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Market Update

What Top Fund Managers Expect in 2017

If you thought 2016 was an up-and-down year, next year could be an even bumpier ride, say the investment pros we spoke with.

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As well as stock markets have done this year--the S&P 500 is up 10 percent year-to-date as of this writing--it's been a wild ride, to say the least. The correction in January, the Brexit surprise, and Donald Trump's unexpected victory are just some of the events that have left many investors feeling increasingly uncertain.

Still, many money managers are cautiously optimistic about 2017. It's far from clear as to how President-elect Donald Trump will impact domestic and global events next year and what Europe's populist push means for equities. But if U.S. GDP growth does indeed expand faster than it has, that's good news for investors. That's what several Morningstar Medalist managers told us when we asked them for their 2017 market outlooks. Here's what else they had to say.

Brian Berghuis, manager of T. Rowe Price Mid-Cap Growth (RPMGX)
I would not be surprised to see further market turbulence following Trump's inauguration as more controversial elements of his agenda either work their way through Congress or are thrown aside. If the new president decides to follow through on his hard-line trade agenda, a great deal of uncertainty will be injected into the businesses of some of our holdings. However, I'd be happy to wait out volatility and take advantage of improved valuations to increase our positions in firms with superior long-term prospects.

As for risks, regulators and central banks continue to engage in an extraordinary monetary experiment by suppressing interest rates. This has impaired the capital markets allocation function and led to greater risk-taking, generally. The experiment's impact is especially evident in Silicon Valley. It's become the epicenter of financial speculation with cheap money cascading in. I'm concerned that 2017 may be the year we see a number of large, privately funded technologies companies falter. Political instability in Europe is also a source of concern, and the threat has increased that a nativist tone to Brexit negotiations will undermine the crucial financial center in London.

Charles Dreifus, manager of  Royce Special Equity (RSEFX) 
Due to unstable economic conditions in many areas outside the U.S., a rising dollar, and the fact that U.S. small-cap companies stand to gain the most from a lower tax rate, U.S. small caps are being recognized as the sweet spot for current asset allocation. We would not be surprised if the market pauses to digest the recent advance while trying to calibrate expectations versus the actions it sees on the paths of successful implementation. We remain positive about the portfolio, but the number of names are shrinking because the pool of acceptable candidates is meager. Valuations keep driving things up, and I end up selling.

I'm concerned that perception has overtaken the likely reality. We hope, and expect, Reaganomics 2.0, but Smoot-Hawley 2.0 cannot, as yet, be ruled out. It also must be said that the Reagan era had a better backdrop--equity valuations as a percentage of GDP are now 196% vs 40% in 1980. Nonfinancial debt as a percentage of GDP was 135% then while it is 251% now. Government debt was 30% of GDP then, it is now 100%. Interest rates were declining from lofty levels while today they are rising from suppressed levels. We hope Trump's promise of growing the pie rather than just redistributing it becomes a reality, but let us not forget that Trump is an "apprentice" president. His first 100 days could see some errors, which could result in a recalibration of expectations.

Michael Clarfeld, comanager of ClearBridge Dividend Strategy (SOPAX) 
Earlier in the year the U.S. Federal Reserve had indicated the likelihood of a gradual path of future tightening. The election of Trump and the potential for passage of his pro-growth policies could change that calculus and hasten a more aggressive program of rate increases. Dividend-paying equities could initially come under pressure in a rising rate environment, but we believe quality companies that consistently grow their dividends are ultimately well positioned for such a scenario. Dividend stocks tend to do well in cycles like the current one where nominal rates start at a low level. Trump's proposals for corporate tax reform, less regulation, and fiscal stimulus should be broadly beneficial to the economy and corporate earnings. Repatriation of overseas cash has the potential to unlock additional cash that can be directed toward dividend payouts. Technology sector, healthcare, and industrial sector stocks stand to free up the most cash from repatriation.

2017 will likely be more volatile than the postelection period would suggest, with near-term uncertainty over the timing of policy implementation, the specter of rising rates and geopolitical uncertainties likely keeping returns in check. One of the biggest risks to U.S. stocks, especially larger multinationals, is a stronger dollar, which has climbed sharply since the election. That's hurt companies that export goods or generate a large portion of their revenues overseas. The prospect for higher rates could further strengthen the dollar.

Peter Langerman, president and CEO of Franklin Mutual Series and lead manager of Franklin Mutual Global Discovery (TEDIX)
Global financial markets and economies appear to be approaching 2017 in a better position than at the start of 2016. Global economic growth, while still modest, has shown signs of improvement in the second half of 2016, labor markets in developed economies have gradually tightened, corporate earnings in the United States have stabilized and crude oil fundamentals have started on a slow path to rebalancing. However, the U.S. presidential election, Brexit, and uncertainty regarding the path of interest-rate hikes by the Federal Reserve are among a collection of factors with the potential to produce short-term volatility and longer-term impacts on sector and company fundamentals.

The Republican sweep has potentially meaningful implications for several industries. Scaling back regulations in healthcare and finance would likely have a positive impact on pharmaceuticals and bank stocks. A sizable infrastructure spending package would be a positive for industrials-sector companies. In addition, a tax repatriation holiday and/or corporate tax reform could encourage U.S. companies to bring back trillions of dollars held abroad which, if history is an accurate guide, would largely go toward special dividends, share buybacks, and mergers and acquisitions.

Marc Nabi, investment specialist at Capital Group who contributes to American Funds Fundamental Investors (AFIBX)
As we enter 2017, political and economic uncertainty signal an investment world in transition. Recent political changes paired with muted economic growth across much of the world leaves many economies vulnerable to shocks. However, in the U.S., a strengthening consumer driven by accelerating wage growth, a tightening job market and low household debt is driving stronger economic growth. This may be aided by President-elect Trump's potential decision for large fiscal stimulus. There's some worry that this recovery is long in the tooth, but the current U.S. expansion continues to show that age is nothing but a number.

The U.S. remains a tale of two economies--consumer strength partly offset by weak industrial activity may cause modest but accelerating economic growth. Valuations in many areas of the American market appear stretched, but it may not remain so expensive if there is a pickup in earnings from potential fiscal stimulus policies. In addition, equity market leadership changes may continue as a result of the election outcome. Companies that have not fared well over the last several years in sectors such as financial services, energy, and industrials could lead the U.S. equity market higher.

Matthew Benkendorf, Vontobel Asset Management’s chief investment officer and lead manager of Virtus Global Opportunities (NWWOX)
We're facing a clear style headwind because of a major market rotation--growth businesses will see low double digit or high single digit returns. We're consumer-oriented, though, because consumer stocks are fantastic businesses that are durable in any economic cycle. There are risks, with the big ones being in the U.S. tax reform, regulatory roll backs and infrastructure spending are all good things, and they all lie in the power of congress. The flip is side is the trade issue and global trading relations, and those things are in Trump's hands. The big risk is how this balances out when they get implemented. And they won't get implemented until late next year at the latest, so how patient will the market be with waiting?

The Europe situation is dangerous as we go forward, because the solutions seem politically unpalatable. There's also the always lingering China issue and there could be fall out from reflating properly again. The last piece is interest-rate policy. How inflationary is the situation and how will markets react to interest rates? I'm optimistic, but there's always a balance of risks. In a global fund context U.S. financials still look good. They're well capitalized institutions with underlying economic growth and the steepening of interest rate curve will help them. We also think the story for emerging markets, which have taken their lumps on back of the election, is still very much intact. Mexico and China, which have been under pressure, still have some great businesses.

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.