While any time of the year can prove to be a worthwhile time to consider changes to your investments, the start of a new year typically seems to arouse the most interest for this kind of activity. It is at this time that it has become clear which investments excelled in the prior year and which didn't, perhaps suggesting the new year will follow suit.
But more astute than trying to jump aboard prior winners and shedding their losers, at this time of the year investors should be trying to anticipate what changes a new year might bring. Thus, while prior trends might continue, new events might shuffle previous outcomes, creating a whole new set of winners and losers.
Right now the biggest questions investors should be asking themselves are these: Is the existing investment backdrop around the world set to change under a seemingly hard-to-predict President Trump administration and if so, how, followed by what are the ramifications of near certain higher interest rates in the US and possible big political and economic shifts elsewhere, especially within Europe as a result of upcoming "Brexit" negotiations and several national elections?
In my opinion, it is still too early to be able to anticipate clear answers to these questions, not to mention whether any such changes brought about by such events will result in big changes to the existing investment climate we witnessed throughout much of 2016, at least through the pre-election period. However, some investors are already jumping into action under the assumption that they can already, even before the late Jan. Presidential inauguration, correctly anticipate the winners and losers of 2017, or even beyond.
Realistically, though, some of these assumptions might be thought of as resembling "if a, then b, and thus c," such as, for example, the one regarding Trump's proposed increased spending on roads, bridges, and airports: "If more infrastructure spending, then more growth, thus more gains for stocks." In effect, not only has "a" come to pass, but then "b," and then "c" must follow as a result in order to be correct. Such an analysis in advance of any these actual outcomes would appear to be a risk-laden proposition since it is possible that at least one of the three assumptions might turn out unexpectedly.
Therefore, a prudent course of action would appear to be, at most, acting in advance only on those investment outcomes deemed most highly likely, and waiting for further certainty on all others. Especially with all US stock indexes nearly at historic highs, additional purchases based on as of yet unconfirmed multiple cascading assumptions may have only a small upside potential for new investment gains vs. larger downside ones. And while international stocks, especially in Europe, could possibly be in for more trouble, selling the most underperforming multi-year categories of mutual funds, such as many international funds have been, often doesn't turn out to have been wise move a year or two down the road.
While the above might be viewed as general guidelines, I will now focus on three fund categories that investors might fail to recognize as having the most potentially changed outlook, not only for 2017, but perhaps for at least several years ahead: international stocks, value stocks, and finally, domestic bonds.
Several years ago, investors were piling into international stock funds as advisors and pundits alike touted the benefits of diversification, often through international index funds and ETFs. For example, assets in the Vanguard Total International Stock Index (VGTSX) had, as of the end of the third quarter 2016, more than doubled over the prior three years, jumping 135%. Yet investors remaining in the fund over the entire period suffered with less than a +1% annualized return. While undoubtedly many of these recent investors will hold on in the hopes of better days ahead, one may wonder whether such results are indeed likely, or whether they are likely to continue to badly underperform the US markets. More up-to-date, over the last 3 years through year end, the annualized return on the average international fund has now become negative at about -2%.
So what will now help determine the future course of your international stock fund? As you may be aware,slow growth, and in some cases, especially so, such as in Japan, has characterized many of the major economies around the world. While generally good for international bonds, slow growth tends to hold back stocks. Looking forward, then, will growth start to improve in the most important world economies?
Within both Europe and Japan, central banks have been struggling to pull their economies out of near recessionary conditions for several years now by dropping interest rates with only mixed results. Will they be any more successful in 2017 than they have been previously?
Both regions are apparently more fully recognizing the need for more than just interest rate maneuvers now that such actions can hardly drop rates any further without causing potential disruptions to their economies. Increased government spending may thus begin to be more fully utilized as a necessary next step to promote more growth.
But a problem for US investors in these regions remains: As US interest rates are higher than in many of these countries, and likely set to go even higher, investors in most international funds do not always profit, or profit as much, from any increases in foreign stock prices. If the US economy does better than in these countries, and as projected interest rates rise more in the US, the US dollar tends to strengthen. Of course, while this has been happening most recently, it is only an assumption that we will have more of this in store for 2017 as President Trump attempts to successfully push the growth "button," and does it faster and more successfully than our international cohorts.
When this happens, what this means is that US investors tend to lose additionally on their international stock returns, even if such stock prices themselves happen to hover near zero, or worse, actually fall. In fact, since the election of Donald Trump, during November alone, the value of the dollar rose by 3.5% in international markets and continued to gain even further in December, the most dramatically against the Japanese yen. This has resulted in little, if any, gains for US investors in foreign stocks, while US stock prices generally climbed. The markets are apparently anticipating an even further outpacing of growth and interest rates in the US than abroad, which tends to attract money from around the world into US stocks and bonds, continuing to hike the value of the dollar versus foreign currencies.
