While the direction of short-term interest rates seems clear, the extent isn’t, reflecting the currently high degree of uncertainty around the U.S. policy outlook. The FedWatch tool (based on the Chicago Mercantile Exchange’s futures prices) shows, for example, that futures investors currently have very mixed views on where the federal-funds rate will be by the end of this year. The most likely outcome is two 0.25% increases, but investors also think there is a good chance of only one, and a reasonable chance of three.

The same uncertainty prevails in the U.S. bond markets. At first, investors believed in significantly higher bond yields—the U.S. 10-year yield hit 2.6% on Dec. 15—but recently have been having second thoughts, with the yield back down to 2.4%. However, while the extent of rises is debatable, the direction looks clearer: U.S. bond yields in the low 2% region look too low now that U.S. inflation has risen over 2%, and looks likely to rise a little more. The latest Wall Street Journal poll of U.S. forecasters found they expect the U.S. yield to rise to 2.65% by midyear and to 2.9% by the end of this year: this could well be on the low side, as even a 2.9% yield would not offer much real (after inflation) return.

U.S. dollar-denominated bonds are consequently likely to face a challenging year as yields rise, though with the potential for the Trump administration to spring surprises and/or take policy mis-steps, there could still be some insurance value against periods of market volatility. Elsewhere, there looks to be less potential for capital loss. For example, although inflation in the eurozone picked up to 1.1% in December, the European Central Bank, or ECB, is likely to keep interest rates very low for some time yet, as is the Bank of Japan, where there is less evidence that efforts to boost inflation have been successful (the latest inflation rate is 0.5%). While central bank policies in Europe and Japan do not pose any immediate threat to bond investors, even in these economies, bond yields look vulnerable from any longer-term perspective.

International Equities — Outlook

At first glance, the outlook for 2017 is looking reasonably promising in terms of the economic fundamentals for world equities. Virtually all the recent data and forecasts have been pointing to reasonable current economic conditions, which are expected to pick up during the course of this year.

In terms of the current state of the global cycle, the latest (December 2016) JP Morgan/IHS Markit global business performance indices finished last year on a strong note. As JP Morgan’s commentary said, “Output growth accelerated to a 13-month high, with solid trends seen at both manufacturers and service providers. Improving rates of expansion in new business and employment suggest that the economy is taking positive momentum into the new year, which should ensure the growth recovery continues to take hold at the start of 2017.” By sector, technology, the financials, consumer goods and industrial companies were all doing particularly well.

The most recent updates to its World Economic Outlook from the International Monetary Fund, or IMF, also showed an expected improvement this year, with the IMF expecting global economic growth to pick up progressively from an estimated 3.1% last year to 3.4% this year and to 3.6% in 2018, with the outlook for the developed economies now looking a bit better than the IMF had expected in its last forecasting exercise in October 2016.

Other forecasters are also more upbeat. The Wall Street Journal panel of U.S. forecasters has added a tad extra to expected U.S. growth (now expected to be 2.4% this year and 2.5% in 2018) while the latest (January) poll of European forecasters by the ECB found that they, too, were in a more optimistic mood. While the expected rates of growth are not stellar in absolute terms—the forecasters are picking 1.5% growth for the eurozone this year—they mark a significant change from previously near-recessionary conditions.

There are pockets of poorer performance—on the Economist’s (January) latest poll of international forecasters, growth in Japan is likely to remain sluggish, and there are considerable uncertainties for the U.K. economy ahead of what look like difficult Brexit negotiations. However, overall, the global outlook appears to be brightening. It has helped that three emerging economies that had been in recession in 2016 (Argentina, Brazil, Russia) all look to resume growing this year (going by the Economist panel predictions), and that China looks likely to keep growing at an impressive rate (by 6.5% this year, and by 6.0% in 2018, according to the IMF).

While the economic fundamentals driving global corporate profit prospects look to be improving, the prices investors are paying for exposure to global growth remain on the high side. In the U.S., for example, valuations are currently on the high side of historical yardsticks. On Birinyi Associates’ estimates, the trailing P/E ratio for the S&P500 is currently 24.7 times earnings, compared with 20.7 times a year ago, and the dividend yield has dropped over the same period from 2.36% to 2.15%. The prospective P/E ratio, based on the earnings expected over the next year, is an expensive 17.45. These already relatively pricey valuations will be challenged if, as seems probable, U.S. interest rates rise during the year and investors revisit the relative valuations between equities and bonds.

As noted earlier, we still do not know a lot about the likely direction of Trump administration policies. At the time of writing, there has been only a limited range of early announcements (repeal of the “Obamacare” health insurance arrangements, penalties for outsourcing U.S. jobs, withdrawal from the Trans Pacific Partnership, a wall with Mexico), but even on this limited sample, they show that the Trump administration is prepared to go in radically different directions to its predecessors.

Performance periods unless otherwise stated generally refer to periods ended January 25, 2017

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