The 'Trump rally' will fade, but this will create buying opportunities
Should we ignore investment risks - perceived and real - and focus instead on the confidence that has been driving virtually every type of asset upwards over the past year?
For a UK investor asking that question, it's important first to assess what drove stock markets, particularly in the US and the UK, to all-time highs in January.
In the UK sterling devaluation has made the equity of large multinational companies in the FTSE 100 index look very attractive.
Not only did sterling's fall of 17 per cent over the year put a rocket under the index in the second half of the year, but it also rescued dividends. Without sterling's fall, dividends in aggregate would have been static at best.
LEADING STOCK MARKETS HIGHER
Indeed, in the words of one fund manager, that currency boost 'made heroes of us all' in 2016, and it was a very thick layer of icing on the cake, doubling the returns made in local currency terms for UK investors in many overseas markets.
In the US, Donald Trump's promise of a large fiscal boost to an economy already leading the developed world out of the doldrums also propelled stock markets higher - notably the narrowly focused Dow Jones Industrials index and the broader Russell 2000 index of smaller companies.
Although beset with concerns about the surge of populist parties and their effects on forthcoming elections in the Netherlands, France and Germany this year (not to mention the potential collapse of Italy's coalition government), European markets managed a small gain.
The FTSE Developed Europe ex UK index made around 5 per cent, and similar performance was recorded by Japan's Topix index.
Even the flight from bonds that gathered pace in the second half of 2016 seemed not to hit UK investors where it hurts.
UK government bonds in aggregate gained 10 per cent over the year, while global bonds made more than 20 per cent (thanks again to sterling) - although like all developed market bonds they were weak in the last quarter of the year.
Indeed, a cursory glance at the benchmark indices that Money Observer monitors each month shows that you would have been very unlucky not to make money in virtually any type of asset in 2016, the exception being UK property.
In fact it was the best year for multi-asset returns since 2009, says Trevor Greetham, head of tactical asset allocation at Royal London Asset Management. Yet who'd have thought that would have been the outcome in a year when the vote went in favour of both Brexit and Trump?
While some fund managers who have wealth preservation in mind see stock markets as being dangerously overvalued, a large majority of investors are optimistic, and few more so than Nick Mustoe, chief investment officer at Invesco Perpetual and manager of the Invesco Perpetual Global Equity Income fund.
A GREAT ROTATION
Although a great many economically sensitive shares globally have benefited from a post-EU referendum and Trump bounce, Mustoe believes a 'great rotation' away from safe, defensive shares and into cyclical businesses is underway, and that it 'has got a lot further to go if you look at valuations'.
Although there has been a pause in the global bond sell-off that saw prices fall and yields rise in the last quarter of 2016, he thinks that 'over time, this will reassert itself and we have a long way to go in terms of this yield correction for fixed income'.
Previously it was defensive, safe dividend-paying stocks, the so-called bond proxies, that benefited most from investors moving out of bond markets in search of decent yield.
This move undoubtedly contributed to the massive growth in passive investing strategies via exchange traded funds and other index-trackers.
Mustoe is among the many stock-picking investors who reckon this has distorted the true value of markets. When yields in bond markets rise, it will be the bond proxies that suffer most as cautious investors return to bond markets.
Despite Mustoe's bullish protestations, these market distortions also validate the concerns of the gloom-mongers who believe equity markets have got ahead of themselves and that a correction is due.
Expected volatility in bond and equity markets this year will certainly create opportunities for canny investors.
For strategists at the investment bank Morgan Stanley, this volatility is most likely to appear when Trump puts some meat on the bones of his reflationary promises to 'make America great again' by investing in infrastructure, cutting taxes and erecting trade barriers to protect US jobs.
As they point out, there are few clues from history to suggest how assets will perform when the fiscal purse strings are loosened during a period of relatively robust growth in an economy that is approaching full employment.
Similar policies were adopted in the 1960s and the mid-1980s under Ronald Reagan, but the latter period was characterised by inflation in the mid-teens and a hawkish US Federal Reserve that raised interest rates to tackle it.
EXPECT DOLLAR STRENGTH
However, despite the uncertainty over outcomes for investors, the Morgan Stanley strategists will have plenty of followers who agree that Trump's policies will continue to support the dollar, as rising inflation, growth prospects and a burgeoning budget deficit rising from 3 per cent to as much as 7 per cent by 2018 prompt the Fed to act and raise interest rates.
Consultancy Capital Economics reckons the Fed will take a wait-and-see approach before pulling the trigger, but it forecasts that rates could hit 2 per cent (from a current target rate of 0.5-0.75 per cent) by the year-end.
That bodes well for another year of dollar strength; this in turn will continue to make returns from foreign investments look good for UK investors and help prop up those flagging dividends in the UK.
However, the measure of uncertainty for asset class returns this year is shown in the potential range of outcomes Morgan Stanley has modelled (see table, click to enlarge).
On a 12-month view, the base case scenario sees very little upside for US and European (including the UK) equities, a small fall for emerging markets, but a near-20 per cent gain for Japanese stocks.
But the bear case suggests losses of between 23 per cent (Europe) and 36 per cent (Japan), while the opposite bullish case indicates gains of between 22 per cent (Europe) and 38 per cent (Japan).
Those potential outcomes, especially the bearish case, cannot be seen in any current measures of volatility. US stock market volatility is currently in its first percentile range (as measured by the S&P 500 Vix index reading of below 11), but since 1990 it has been higher 99.4 per cent of the time.
PLENTY OF OPPORTUNITIES
With all the uncertainty surrounding Trump's policies, Brexit negotiations, the sanctity of the eurozone and inflation (and how that works through into interest rates), there really is only one way for volatility eventually to move - up.
That should allow Mustoe and his ilk to buy the fundamentally attractive shares he likes, at even better valuations.
He says: 'Because of the trends in the past few years towards passive investing, a lot of investors have ignored valuations, and in the valuation gap we are seeing huge upside opportunities from taking active positions in stocks.'
Mustoe prefers to see past the political risks, and he views European equities as being among the best opportunities.
From Greetham's multi-asset perspective at Royal London, the political risks in Europe mean he is underweight there, as well as in bonds and emerging market equities, both of which are likely to suffer from Trump's reflationary and protectionist agenda.
In contrast, like many professional investors, he sees upside in Japan equities and, given continued global economic buoyancy, more gains to come from commodities.
As the 'patchwork' chart shows, there is much to be gained from taking a multi-asset approach in a portfolio. Not only were returns robust in 2016 (11.9 per cent), but since 2009 such an approach has netted a respectable uplift of 78 per cent.
One further thought on the merits of ensuring you have a decent spread of risk and asset types comes from Guy Stephens, technical investment director at wealth manager Rowan Dartington.
He says: 'Globalisation and political world harmony would appear to be in reverse gear at the moment, and that introduces extra risk and uncertainty for the outlook.
'The demise of the EU - which could be sparked by another member state having an EU referendum - would introduce huge economic instability.
'As with all outcomes perceived desirable, be careful what you wish for. Brexit and Trump are introducing a huge amount of unknown consequences that are impossible to predict and make investment decisions particularly challenging.'
I couldn't agree more.