January 2018

Risks remain, including: DC turmoil, geopolitical events, increased global competition, digital disruption and rising interest rates. As these unfold, financial market volatility may return.

Typically, there are three 5% corrections per year. However, since early 2016 the S&P 500 and the Dow Jones Industrial Average have not had a 5% correction. As such, the next 5% market pullback may provoke more negative emotions than previous 5% pullbacks.

Long-term investors should keep in mind that the 100-year average US stock market return is about 10%. Compounding those positive returns long-term can produce powerful results.

Another area of low volatility has been the bond markets. As interest rates fall, most bonds rise in value and pay a coupon. Some investors have become accustomed to this. However, a stronger economy can lead to rising inflation and higher interest rates. As this occurs, the market value of most bonds may decline.

The Fed has been one of the largest buyers of bonds over the last nine years; however, the Fed is expected to cut its US Treasury bond holdings by $252 billion in 2018 and $360 billion in 2019. At the same time, the federal government is expected to increase its debt by $550 billion in 2018. Consequently, new buyers of at least $0.8 trillion US Treasury debt may be needed annually for the foreseeable future (vs. about $0.4 trillion in 2017).

Eventually, bonds should have to offer higher interest rates to attract record amounts of new buyers. This means that bond prices should fall and current long-maturity bonds might provide negative total returns.

As interest rates rise, investors should avoid long-term bonds, preferred stocks, utility stocks and some levered closed-end funds. On the other hand, other investments may benefit from a stronger economy despite higher inflation and interest rates.

Common stocks of these types of companies and funds may perform well in this environment:

  • Global companies benefiting from exports and strong foreign operations and repatriation of foreign profits at a low tax rate.
  • Small and mid-capitalization companies that paid the full US corporate tax rate should experience higher earnings and cash generation from a lower federal corporate tax rate.
  • Financial service firms that benefit from rising interest income and increasing merger and acquisition activity.
  • Leading consumer discretionary firms that continue to dominate their niche should reap rewards from rising consumer jobs, wages and confidence.
  • Companies using technology to drive productivity and sales growth should continue to profit from the ongoing digital revolution.
  • International companies boosted by the synchronized global economic recovery may boost certain international mutual funds and exchange traded funds (ETFs).

Many equities with these traits pay attractive dividends and increase them annually. The combination of strong long-term growth and a rising stream of recurring cash dividend income can produce strong results.