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The Trump bump in the stock market ran into trouble when the Republican effort to “repeal and replace Obamacare” foundered in Congress and the Federal Reserve increased interest rates, raising doubts that developments in Washington would treat the markets as kindly for the rest of the year as they appear to have done right after Election Day.
Stocks had recorded a succession of highs in the hope that President Trump’s proposals for significant infrastructure spending, reduced regulation and an overhaul of the tax code would be enacted and be good for business.
But then, the market became choppier.
“The realization is setting in that even with a Republican White House and congressional majority, it doesn’t ensure a smooth enactment of legislation,” said Rebecca H. Patterson, chief investment officer of Bessemer Trust, a firm that advises wealthy families. Referring to the decline in March that accelerated after the health care bill showed signs of stalling, she added: “How much hope was priced in? Well, that much was priced in.”
Maybe more than that, according to Komal Sri-Kumar, president of Sri-Kumar Global Strategies.
“We need all of the Trump stimulus to take place, and we need a tax cut,” he said, to justify stocks’ trading as high as they are. “I don’t think either is going to take place in a hurry.”
If at all. Robert Arnott, co-manager of the Pimco All Asset Fund, said that while the prospect exists for Mr. Trump to be “a transformational president” who can succeed at “disentangling the regulatory state, cutting a lot of red tape, making it easier for free enterprise to be free, a lot of that is likely to turn out to be wishful thinking.”
It was wishful enough to take the Standard & Poor’s 500-stock index up more than 12 percent between Election Day and the beginning of March. For the first quarter, the benchmark index rose 5.5 percent, closing at 2,362.72.
When it comes to the outlook for monetary policy, the thinking is mixed. Ms. Patterson said the Fed’s move last month “was perceived as an incredibly dovish hike, if that’s not too much of an oxymoron.” That’s because Janet L. Yellen, the Fed chairwoman, declined to discuss plans for selling trillions of dollars of Treasury instruments and other securities added to the Fed’s balance sheet after the global financial crisis through its quantitative easing program.
Mr. Sri-Kumar envisions a more accommodative Fed than is widely expected. The economy will remain too anemic for more than one rate increase a year for the time being, he predicted.
Jeffrey Gundlach, chief executive of DoubleLine Capital, counters that central bankers would have to be more assertive because, with the unemployment rate below 5 percent and inflation above 2 percent, “they have met their policy objectives.”
“We’ve moved into a base case where it’s not so much that if the data improves, the Fed will consider raising rates,” Mr. Gundlach said. “Now if the data stays where it is, the Fed will raise rates once a quarter. If you look under the hood” at Ms. Yellen’s commentary last month, “it wasn’t that dovish.”
Tighter monetary policy is ultimately good for long-term government bonds, all else being equal, he said, because it depresses economic growth and inflation. As he put it, “the long-bond market wants the Fed to destroy the economy.”
But the economy is still doing well enough to keep the 10-year Treasury yield from falling much further, Mr. Gundlach predicted. He foresees it falling to 2.25 percent from 2.4 percent on March 31, before heading close to 3 percent later in the year. He would avoid buying longer-term government debt, therefore, and high-grade corporate bonds, which he said had “huge interest-rate risk.”
As for stocks, they would face pressure from a further rise in bond yields, he warned.
“The argument for stocks has for quite some time been that they’re better than bonds,” Mr. Gundlach said. “As interest rates move higher, you start to get real competition” for investors’ money. “It’s going to be a tough environment in the middle of this year with bond yields rising.”
It was a sufficiently favorable environment in the first quarter to send the average domestic stock mutual fund up 4.9 percent, according to Morningstar. Portfolios that focus on technology and health care did especially well, while specialists in industrials and financial services lagged.
The average taxable bond fund gained a modest 1.6 percent.
Tobias Levkovich, chief United States equity strategist at Citi Research, contends that the economy is humming along better than many on Wall Street believe and that it makes more sense to attribute the rally in stocks to stronger growth than to a Trump bump.
“The economy and earnings data were getting better before the elections,” Mr. Levkovich said, with measures like new business orders and capital spending already on the rise. “The Fed was watching all this data, as well,” he added, and that’s why it raised rates in March.
His benign economic view leads him to be wary of bonds; he expects a 10-year Treasury yield of 2.6 percent at year’s end, and little opportunity for gains. He encourages investing in stock sectors that are especially sensitive to growth, like energy — which he said had been underperforming technology almost to the extent that it did during the 2000 tech bubble — and industrials. He also likes narrower segments like biotechnology and producers of entertainment and media content.
Ms. Patterson is less hopeful about the economy and stocks. While she finds that economic and earnings growth “continue to look pretty good,” she thinks a downward turn in the cycle is approaching.
“We’ve been neutral on stocks since late spring, and we’ll probably stay neutral until it’s time to go underweight,” she said, adding a caveat: “You don’t want to be too nervous too early.”
Although she is less hopeful on the economy than Mr. Levkovich, Ms. Patterson likewise favors energy stocks. She also recommends health care and would avoid materials stocks, another economically sensitive sector.
“We went into the year thinking equities were already highly valued and we’re in the latter stages of the economic cycle,” she said. “We’re telling our clients that over the next few years we’ll have positive equity returns, but that they have to manage their expectations.”
With his low expectations for the economy, Mr. Sri-Kumar advises a liberal allocation to Treasury and high-grade corporate bonds, and he would limit exposure to the stock market to defensive sectors like utilities and consumer staples.
Investors have seldom felt the need to go into a defensive crouch during the eight-year bull run in stocks. The market appears pricey, Mr. Arnott said, based on the CAPE Shiller ratio, which compares share prices to the last 10 years of inflation-adjusted earnings to get a valuation reading that adjusts for the shifts of the economic cycle.
“Now, we sit with a Shiller P.E. that briefly touched 29,” he said. “That’s pretty expensive,” more so than at any time in the last century, he said, other than just before the 1929 crash and in the run-up to the popping of the tech bubble in 2000.
“That’s heady company to be keeping,” he said. “It’s not a slam-dunk formula for a market crash, but it suggests very high odds for long-term anemic returns.”
Mr. Arnott finds the return prospects much better abroad, with stocks trading at 13 times earnings in Europe and 12 times in emerging markets. As for bonds, local-currency debt in emerging markets yields about 6.5 percent on average, compared with 1.5 percent for a basket of long-term government issues from the United States, Germany, Japan, Britain and France.
Emerging markets “are priced for deep disappointment,” he said. “Any upside surprise is not priced in.”
Funds that invest in emerging stock markets did not disappoint in the first quarter. The average one rose 11.9 percent, helping the average international stock fund to return 7.9 percent.
Mr. Gundlach prefers foreign markets for similar reasons. He favors France, where returns have lagged those in other European countries, like Germany and Britain, over the last year. A populist presidential candidate, Marine Le Pen, has continued to poll well ahead of French elections that will begin next Sunday, although she is not expected to win.
Among emerging markets, he considers India an excellent investment over the very long term. He foresees its economy developing much as China’s has over the last few decades.
“When foreign markets outperform the U.S., you see tremendous enthusiasm for U.S. investors to diversify, but they’re buying what has already gone up,” Mr. Gundlach said. “If diversification is prudent, why not do it when you’ve already made big profits on U.S. investments?”