2016 Year in Review – Commentary

2016 Year in Review – Commentary

ARQ Wealth Advisors 4Q 2016 Commentary: Year in Review

by Richard Siegel, CFP®

If one year ago, you were told that 2016 would be the worst ever start to a calendar year for the stock market, a high profile business man/reality TV star would be elected the 45th President of the United States, the Cubs would win the world series, and Bob Dylan would win the Nobel Prize, you would not believe it. Additionally, there were two “black swan” events in 2016: The oil market collapse and the Brexit vote. Interesting, the market has taken these events in stride, proving that emotionally reacting to unexpected or unforeseen episodes is usually counterproductive. Other factors that affected the markets in 2016 included a strong rebound in economic data, the Fed’s monetary policy dialogue, and the sharp reversal in oil prices and interest rates. What surprises does 2017 have in store? I have no idea, but what I do know is that we will continue to focus on fundamentals, which is a proven and prudent way to manage assets.

The first few months of 2016 were marked by talk of a recession, deflation and the Fed’s first rate hike in nine years. The chart below illustrates the precipitous drop in global equity prices during the first part of the year, the brisk rebound, and then the overreaction to the UK’s Brexit vote in June. During the turmoil, global bond prices moved up in an orderly fashion as interest rates dropped to historically low levels. During the second half of 2016, rates promptly reversed course and bond prices fell based on improved economic growth and the optimism surrounding a growth focused Trump administration.

The chart below clearly shows the rebound in GDP, housing related transactions, and auto sales in the latter half of 2016. Housing and autos are key components of consumer spending, which is the primary driver of GDP.

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Equity Overview:

2016 was a fascinating year for stocks. Pessimism turned to optimism in the face of the Brexit vote, Donald Trump’s election and the Italian constitutional referendum. These events seem to be pointing to a rejection of globalization in favor of nationalism and protectionism. It remains to be seen how this trend plays out and the effect it may have on global trade and corporate earnings. As we have mentioned in previous communications, corporate earnings are the lifeline of stock prices. Over the past 2 years, earnings growth faltered due to strength in the dollar, ultra low interest rates and anemic oil prices. As we transition into the New Year, interest rates have begun to normalize, increasing the profitability potential for financials. Oil prices are trading over $53/barrel, doubling from the February 2016 low and providing a tailwind for energy related earnings growth. If the U.S. dollar remains strong based on economic growth and rising rates, U.S. exporters may continue to struggle.

According to both Zacks and Thomson Reuters, corporate earnings growth in 2017 will be in the 12% range, which should support stock prices at current and higher levels. Additionally, Trump’s fiscal/economic stimulus program could dramatically lower corporate tax rates. Currently the top corporate tax rate is 35%. The proposal is to drop the tax rate to 15%, which would not only increase profitability, but bring cash back to the U.S. from overseas (repatriation). If the new administration’s program is not aggressive enough or worse, not executed at all, the stock market could retrace its recent gains.

Below are some key changes we made throughout 2016 to our equity allocations:

  • An increase in foreign exposure including both developed and emerging markets to capitalize on lower valuations.
  • A slight increase to mid and small cap holdings to hedge against a strong dollar, which can hurt the earnings of export dependent, large corporations.
  • A decrease in defensive sector exposure such as utilities and consumer staples in order to take profits from areas that are now quite expensive.

From an asset allocation standpoint, we feel that our current positioning provides the ability to capitalize on future economic and corporate growth forecasts as well as the ability to provide downside protection in the event that fundamentals deteriorate.

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Fixed Income Overview:

Consistent with the wide swings of the stock market, 2016 delivered similar volatility for the fixed income markets. Due to extreme  investor nervousness in the first part of the year, money looked for a home in high quality corporate and government debt instruments, driving prices higher and yields lower. In fact, yields were so low that in much of the world including Germany and Japan, yields actually went into negative territory! Bonds in general are certainly more of a bargain today than they were six months ago as yields are higher and prices are lower, but overall we feel that the three decade plus cycle of falling rates came to an end in 2016. During the year, we reduced our exposure to traditional fixed income holdings in order to take a position in non-traditional investments. The rationale was to reduce the impact of rising rates, while still maintaining upside appreciation potential with low risk and low volatility.

Based on future growth projections driven by fiscal stimulus, Fed policy and reduced regulations we believe that the path of least resistance for interest rates is moderately higher. The short end of the yield curve will be impacted by the Fed raising rates while the long end can move higher based on economic growth and inflationary pressures. Conventional wisdom says that when interest rates rise, bonds looks more attractive, diminishing the appeal of stocks. Recent history around this concept begs to differ however; According to LPL research, there have been 11 periods of rising rates since 1996 with an average increase to the 10-year Treasury of 1.46%. During these periods, the S&P 500 consistently delivered positive returns averaging 9.0%.  That said, at some point in the future when rates are significantly higher from here, it is our contention that conventional wisdom will rule the day. Being that robust yields are hard to come by, our allocation in bonds and non-traditional investments are designed to provide a hedge against the inherent risks of the stock market, therefore delivering a smooth ride for client portfolios.

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2017 will certainly be an interesting year. We anticipate more twists and turns driven primarily by two or more Fed rate hikes and the new administration’s changes to policy as we know it. Overall we are optimistic about the coming year and feel that our clients are well positioned to take advantage of the upside potential in the capital markets with a built in level of downside protection.

 

—Have a happy and healthy 2017—-