Santa came early for many U.S. stock investors this year. The market entered the holiday season in high spirits thanks to a post-election run that set the MSCI USA Index up for what could be a 10% gain in 2016.
And there are signs the good mood could carry over into 2017. A few weeks after the election, the Organization for Economic Cooperation and Development (OECD) predicted the U.S. growth rate would tick up to 2.3% next year from 1.5% this year.1 The Federal Reserve also seems more sanguine: It raised interest rates for the first time in a year in mid-December and projects three more hikes in 2017. In September, it foresaw just two hikes in 2017.
The outlook overseas is a little more muddled. The U.S. economy looks set to comfortably outpace growth rates in other parts of the developed world, and while emerging markets may be in better shape, a rise in protectionism and a stronger U.S. dollar could pose challenges.
“International stocks could face some risks in the near term, but investors should still keep some international exposure to ensure their fortunes aren’t tied to a single country. Global diversification is the goal,” says Jeffrey Kleintop, senior vice president and chief global investment strategist at Charles Schwab & Co. “No one country—including the U.S.—offers full global stock market exposure.”
The following are some of the key risks to be aware of in the months ahead.
We see a few headwinds for developed countries outside the U.S. in 2017.
- Political risk. European heavyweights France and Germany are among the countries heading to the polls this year. Could the populist surge that helped elevate President-elect Donald Trump and turned Britain against the EU happen in the heart of Europe? A populist turn in France or Germany could have serious consequences for the future of the EU, so many investors may avoid European stocks ahead of the elections—France votes in April/May 2017 and Germany will follow later in the year.
- Lagging growth. The OECD expects growth in the euro zone to edge down from 1.7% this year to a still-solid 1.6% in 2017, and British growth to slow from 2.0% to 1.2%. Japan’s anemic 0.8% expansion this year is seen ticking up to 1.0% in 2017. These are all below the U.S.’s projected 2.3% rise. Stock market returns depend on many variables, but in general slower growth rates in much of the developed world tend to make U.S. stocks look relatively more favorable.
- Fewer upside surprises. The strength of European economic growth often surprised economists this year, according to Citigroup Economic Surprise Index for the euro zone (the index rises when economic data exceeds economists’ expectations).2 Upside surprises tend to be good for stocks. However, with the surprise index now hovering near its peak levels of recent years, a continued run of unexpectedly strong data releases seems unlikely.
- Strong dollar. The dollar surged after the U.S. election, pushing down the currencies of many of the U.S.’s trading partners. That could hurt returns from foreign investments once those returns are converted into dollars. A continued rise in the dollar could also make it harder for foreign central banks to continue supporting their economies with loose monetary policies, as a weakening currency could lead to inflation.
Things look a little better for emerging countries. The International Monetary Fund expects economic growth in emerging markets to accelerate to 4.6% in 2017 from 4.2% this year. And stronger growth in the U.S. could help boost emerging countries’ exports.
However, there are a few risks. A rise in protectionism in the U.S. could depress trade. Meanwhile, a stronger dollar could cause investors to pull needed capital out of developing countries’ economies and also make it harder for borrowers there to service their large outstanding dollar debts.
What should investors do?
We don’t think these risks are a reason to retreat completely from the rest of the world. International exposure offers increased diversification that can help buffer your portfolio against market downturns. And staying at home can leave you with potentially unexpected concentrations in particular sectors.
For example, the broad U.S. stock market has tracked the global information technology sector pretty closely in recent years.3 After all, IT has the heaviest sector weighting in the U.S. stock market, as measured by the MSCI USA Index, and U.S. stocks have the heaviest weighting in the MSCI World Information Technology Index.
That works well for the U.S. when the tech sector is performing strongly, as it has over the past five years.4 And a potential wave of new investment in new technology could continue to drive the sector higher in 2017, as business confidence grows and companies catch up on long-delayed upgrades.
“However, even if the tech sector outperforms in the near term, experienced investors still wouldn’t put all of their money in tech stocks. The same goes for countries, regardless of their near-term growth prospects,” says Jeffrey. “To avoid the potential shocks that can come from a lack of diversification, an investor should aim for broad exposure to the stock market. The best way to do this is to build a global portfolio, diversified across many sectors and countries.”
1“Escaping the Low-Growth Trap? Effective Fiscal Initiatives, Avoiding Trade Pitfalls,” OECD, 11/29/2016.
2Source: Charles Schwab, Bloomberg data as of 12/11/2016.
3Source: MSCI USA Index and MSCI World Information Technology Index. Data as of 8/11/2016.
4MSCI World Information Technology Index. Data as of 11/2016.