January 3, 2017
2016 Recap: Market Survived Many Surprises, but Pollsters Didn’t
“How strange to be surprised at anything which happens in life” – Roman Emperor, Marcus Aurelius
If there was a dominant theme that characterized the investment landscape in 2016 it was the resiliency of the markets to multiple surprises. In January, China’s decision to let the yuan slide roiled global equities and gave investors the false impression that they might be in for a long year. The continued slide of oil prices that month didn’t help either. The equity markets, however, soon recovered their losses and reassumed a growth trajectory. In late June, it was the U.K.’s surprise “Brexit” referendum vote that caught the markets by surprise. Global equities fell initially, but soon after, resumed their higher climb. And in November, the polls again faltered as Donald Trump’s unexpected win in the presidential election threatened to stifle the market’s momentum heading into year end. Analysts had predicted a sharp selloff in domestic equities in the event of a Trump win, yet stocks moved higher after the election.
The domestic and global gains and losses this year were somewhat remarkable. The S&P 500, after some fits and starts during the first two months of the year, finished 2016 up 12.0%, tacking on a 3.8% gain in the fourth quarter. Global equities, as reflected by the MSCI All Country World Index, also advanced. The index logged a 7.9% gain for the year, adding 1.2% in the fourth quarter. Emerging market stocks reversed their poor performance in 2015. The MSCI Emerging Markets Index was up 11.2% last year, although absorbed a -4.2% hit in the fourth quarter as the U.S. dollar gained strength. Eurozone stocks were able to recover much of their losses following the Brexit vote, as political uncertainty across the region weighed on the broader market. The MSCI European Monetary Index finished 2016 with a slight gain of 1.3%, posting a fourth-quarter gain of 1.4% (Exhibit A).
Many commentators wanted to attribute the year’s strong finish to the anticipated policy positions of the incoming Trump administration. While they certainly played a role, the most important factor was likely the positive economic data that provided the oxygen to December’s rally. Moreover, as we pointed out in our 2016 Q1 Outlook, the S&P 500 has now advanced in 15 out of the past 19 election years – going back to 1944.
Among the economic drivers supporting the U.S. markets, the news was largely positive in the fourth quarter. The November jobs report showed little in the way of wage gains, but the low 4.6% unemployment rate brightened the picture. The manufacturing sector accelerated, as strong growth in new orders and production bolstered the November Purchasing Managers’ Index (PMI) for Manufacturing, whose 54.1 reading came in above the consensus range. The U.S. Services PMI was equally strong, as new orders in November posted their highest rate so far in 2016, while the Non-Manufacturing Index easily beat expectations with a 57.2 reading. Consumer spending helped fuel an upward adjustment to GDP, reflecting 3.5% growth in Q3. The latest GDP data also showed that inventories narrowed, which only added to the confidence for the fourth quarter.
This positive sentiment translated into long-awaited earnings growth. After seven quarters of negative earnings per share growth among S&P 500 companies, corporate profit growth was positive in the third quarter, and Q4 earnings are projected to be up as well (Exhibit B). As of December 31, 2016, equity valuations reached a 16.8 forward price-to-earnings ratio for the S&P 500, which is somewhat higher than the historical average of 14.8 since 2002.
Given the strong economic performance, the Federal Reserve had little choice but to raise interest rates in December, a move that Fed Chair, Janet Yellen, had been telegraphing for some time. During the first three quarters of the year, the 10-year Treasury yield reached all-time lows, and ended Q3 at 1.60%. However, by the end of the year the 10-year Treasury yield rose to 2.45%, increasing 85 basis points in the quarter, most of which occurred post-elections. A remarkably fast upward shift of the entire yield curve followed, in sharp contrast to pre-election expectations.
Overall, it was a solid to strong year in most asset classes, with the notable exceptions being Managed Futures as well as Global Bonds which gave up nearly all of their gains in the fourth quarter (Exhibit C).
2017 Outlook: Plan for the Unexpected
“In preparing for battle, I’ve always found that plans are useless, but planning is indispensable.” – Dwight D. Eisenhower
Looking ahead for this year, positioning portfolios for 2017 requires more adaptive planning than usual. Planning amid the constant uncertainties of world economics, asset valuations, and other usual investment matters is a familiar challenge. Factoring in the additional uncertainties of the president-elect’s policies presents a more complicated picture, however. Our strategy is to construct portfolios to prevail in the face of this above-average uncertainty. As Eisenhower noted, planning is absolutely necessary, assuming that new information will make it necessary to be adaptive and to modify as needed.
