In review, 2016 was quite a year to say the least. We started the year on a down note as global recession fears drove down stock prices. Stock prices turned around in February only to correct in the face of the Brexit vote in June (UK’s vote to leave the European Union). The unexpected result of the U.S. presidential election caused an overnight selloff in stocks but by the following morning stocks were positive and have charged higher into the year end. These events were part of a political season that changed the status quo and have impacted markets globally.
The new year has begun with raised expectations for economic growth. The economy appears to be on solid footing and the leading indicators we follow are pricing in growth at levels above what we have seen for the last several years. Equity valuations of the overall indices are above historical averages, though we are still finding good value in certain sectors. Bonds corrected sharply post-election due to the increased inflation expectations and the rise in interest rates. We feel much of the pain has been felt and there is value in the bond market once again. In the paragraphs below, we do our best to highlight those variables that we are focused on and how they affect the various asset class valuations.
Although final numbers are not yet in, it appears 2016 will have experienced GDP growth near 2%. This should come as no surprise as we have discussed the slow growth economy for some time now. Looking ahead to 2017, economists are more optimistic with GDP growth estimates hovering around 2.5%. GDP expectations will be affected by some interesting dynamics in the coming year: proposed changes in tax policy, trade policy, infrastructure investment and the potential repeal of the Affordable Care Act. Any material change on these policies will have meaningful economic effects on GDP.
Consumer confidence is high heading into 2017 with the Conference Board's Consumer Confidence Index surging to 113.7 from an upwardly revised 109.4 in November. December marked the highest reading for the index since August 2001. Expectations are being driven by post-election optimism related to the economic outlook, jobs, income prospects, and stock prices.
While confidence is high, it appears consumers will experience inflation for the first time in recent history. Energy prices rebounded in 2016 and could climb higher in 2017 with the agreement between OPEC member nations on Nov 30th to curb up to 1.2mil barrels of daily production which could ultimately impact consumer spending. Interest rates have begun to rise as the Federal Reserve raised rates in December for the first time in a year. The Fed has made it clear that more increases are likely coming in 2017. Hence, the U.S. dollar continues its bullish run, up an additional 7.0% post-election, and now sits near its highest levels since December 2002. This, along with lower economic growth expectations outside the U.S., has impacted International equities, which continue to underperform domestic equity markets.
The job market should continue to tighten as unemployment continues to fall. In fact, we may see unemployment at the lowest levels since the 1990s expansion – if recent trends persist. Also, consumer balance sheets are in the best shape in a decade. Business investment was lackluster in 2016 and we think, with an increase in confidence, there is a chance businesses will begin to spend more heavily in 2017. This is especially true if changes in the tax code and a looser regulatory environment materialize that would encourage investment. Repatriation of dollars in foreign countries could also provide stimulus to the domestic economy.
The S&P 500 posted a positive 3.8% return for the fourth quarter (Q4). For 2016, the S&P 500 finished the year up 12.0%. U.S. equity markets began the quarter in negative territory, falling nearly 4.0% leading up to the presidential election.
For Q4, eight of the eleven economic sectors in the S&P 500 posted positive results. The Financials sector was the best performing sector during the quarter (up 21.1%). Higher interest rates, along with the prospects of increased loan activity and fewer regulations, propelled banks and other financial companies higher during the quarter. Energy (up 7.3%) and Industrials (up 7.2%) were the next best performing sectors in Q4. The top performing sector for 2016 was Energy (up 27.4%).
The three negative sectors during the quarter were Real Estate (down 4.4%), Healthcare (down 4.0%), and Consumer Discretionary (down 2.0%). Healthcare was the only sector in negative territory for the full year (down 2.7%). Healthcare companies have continued to draw the ire of both politicians and consumers for the perception of egregious and unwarranted price increases. We believe that over time, the market will reward those “innovators” that are developing new drugs and new medical devices to fill unmet needs, while continue to punish “exploiters” who are raising prices swiftly (often on old drugs/devices) until new competition comes in. We are currently finding some opportunities in the former as the market seems to be unfairly lumping all healthcare companies together.
As equity markets have moved higher, the price multiple investors are willing to pay for future earnings has also expanded. According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is now 16.9x, which is almost a point above long-term averages. If the policy changes discussed above (lower corporate tax rate, increased infrastructure spending, regulatory overhaul, etc.) are achieved, corporate earnings would likely come in stronger than what the consensus currently expects. However, any delays or policy inaction could lead to investor disappointment and lower equity multiples.
The positive sentiment witnessed in the domestic equity markets during Q4 stood in stark contrast to the weakness in the bond market. The U.S. ten-year Treasury began the quarter with a yield of approximately 1.7% (from a low of 1.36% in July) and only fluctuated a small amount until election day. Election night was the last time we saw yields below 2%. In a little over a month the U.S. ten-year Treasury yield skyrocketed and briefly rose to yield over 2.6%, representing an 8% price correction.
It appears the pro-growth policies that investors expect in short order have raised inflation expectations domestically, and we believe rightfully so. Overall, the bond market (as represented by the Barclays Aggregate Index) fell 3% for the quarter, with longer bonds falling the most.
The U.S. bond market seems to have “decoupled” from the rest of the developed world. Yields are negative in Europe out to five years, with ten-year yields across all countries lower than the U.S. rate, regardless of credit quality. The Japanese Central Bank is targeting the Japanese ten-year yield at zero, and is currently about 0.05%. While things are looking up domestically, stress remains in the economies of our major trading partners. We would expect the sell-off in the U.S. bond market to moderate, particularly if the dollar maintains its recent surge relative to our European and Asian partners. With very little yield opportunity in their local markets, the strength of the dollar may encourage foreign capital into U.S. investments, further keeping a potential lid on yields.
The municipal market was hit with a perfect storm. One of the major initiatives of the new administration is for lower corporate tax rates. This possibility had a direct impact on municipal bond yields as many corporations, banks and insurance companies have become the marginal buyer of tax free debt over the last few years. With a potential 15% tax rate, the incentive for corporations to purchase tax free bonds diminished and in fact sent these buyers to the sidelines. This was in addition to the issues facing the overall bond market described above. The resulting correction in municipals triggered an outflow in the mutual fund sector, leading to forced selling by fund managers as illustrated in the chart below.
On a positive note, this forced selling allowed SS&A to purchase very high quality bonds at attractive values. Finally, tax loss harvesting further exacerbated the sell-off. The ten-year municipal curve increased from a 1.5% in early July to 2.6% on December 1st, representing a 9% correction in prices. We believe that the potential tax rate changes are now fully priced into the municipal sector and the pressures from panic selling and mutual fund redemptions are largely behind us. Long municipals have rallied back nearly 35 basis points since early December. We are able to achieve 2% tax free yields in 5-6 year bullets, and north of 2.5% in longer dated callable bonds.
The dramatic moves in the stock market, bond market and the dollar tell us the market is pricing in growth, less regulation and tax reform among other things. Our role as fiduciary is to not form an opinion on the market based on political beliefs, but rather try to measure what has been priced correctly. Has the market overshot the growth to come? Are expectations too high? Will tax and regulatory reform unleash the economic engines? Time will tell if that future plays out. In the meantime, we will get ready for upcoming earnings season and listen to what companies are saying about their prospects and end markets for 2017. We don’t know if markets will rise or fall in 2017, but that said, we don’t see wild overvaluations or speculation in our investments. We enter the year knowing that markets are priced optimistically and we hope the optimism is well placed. The coming months and year will require diligence and flexibility as we get clarity on these various issues. We will continue to work hard to gather information, process it and execute a strategy to protect and grow your investments.