Thus, aside from the question of how well, or even if, international economies will recover from their growth droughts, one must consider whether the assumption of a continuing strengthening dollar will prove to be correct. Further, if the eurozone continues to suffer politically at the hands of "populist" forces that are not enamored either of a unified Europe nor a unified currency, namely the euro, the dollar could continue to rise, hurting US returns in European stocks. Then, too, the "Brexit" vote may eventually hurt Britain more than it currently has, creating similar drags on the U.K. economy and the British pound.
Finally, if Japan cannot successfully start to improve its economy, the rise in the dollar against the Japanese yen could continue to hurt US investors in international funds. In many such funds, Japan is the country whose percent of assets invested are generally second most, with assets invested in Europe and Britain combined occupying the top spot. For example, the Vanguard Total International Stock Index Fund (VGTSX), as well as its ETF counterpart, (VXUS), currently have 18% of assets invested in Japan, but over 42% invested in Europe of which about 13% is in the U.K.
The first question to be answered then is: Will the US economy continue to do better than elsewhere? The second is: Will the US even increase its current advantage, as potential pro-growth policies are pushed by the new president? Many investors are currently betting yes to both. So, does such a forecast imply that readers should lighten up on international stocks?
But muddying that prediction might be that international stocks have considerably more reasonable valuations than US stocks, with a forward-looking P/E ratio of about 15 for VGTSX vs. nearly 20 for the US total stock market (e.g. VTSMX). And, according to my own proprietary measures of valuation, almost all categories of US stock funds are somewhat close to a designation of overvaluation, which, when reached, would mean a recommendation of "Reduce." International stock funds, while not showing particularly good prospects, are still considered "Holds."
Also of interest is that growth in emerging market economies (with the exception of China) is expected to accelerate for the first time in six years according to the International Monetary Fund (IMF), potentially helping emerging market funds whose returns have been stuck just a little north of zero over the last five years. Investors are urged to consider adding to such holdings, or at least, broader international funds that have a relatively high percentage of emerging market stocks, such as VGTSX with approximately 19% in emerging markets; Vanguard International Growth (VWIGX) has slightly more at about 21%.
So here is my recommendation regarding international funds: While one might reduce allocations internationally marginally, especially to a troubled Europe, long-term investors should probably continue to hang on to well-diversified international funds and emerging market funds. Note that one of our recommended international funds, Tweedy Browne Global Value (TBGVX), employs a tactic called hedging to eliminate the negative effect of a rising dollar for US investors so it may be especially good choice if the above scenarios play out. On the other hand, if the dollar falls, funds without this tactic (that is, that are not hedged which includes most typical international funds) might be expected to be better bets. Several other international ETFs that use hedging have been recommended by me before, namely, WisdomTree Europe Hedged (HEDJ) and WisdomTree Japan Hedged (DXJ); both are doing better in the last few months than the typical non-hedged international fund.
As discussed in previous Newsletters at my website (for example see last January's Newsletter), up until recently growth funds had been outperforming value funds for quite a while. Both types of funds are often recognized (but not always) by the presence of "growth" or "value" in their names.
However, starting at the beginning of 2016, as I pointed out in the May 2016 Newsletter, the tide began turning, with value now exceeding growth. According to the Wall Street Journal, the average one year performance for multi-cap value funds in 2016 was 15.2 vs. only 1.8% for multi-cap growth funds, as of 12-30.
Delving further, using specific data for Vanguard index funds, in the large and midcap sphere VIVAX has outperformed VIGRX 16.8 vs. 6.0% while in the small cap realm, Vanguard Value Index (VISVX) has outperformed Vanguard Growth Index (VISGX) 24.7 vs 10.6% (thru year end). These performance discrepancies have gone from being only mild before the election to extreme in its aftermath.
What can explain this significant reversal which was apparently accelerated by Mr. Trump's election, and more importantly, can one expect this trend to continue? Perhaps this: Growth stocks, historically, tend to outperform value in times of low growth and low inflation which certainly describes what we have had for many years now. However, value stocks tend to outperform during periods of higher growth and higher inflation.
Slowly but surely, both growth and inflation have been picking up in 2016. According to several sources, such as this one from a 2015 article, at different times during the economic cycle, one investing style tends to outperform the other:
"value ... outperforms growth amid high GDP growth and high inflation, signifying that the market may be overheating. At that late stage in the cycle, businesses have increased capital expenditures and wages, primarily benefiting two of the largest value sectors – industrials and financials."
Sure enough, these stock sectors have been among the strongest in 2016. Thus it appears that investors may be anticipating that the prior lower growth and lower inflation, which previously aided consumer spending, may now be expected to hinder it if they indeed start to kick in. And in fact, consumer-oriented stocks have done considerably more modestly in 2016 than industrials and financial stocks. Such consumer stocks, especially so-called consumer cyclical (or sometimes called consumer discretionary) stocks, are an important component of most growth category funds while much less so in value category funds.
