Equity Update - Mark Evans, CFA
The first half of 2016 was constrained by risk averse sentiment resulting from a slowing of China's economy, oil prices that continued to tumble, and a slackening in U.S. growth. As these factors stabilized or improved in the second half of the year, a rotation back into 'risk' assets helped drive equity market gains. From a macroeconomic point of view, 2016 ended on a solid note (record consumer confidence, U.S. home prices rising, an expansionary manufacturing sector, encouraging data out of Japan, etc.).
Small cap U.S. equities outperformed all other asset classes with the Russell 2000 up 21.3% for the year. U.S. large caps were up 12% on the year, while commodities ended up +11.8% supported by OPEC production cuts and increased prospects of infrastructure spending. International developed equities were flat for the year while emerging market equities returned +11.1% supported by a rebound in commodity prices.
Large cap value stocks outperformed growth stocks in 2016, up 17.3% vs +7.1%. This is a dramatic contrast to trend, where growth outperformed value for a decade by roughly 70% in cumulative total return. Value stocks rallied further after the November election with performance comparisons shown below.
Since the election, there has been a rapid rotation out of bonds and into stocks. Bonds, which were already expensive on a historical basis, continue to be less attractive than stocks on a valuation basis, even after the recent selloff in bonds. This can be seen from the chart below which shows that the earnings yield on the S&P 500 minus the 10-year U.S. Treasury yield is still one standard deviation above the historical average.
As we look out into 2017, 'risk' assets should fare well with both inflation and global growth expected to pick up. Earnings growth, pro-growth policies, and deregulation should help support the equity markets. The chart below shows that U.S. corporations have a tremendous amount of cash on their balance sheets. A substantial percentage could come home from overseas and be reinvested into the economy in the event of tax repatriation changes.
Overall, we are positive on the outlook for stocks despite the headwinds of rising interest rates.
Fixed-Income Update - Richard Sasala, Ph.D., CFA
The Barclays US Aggregate posted a loss of -2.98% in Q4 which brought down the YTD return to 2.65%. The Intermediate Aggregate index lost -2.05% in Q4 and was up 1.97% for the year. The Q4 losses resulted from sharp rate increases that occurred right after the election. As the market adjusted to a new view on the economy.
While the fixed income market on the year posted returns commensurate with their yields, details reveal that market timing and unusual variances between fixed-income sectors had an oversize effect this last year. Segment divergences can be seen in the graphic below where high yield bonds posted a 17% annual gain while municipals eked out only 0.2%. The high yield bonds reversed losses posted in 2015 as spreads retracted back to more normal levels. Inflation Protected Securities also had above average returns due to raised expectations for inflation post-election. Municipal bond returns suffered from the uncertainty of the continued value from tax shelter benefits as the new-administration weighs possible income-tax reductions that would make taxable securities more attractive.
Timing discrepancies, illustrated in the line chart, show the total return of US Aggregate index reaching an impressive 6% cumulative total return by mid-year, only to give most of it back as rates rebounded sharply after the election as shown by the 10-year treasury rate curve.
In December the Fed increased short term rates by 25 bps for only the second time since the great recession. This was widely expected by the market, especially post-election with the equity markets signaling potentially higher growth rates as well as potential increases in inflation. The view going forward is for 2-3 rate increases in 2017 and a similar number in 2018. Compared to past rate increase cycles, this is much slower and will hopefully allow the US to exit gracefully out of the unprecedented accommodative monetary policy period.