4Q16 MARKET OVERVIEW
Last year tested the patience of long-term globally diversified investors. The first ten trading days marked one of the worst starts ever for U.S. equities. The wall of worry initially focused on China’s slowdown and then shifted to oil’s free fall before concerns turned to slowing U.S. growth.
To top off the year, we dealt with the Brexit vote in June and then headed to the election polls in November to elect Donald Trump as our next President. The election outcome was supposed to spook investors with a sharp pullback. Instead, the markets celebrated the unexpected results by reaching an all time high while hopeful investors contributed record amounts to charity to close out the year.
As we begin the New Year, we are likely to experience more ups and downs since investors already celebrated many of the potential policy changes that might be headed our way. We will have to be patient while President-elect Trump and his new administration work with the Republican controlled Congress to shape new policies. As long as there is a consensus and reasonable approach to various issues on the table, we could be in for continued positive momentum. If the government can’t reach an agreement on Obamacare, new trade policies and tax law changes, we will be in for a bumpy ride.
Looking forward, we will continue to take advantage of diverging market trends by rebalancing to target allocations while maintaining your desired risk level and fulfilling your cash flow needs. This process typically involves harvesting gains or losses in the most tax-efficient manner possible and then re-allocating the proceeds to out of favor asset classes that offer more attractive long-term opportunities such as international equities and bonds. This process is likely to become more interesting and involved in the months ahead as we absorb potential tax law changes.
U.S. Equity Markets
The U.S. equity markets surged in November and then held on to close out a positive quarter; the Russell 3000 return was up 4.2% for the quarter and 12.7% for the year. The postelection rally rewarded financial and small cap investors most with healthy gains. Higher interest rates and more optimal lending margins coupled with less expected regulation under the Trump administration boosted financial shares further than 20% in the fourth quarter. The Russell 2000 index of small cap stocks rallied nearly 20% since the election (significantly more than larger cap companies) since they are less exposed to the stronger dollar and Trump’s expected legislation to fine tune trade imbalances. The Trump effect overshadowed generally more favorable economic news. According to the Institute of Supply Management (ISM), manufacturing expanded in December to a new high reading for the year, signifying growth for the fourth consecutive month. The U.S. Bureau of Labor Statistics reported that the unemployment rate ticked up slightly to 4.7% in December as the economy added another 156,000 jobs. The more positive economic landscape and wage growth gains help explain why consumer confidence spiked towards the end of the year.
International Equity Markets
International developed equity markets lost 0.7% for the quarter and returned a modest annual gain of 1.0% for the MSCI EAFE. Without the strong December finish of 3.4%, the year would have been even more disappointing for U.S. investors since the dollar gained additional ground against most major currencies and negatively impacted returns. European equities had a solid quarter with the help of encouraging economic news. Their unemployment rate fell to 9.8%, consumer sentiment rose and the Purchasing Managers Index reflected improving business conditions. After dealing with Yen strength most of the year, Japan’s equity market finally benefited from Trump’s victory with a plummeting Yen. The weaker Yen along with improving corporate earnings helped elevate their equity market by 15% in the fourth quarter. Emerging markets reacted much differently to the U.S. election results as investors struggled with rising interest rate pressure, dollar strength and fears surrounding the potential impact of new protectionism trade laws that could negatively impact exports. Even after factoring in investor withdrawal pressure, MSCI EM managed to overcome the 4.1% fourth quarter loss to post a 11.2% annual gain. After four consecutive and painful years of underperformance relative to the U.S. markets, both developed and undeveloped international markets look much more attractive for patient long-term investors who can take advantage of the dollar strength to buy in at lower prices in anticipation of a reversal of these trends.
Fixed Income Markets
Safety-minded investors experienced a concerning loss during the quarter; the Barclays Aggregate was down 3.0% for the quarter and posted a 2.7% full year gain. After the Fed raised rates for the second time in ten years, the 10-year Treasury yield rose during the quarter from 1.6% on September 30 to 2.45% on the final trading day of the year. Given the 85 basis point overall yield increase, the longest dated maturities posted more negative returns since their existing bonds became less valuable compared to newly issued securities. The Barclays US Government Long posted a 11.5% quarter loss, Intermediate 2.2% loss and Short .45% loss. The same trend played out on an annual basis since the 10-year Treasury yield barely moved from 2.27% on January 1 to 2.45% on December 31. In the international fixed-income arena, the JPM Non-US Unhedged retreated 11.0% in the quarter and still managed to eke out 1.9% annual gain under the weight of an exceptionally robust U.S. dollar. The Barclays Municipal lost 3.6% during the quarter and only returned .25% for the full year. Given the potential 2017 tax law changes and higher interest rates, concerns weighed on the Municipal market. We see this as an overreaction and long term buying opportunity.