Monthly Markets Memo - January 2017
by Dan Zalipski & Scott Rosenquist, CFA
Another year in the books. From Brexit to the U.S. Presidential Election, 2016 was a year of surprises, some good, and some bad. The first half of the year saw volatile swings as concerns about the economy dominated the markets sending them into correction territory.
Safe haven & defensive assets were bid up driving their returns higher. This trend reversed for the 2nd half of the year, with the reversal accelerating after the U.S. Presidential Election essentially changed forward expectations overnight. At the end of the year, the developed international markets measured by the EAFE Index gaining just shy of 1%. Emerging markets, as measured by the MSCI Emerging Markets Index, provided positive returns of 10.51% in 2016 after years of negative performance. Treasuries had a volatile year, rallying strong in the 1st half, but giving up much of their gains by the year end as rates began to move higher. In contrast, high yield bonds, as measured by the Barclays U.S. Corporate High Yield index, were the best performing fixed income asset with indices up over 17% in 2016.
It is likely that U.S. growth will increase in 2017 for a variety of reasons. Corporate Earnings Growth was positive in Q3 for the first time in 5 quarters. Consumer confidence is at recent highs, and unemployment near recent lows. Combine that with a new President that is expected to tackle corporate tax reform, scale back regulations, and implement fiscal stimulus, and the outlook looks compelling. We have covered in previous memos many of the potential positive impacts that President Trump’s initiatives may bring, but new opportunities bring a new set of risks into the picture. The exuberance of the post-election Trump rally may be showing signs of fading as investors assess what risks the market may have in store for 2017.
Some of the items on President Trump’s agenda that fueled the rally may also lead to an increase in interest rates. Lower taxes and fiscal stimulus are likely to increase the deficit, leading the government to increase borrowing to fund itself, potentially increasing rates. Another path to higher rates is if the U.S. grow too fast. In this scenario, inflation may increase quicker than expected causing the Fed to react and aggressively raise rates. Higher interest rates increase borrowing costs for business and consumers, potentially reducing economic activity.
Higher interest rates in the U.S. may attract foreign flows. With the rest of the world still stuck in a relatively low-growth, low-rate environment, international investors may be attracted to the prospect of higher growth and higher rates in the U.S. As this foreign money flows into the U.S. it is converted to the U.S. dollar, increasing the demand for U.S. dollars. As the demand increases, the dollar appreciates relative to other currencies. A strong dollar puts U.S. multinational corporations at a disadvantage, as foreign profits become worth less in U.S. dollar terms. A combination of rising interest rates and a stronger dollar could have the potential to subdue the expected increase in growth.
Since November, correlations among stocks have fallen as the financial markets try to assess potential implications of new policies. The move from monetary to fiscal stimulus has investors searching for potential opportunities causing dispersion in returns among sectors. Given this backdrop, being selective with sector exposure and security selection could prove to be beneficial. Active management may have more opportunities in this environment as the Fed forecasts continued interest rate hikes and the market may become less Fed dependent making company specific fundamentals such as earnings and growth the driver of market returns.
Moving into 2017, we maintain a preference for equities over fixed income with an overweight to the U.S. Within fixed income, we also believe being selective with exposure will be beneficial with rates still low historically and the Fed looking to raise interest rates. We continue to look at areas outside the broad bond market index. Internationally, valuations are attractive relative to the U.S. but there is potential political uncertainty across the Eurozone. While we expect volatility in the U.S. as the year unfolds, the economy and consumer are generally in good shape and sentiment for both is high. Potential volatility can bring opportunities and we will be monitoring as events unfold this year.
"An investment in knowledge always pays the best interest."
- Benjamin Franklin
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.