We typically employ a data-heavy, fundamental approach to formulating our market outlook. In more tempered markets, this makes sense. But given the less familiar style of president-elect Trump, we must also consider a range of subjective scenarios. As the presidency develops and becomes more established, we will incorporate unfolding information into our market guidance (see our article, “The Evolution of Trump’s Transition,” for additional detail). It is important to realize that prior to the election, the U.S. economy had been improving, with companies reporting strong operating results, the labor picture brightening, and overall growth increasing at a reasonable rate. For example, consumer confidence has shown strong positive trends with December’s reading being the highest since January ’15. Even before the election results, the consumer was expressing a growing optimism. Using this generally improving foundation as our baseline, we make the following observations on interest rates, markets, and portfolio positioning:
Interest Rates: The U.S. economy’s improving condition is now quite evident, yet short-term interest rates remain exceptionally low. The Fed’s rate increase in December 2016 implies the Fed believes that growth is on a steady track. Given our baseline and the Fed’s latest action, we expect the economy will continue growing at a modest, but steadily improving pace — even without factoring in the potential of several Trump policies to boost economic growth. This will result in possibly several measured rate hikes by the Fed in 2017. As the year progresses, and if the new administration rolls out pro-growth policies, inflation could increase beyond our expectations and drive the Fed to raise rates faster than our baseline scenario. However, the opposite could occur, where the new administration is hampered by a gridlocked Congress, and anticipated growth is less than our baseline scenario. Currently, it is impossible to assess accurately either likelihood. Thus, it is important to maintain exposure to investment grade fixed income which should act as ballast against uncertainty and the return of risk aversion. On the other hand, if the pace of growth increases, interest rates will most likely rise, but should reach a ceiling as demand for higher yields limits the rate rise at some point. In addition, such excessive demand could bolster the dollar further, possibly causing international market turmoil. We have already seen how countries such as China have been selling treasuries to support its own currency level. So far, these actions have had marginal effect, but could escalate if rates were to continue upward. The general desire to avoid this global involvement could also act as a possible governor for higher rates. Higher rates could impact U.S. companies with international divisions, since the resulting stronger dollar would weaken earnings contributions from overseas operations.
U.S. Markets: The stronger earnings and GDP results have boosted optimism for U.S. stocks in the year ahead. Several industries are increasingly attractive within the improving economic backdrop. For example, many banks have begun to recover from a long period of regulatory fines and lawsuits related to the 2008 credit disasters. In addition, banks have returned to making their profits from traditional lines of lending, not through derivatives and other channels that fueled the financial crisis. Consumer discretionary stocks should perform well too, as the consumer recovery continues. Because they have adjusted their operations to accommodate lower oil prices, select energy companies should also perform better and be profitable in 2017.
The general outlook for U.S. securities is complicated by the possibilities that the new administration will enact policies that could be favorable to equities. If that occurs, we will adjust our forward-looking expectations for the impacted asset classes, which will certainly include U.S. stocks. We have already seen how sensitive the U.S. markets are to the possibilities: In November, the anticipation alone regarding the impact of Trump’s potential policies on markets drove the 10-year U.S. Treasury well above 2%, while four major equity indices reached record levels. While part of these results were certainly attributable to fundamental improvements, it is likely that speculation also contributed to the impressive rally in equities and the associated back-up in interest rates.
International Developed Markets: We are expecting only moderate potential for increased earnings post-Brexit. Looking at GDP growth by region, the developed markets are expected to post the now familiar lackluster growth in GDP. The European Central Bank may continue to be supportive, but strong headwinds will persist. Although quantitative easing will continue through the end of 2017 and support the fledging signs of economic recovery, our view remains that the process of executing the Brexit presents far too many unanswered questions at this point. Additionally, analysts will be closely watching the elections in France and Germany. These elections have the possibility of challenging the rationale for a European Union by this time next year. It is possible that such uncertainties will impact consumer confidence and general businesses. This, in turn, would drive only modest earnings growth for international developed market asset classes, especially if there are better, less-complicated opportunities elsewhere in the world. Additionally, parts of Europe are seeing somewhat slow growth, and Japan appears, for now, to be stabilized. Japan’s continued weak economy may be helped by the Bank of Japan’s extremely accommodating monetary policy, but serious questions remain.
Emerging Markets: We are more optimistic on this area of the world. There are improving company fundamentals as well as fair stock valuations at this point. Also, GDP consensus growth for the member countries appears bright. The asset class appears less impeded by Brexit concerns, but may be impacted by U.S. trade policy changes. Our 2017 baseline scenario for China is stable economic growth as the government will go to greater lengths to encourage a calm environment as a backdrop to the Party Congress meeting in December 2017. This baseline assumption is complicated by recent comments from president-elect Trump. Public comments suggesting a review of current trade relations may introduce uncertainty and add volatility to our base assumptions. Elsewhere, we see signs of structural changes, such as India’s elimination of its higher denominated bank notes, intending to cast sunlight on an underground community. In other emerging market countries, the likely turning of the commodities cycle may provide some economic relief to countries such as Russia and Brazil. These specific details would support the general theme of a collectively improving asset class.
Exhibit D summarizes our views on these asset classes, as well as provides our perspective on a variety of other assets.
These basic outlooks on various asset classes will no doubt be adjusted as greater clarity emerges on the direction of taxes, financial services and energy regulation, infrastructure investment, health care, and trade policy. It will likely take some time for nominated cabinet members to be confirmed by Congress, and then additional weeks and months before a number of the new policies are approved. Hence, it is early to incorporate this speculative data into our outlook, but our forward-looking expectations are adaptable to the likely rolling disclosure format. We will plan accordingly because planning is indispensable and an important component of Fiduciary’s investment approach.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.