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Investment markets started the year on a positive note with the major U.S. and foreign stock indices up more than 2% through late January and gauges of investor sentiment and business optimism indicating an upbeat mood to start the year. At the same time, the potential for surprises, both positive and negative, is greater this year than at any time since the financial crisis. Given this uncertainty, investors should proceed carefully and focus on diversification. In this article, we share some thoughts on the economic and market environment. We also review one of the key components of a diversified portfolio, foreign stocks.

Uncertainty Reigns

After last year’s political shocks of Trump’s election victory and the British vote to exit the European Union, 2017 is shaping up to be another year marked by surprises. President Trump ran on a platform of dramatic change to the status quo and he has already demonstrated his intent to follow through. Major uncertainty exists in key areas including foreign relations, trade policy, tax policy, and the structure of the U.S. healthcare system. Overseas, France and Germany hold presidential elections this year and anti-E.U. candidates have a legitimate chance of winning. With uncertainty so high, the range of potential outcomes for economies and markets is wider than usual.

Growth and Inflation Likely to Increase

Although difficult to make predictions in this state of uncertainty, we believe the most likely scenario for the U.S. economy is for growth to accelerate moderately from the sluggish rates of the recent past. Subdued business investment has held back growth since the Great Recession and we expect some improvement on this front. Business owners are generally more optimistic, encouraged by President Trump’s pro-business platform of deregulation, lower taxes, and increased infrastructure spending. To the extent this optimism translates into decisions to expand and invest, economic growth should receive a boost. The chart below reflects one measure of the improved mood, showing a big jump in optimism among small business owners since the election.

Small Business Optimism Index
Source: Bloomberg, National Federation of Independent Business

We expect inflation to increase slightly but to remain low by historical standards. The Federal Reserve’s preferred metric, the core Personal Consumption Expenditures Index (PCE), is currently growing at an annual rate of 1.7%, and we expect this rate to approach the Fed’s target of 2% by the end of 2017. While unlikely, inflation could rise even faster if wage growth continues to accelerate and companies respond by raising prices. As the chart below shows, hourly wages grew 2.9% last year, the largest increase since 2008. We will be monitoring the trend in wages for signs of potential inflationary pressures.

Source: Federal Reserve Bank of St. Louis

Foreign Stocks – Key Component of Diversified Portfolios

Over the past six years, foreign stocks have underperformed U.S. stocks by nearly 11% per year.1 Given this poor relative performance, some may now question the value of owning them. We believe the case for owning foreign stocks is compelling for a few reasons:

Diversification – Foreign stocks comprise nearly half (46%) of the value of all stocks in the world. In an unpredictable world, nobody knows with any certainty which countries’ stocks will be the best performers in the future. By spreading one’s bets and owning companies based in many different countries, investors who own foreign stocks in addition to U.S. stocks ensure they will own some of the future winners.

Rotation – The strong outperformance by U.S. stocks is not particularly unusual. In fact, as recently as 2007, the degree of outperformance over the prior six years was even greater. Back then, however, it was foreign stocks that led the way, outperforming U.S. stocks by more than 13% per year from 2002 through 2007.1 Relative performance between U.S. stocks and foreign stocks tends to rotate over time and investors should be careful to avoid the potential trap of selling the recent laggard shortly before its performance turns up.

Valuation –The valuation differential between U.S. and foreign stocks provides a strong case for owning foreign stocks. As of the end of 2016, the Cyclically Adjusted Price Earnings Ratio (CAPE) of U.S. stocks stood at 28 while the CAPEs of developed country and emerging market stocks were just 14 and 11, respectively.2 At these valuation levels, U.S. stocks are expensive relative to both their own historical average and to foreign stocks. Given these valuation differences, we believe the odds are reasonable that foreign stocks will outperform U.S. stocks over the next five-to-ten years.

At present, we typically recommend a 30% allocation to foreign stocks within the stock portion of our clients’ portfolios. This allocation is consistent with our research indicating that U.S. investors can capture most of the diversification benefits of foreign stocks by allocating between 25% and 35% of their equity holdings to foreign stocks.

Proceed Carefully

If the new Trump administration avoids major stumbles and the U.S. economy performs in-line with our expectations, stocks should generate solid returns this year and bond returns should be positive. However, given the high levels of uncertainty (and high U.S. stock valuations), investors should resist the temptation to increase their stock allocations in an attempt to capture more of the market’s gains. By remaining disciplined and maintaining diversified exposure to stocks and bonds in both U.S. and foreign markets, investors should be well-positioned to navigate what 2017 may have in store.

1 U.S. stocks represented by the S&P 500 Index, foreign stocks represented by the MSCI All Country World excl. U.S. Index. For the period 2011 through 2016, U.S. stocks and foreign stocks generated annualized returns of 12.47% and 1.62%, respectively. For the period 2002 through 2007, U.S. stocks and foreign stocks generated annualized returns of 2.94% and 16.46%, respectively.

2 Source: Robert Shiller, Research Affiliates

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