stocks tend to be more volatile than large company stocks. Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events. Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity. High-yield bonds are subject to a greater risk of loss of principal and interest than higher-rated bonds.

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