Beware Irrational Complacency

Beware of Irrational Complacency

Podcast

Q2 2017 CIO Insights – Multi-Asset Strategies

Hope is not a very effective investment strategy. As we write this, stocks stand at record highs with volatility near record lows, reflecting hopes for business-friendly policies from the new administration. In our view, this fails to account for the highly uncertain policy environment and wide range of political and economic outcomes. While we wait for greater clarity on some big policy decisions and their relationship to corporate fundamentals, we remain broadly diversified around our neutral asset weights.

Political Uncertainty

Popular academic research on financial markets amid political uncertainty focuses on periods of weak economic conditions, because that this is when changes in governing coalitions and policies typically occur. But how to make sense of election results that challenge the entire post-World War II global political and economic order in a period of slow but steady economic growth and modest unemployment? Simply put, we are in uncharted territory.

“Simply put, we are in uncharted territory.”

We’re not alone in this—Federal Reserve (Fed) watchers have pointed out that the word “uncertainty” in the recently released transcript of the Fed policy meeting appeared more times that at any point since the financial crisis.

One obvious reason for the policy uncertainty is that President Trump ran as a political outsider/anti-establishment candidate. But it is difficult to implement a reform agenda without the help of “establishment” Republicans in control of the House and Senate. The Obamacare example is instructive—there’s a great deal of space between the Congressional Republican desire to “repeal and replace,” on the one hand, and Trump’s stated goal to “cover more people for less cost,” on the other hand. In other words, there’s significant tension between Trump’s own pro-business and populist policy proposals, as well as with traditional Republican ideals, and it’s not clear how that tension is ultimately resolved.

We’re cautious because stocks have rallied hard on the presumption of lower taxes and less regulation, with certain sectors and industries being significant beneficiaries of the “Trump trade.” As a result, valuations in many segments of U.S. equity markets are stretched, and we need the follow-through in terms of policy and fundamental improvement to justify those prices.

Potential Positive Outcomes

We don’t want to be nattering nabobs of negativism—it is certainly possible to imagine positive outcomes for business on taxes and regulation. Perhaps the Republican majority in Congress will be able to deliver coherent, business-friendly policies that contribute to Corporate America’s bottom line through successful tax reform. In addition, it is at least possible Trump could actually produce better trade arrangements for U.S. companies.

Diversification Is King

To summarize, with both complacency and uncertainty running high, we prefer to move back to our long-term strategic asset allocation and wait for more information. We believe this well-diversified approach provides an effective framework for investing at such times. It does not require perfect information or one-way outcomes to be successful; rather, diversification seeks to reduce volatility and maximize risk-adjusted return regardless of economic and political outcomes.

We have made some modest adjustments at the sub-asset class level, however. Within equities, we favor stocks of developed economies over those of emerging markets, in part because of the uncertainty—expectations for higher U.S. interest rates and stronger dollar could present challenges ahead for emerging market stocks more broadly. In terms of our fixed-income allocation, we continue to favor select corporate bonds over U.S. Treasuries, and have been adding attractively valued inflation-linked debt as opportunities allow.

Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Scott Wittman, CFA, CAIA, and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice. Past performance is no guarantee of future results.