If further renewed growth and subsequent inflation are on the horizon, as already started to show up prior to the election and as apparently are now being further projected by investors for the years ahead as a result of Trump's campaign and post-election statements, investors may continue to drive value stocks higher than growth stocks. If so, this will be consistent with the likely outperformance we have foreseen for value stocks over growth stocks for quite a while now.
During the first half of 2016, the average bond fund was still coasting along, doing even better over the prior 12 months than the average stock fund. However, by the end of the 3rd quarter, all that had started to change as interest rates began to rise, having the effect of dampening bond prices. As Election Day approached, the rising rate trend continued, possibly pushed along further by the prospect of upcoming Fed fund rate increases.
Now, well after Nov. 8, bond prices have taken a definite negative turn. So does this approximate six month downdraft in bond prices suggest that bond investors should be lightening up on their bond fund exposure?
It is important to recognize that the rise in interest rates from the extremely low levels that prevailed in mid-2016 likely did indeed signal an important turning point in rates. But even more important than what preceded, the election of Donald Trump, as discussed above, seemed to have caused aggressive investors, and perhaps many others, to assume that if Trump's campaign promises were enacted, the economy would most likely undergo much more government stimulus along with lower taxes, all of which could tend to be inflationary and lead to higher interest rates.
Since higher rates almost always lead to lower bond prices, such investors are likely assuming further declines in bond prices, and coincidentally as well, higher stock prices since stocks might well be the main beneficiary of the expected economic stimulus and the resulting bond market outflows.
Given the already in place upward trend in interest rates from historically low levels, coupled with the projected "Trump effect" of increased economic activity, it does seem like a reasonable conclusion to assume that bonds, at least for now, have become a somewhat less attractive option within an investor's portfolio. However, this urge to sell bonds should be tempered at least somewhat by the fact that the act of transferring money from bonds to stocks may turn out to be unwise at this time of near record high stock prices.
Bonds may still offer some value, especially once recognized that not all bond funds are "created equal," and thus, that not all types of bond funds may necessarily produce poor returns going forward. Additionally, if interest rates do rise, so do dividend payouts, which over the long term provide the biggest component of bond fund total returns, not the price fluctuations which preoccupy investors who might focus more on short-term losses.
One useful guide may well be to consider a possible reversal from the kinds of bonds that have done particularly well or poorly over the last 3 years or so. In the former category are long-term bonds, especially government bonds, while over a similar period, short-term bonds of all types as well as inflation-protected bonds have shown unimpressive returns. If the investment climate is indeed changing, these latter types of bonds might be expected to outperform the former, and recently, this has indeed been the case.
Bond funds that suffer the most during a period of rising rates tend to be US government bonds, especially those with long maturity dates. Since many bond funds designed to mirror the broad bond market, such as the Vanguard Total Bond Market Index (VBMFX), have a relatively high proportion of US Treasury bonds, one might consider keeping such exposure particularly low.
Inflation-protected bonds, which have performed poorly over an extended period due to low measured inflation, now seem to be a relatively better bet than ordinary government bonds, although this does not guarantee one will necessarily get a positive return if we get a true bond bear market. In fact, since June 30th, they have suffered too, although not quite as much as non-inflation-protected bonds.
It would still appear that international bond funds make considerable sense since interest rates outside of the US are unlikely to be rising any time soon. To offset a negative effect on returns to US investors if the dollar continues to rise (as discussed above), a fund that tries to remove such a "currency effect," that is, a fund that hedges such exposure seems to make the most sense, such as PIMCO For. Bond (USD-Hedged) Adm (PFRAX) or Vanguard Total International Bond Index (VTIBX).
High yield bond funds, which hold corporate rather than government bonds, tend to be less negatively affected by rising US rates. In fact, they may indeed profit if the US economy strengthens as they tend to correlate more highly with stocks than with many other types of bonds. After a rocky start to the year, they have greatly outperformed all other types of bonds in 2016.
Tax-free municipal bonds, although a type of government bond, still offer higher after-tax yields than most ordinary taxable bonds when your Federal tax bracket is currently 28% or more and you are investing for mainly for income. However, if the Trump administration is successful in lowering investors' tax brackets, muni bonds may become less effective as a tax reduction tool, and therefore, may suffer a hit to their prices.
Finally, while lately, funds with mortgage-backed securities, such as Vanguard GNMA (VFIIX), have still suffered as interest rates have risen, they too have dropped less than other government bond funds. Thus, while the price of VBMFX has dropped about 5% since early July, VFIIX has dropped only about 3.5%. Looking forward, there appears to be moderately less risk in the latter fund than the former.
Refer to my January 2017 Newsletter article for my specific Model Portfolio recommendations