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Investing in 2018: Mind Inflation, Show Caution

2017 was a better year than expected for investors - but what will 2018 deliver for shareholders of US equities?

Russel Kinnel 10 January, 2018 | 1:00PM

Outgoing Fed Chairman Janet Yellen

2017 was a better year for investing than I had expected. Emerging markets were the best place to be. The average India fund gained 47%, the average China fund was up 42%, and diversified emerging markets were up 34%. And the United States was no slouch, with gains of 21%.

The two takeaways from the 2017 rally are: 1) You can’t afford to be out of the market. It is tempting to market-time, but rallies are unpredictable, so stick with your plan no matter what the headlines say. 2) There are no screaming bargains left out there. Low interest rates and economic growth have pushed investors around the world to keep buying stocks, bonds, and any other financial asset.

What Next for 2018?

The US is facing a dramatic change in taxes. It should prove a boon for corporations, and it is also expected to add a trillion to the deficit. You should talk with your tax preparer to see what impact it will have on you, but so far as investors sift through all the changes it does seem like there are some clear takeaways.

First, analysts expect much of the benefit in lower tax rates to flow through to shareholders in the form of dividends and stock buybacks. Thus, we have a new support to the equity market just as it seemed to be getting too pricey.

Second, we have a boatload of stimulus coming at a time when the economy is already strong. When we got stimulus amid the recession of 2008 and 2009, it didn’t spur inflation. But we might not be that lucky this time with the economy going full throttle. The New Fed Jerome Powell will replace Janet Yellen as Federal Reserve board chair, but that’s not all. Stanley Fischer and Daniel Tarullo have resigned from the board of governors.

In addition, there were two openings when President Trump took office. Thus, you have four pending vacancies, and Trump has nominated Marvin Goodfriend to take one of those seats. Goodfriend has not been approved yet. It is very rare to see so much change in such a short period of time at the Fed. And markets hate uncertainty at the Fed.

The current Fed had signalled it planned to hike interest rates three times in 2018, but does that plan really matter with a line change in the works? It is not clear whether this change is bullish or bearish for equities or for bonds. It would seem to increase the chances that volatility picks up at the very least.

Inflation Plays and Small Value Stocks

Productivity gains and sluggish growth outside the U.S. in recent years have kept inflation under wraps. But as I mentioned, the huge stimulus and deficit increase could mean that inflation could return. If you have a bond-heavy portfolio that is vulnerable to rising inflation rates, it makes sense to have some protection. However, I wouldn’t make inflation protection a huge part of my portfolio.

Small value last lagged large growth by a wide margin in 2007 and before that in 1999. In the ensuing years, small value outperformed dramatically the first time but only modestly the second time. This certainly reminds me of 1999 when small-value stocks just looked stodgy and boring in comparison with the dynamic Internet and technology companies powering the markets.

It seems to me that caution is in order. We could be looking at a topsy-turvy year, so stick to your plan and look for good opportunities as they arise.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Russel Kinnel  is Morningstar's director of fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping US investors build winning portfolios.