From an investment perspective, 2016 is a year that can be thought of in three acts. The first was dominated by fear and anxiety of global recession. This was driven by a slowing Chinese economy, plummeting oil prices, and a rising U.S. dollar that negatively impacted the country’s exporting firms. The second and third acts were similar in that they both centered on political events. The result of the Brexit vote shocked even those who had led the campaign for the United Kingdom to leave the European Union. The U.S. presidential election was also a surprise upset of the status quo. In both cases, market participants initially took voters’ unexpected preferences negatively only to quickly reverse course with a wave of buying that brought share prices to new all-time highs. We enter 2017 with a new investment environment that has priced in an optimistic outlook for the road ahead despite the inherent uncertainties.
The triumph of Donald Trump in the U.S. presidential election unleashed a rally in the stock market that led to above average gains for all the major indices for 2016. The driving influences behind the rally seemed to be excitement for some of Mr. Trump’s proposed agenda. Namely, significant fiscal stimulus coupled with a relaxed regulatory environment. The proposed tax-cuts and lowering regulatory requirements should feed directly into firms’ bottom-lines. If the new administration can pass additional spending bills for infrastructure spending, that would further stimulate economic activity.
Thus far, investors have focused on these benefits. The timing of these initiatives, along with other proposed policies by the new administration, will be important for investors. For example, tightening immigration policy, imposing a border-tax on imports, and significant shifts in geopolitical policy with both our traditional allies and adversaries could have profound effects on the outlook for the economy and therefore the markets. Only time will tell how the new administration’s agenda will unfold.
A Changing Landscape
As equities rallied post-election, so did interest rates. Recall that as interest rates rise, bond prices fall. What we experienced in November and December was the fastest and most dramatic rise in interest rates since 2013, when the Federal Reserve communicated that it was ready to begin tapering Quantitative Easing.
The above chart illustrates how the interest rate of a 10-year U.S. Treasury note changed over the last year. For a detailed explanation click here. The fall in interest rates from approximately 2.2% to the all-time historic low of 1.38% in the first half of the year illustrates how the market changed as expectations of further Fed rate hikes were scaled back. The low in July occurred immediately after the Brexit vote, when global economic fears were exacerbated. Since then, the underlying strength in the U.S. economy and quietly rising inflation have established a foundation for confidence. The acceleration in the rise in rates is clear on the far right of the chart and corresponds with the U.S. election.
As noted above, investors’ animal spirits have come to life. The interest rate market is now pricing in more hikes from the Federal Reserve and a more inflationary environment than we have seen in years. The consensus view remains that interest rates will stay below historic averages for the foreseeable future, but likely higher than we have seen more recently. Investors have been waiting for the Federal Reserve to begin its tightening cycle in earnest for years. It appears, the time may have arrived.
In contrast to last year, today’s energy market appears to have stabilized. The recent agreement between Opec and Non-Opec producers to cut global oil production has worked to put a floor in on petroleum prices for now. If the deal holds, commodity prices and the prices of petroleum related assets should be less volatile than they have been since Saudi Arabia decided not to cut its production to stabilize the market in 2014. Hopefully, this is an investment theme that will fade into the background for some time to come.
The economic landscape abroad has improved from last year. European equities have had two major headwinds: falling interest rates and weak commodity prices. While the European Central Bank has yet to raise rates, the market is expecting current rates to hold and eventually rise. This outlook has boosted their banking sector. An index of European bank stocks rallied approximately fifty percent from July through December last year. In addition, European oil companies were lifted along with the price of oil. Economic statistics like retail sales, unemployment, and purchasing manager sentiment are all trending in a positive direction throughout the Euro-area.
Hopefully these trends in Europe will continue. However, the coming year will see major elections in the Netherlands, France, and Germany. Additionally, Brexit will continue to unfold over the course of the year and the long term economic fallout is still highly unpredictable. As 2016 demonstrated, attempting to anticipate individual winners and losers from events such as these is exceedingly difficult, if not impossible. However, unexpected results that fall outside the realm of conventional wisdom need not be catastrophic.
Most forecasts for emerging market economies center on China. The IMF recently updated its forecast for the region and is anticipating continued and improving rates of growth. However, the ongoing risks continue to be a large and growing burden of debt throughout the Chinese economy. Over the last year, the Chinese government continued to support the economy and keep it on track. The general theme of cautious optimism with a sober awareness of the inherent risks holds for this sector of the global economy.
As we begin a new year, we remain vigilant and appreciative that our strategy leaves our portfolio allocations less reliant on the stock and bond markets than the traditional approach. The alternative investment opportunities that we have pursued performed well over the last year. The current focus of the markets is the potential impact of the incoming Trump administration. This is a distinct change from anything we have seen in recent years. As the weeks and months unfold we stand prepared to weather any future volatility that may emerge from the markets, the headlines or even the occasional tweet.
As always, please contact us with any questions.
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