On behalf of everyone at Wagner Wealth Management, we wish you a very Happy New Year.
The 4th quarter of 2016 was a period of elevated uncertainty amid the much anticipated U.S. presidential election. The table below summarizes select asset class returns for both the 4th quarter and full year.
The surprise Trump victory in early November led to significant price acceleration for certain risk-based assets that investors expected would benefit from future policy shifts towards higher spending, higher inflation, and higher trade barriers. Among the biggest beneficiaries of the “Trump trade” were industrials, commodities, financials, small cap stocks, and the U.S. dollar.
On the flip side, certain assets suffered short-term losses based on these same policy assumptions. Bonds, REITs, foreign developed stocks, and emerging markets all sold off in November. Most of these assets, however, regained a positive trend by year-end, including strong outperformance from REITs and foreign stocks in the month of December.
For the calendar year, solid returns for U.S. equity markets were driven by an improving economic backdrop, stabilization in commodity prices and foreign markets, and a positive trend in corporate earnings growth as the year progressed. The year ended with the Federal Reserve raising rates a quarter point as expected at its December meeting, noting strength in the labor market and improvements in both household spending and inflation.
While these positive trends are expected to continue as we move into 2017, it’s worth noting that the U.S. economy is now in the eighth year of the current expansion, marking the 4th longest such period since 1900. With current stock valuations slightly above average, we feel that earnings will need to keep pace in order for the market to continue to post meaningful gains from here. Historical data bears this out, showing that expected future returns moderate as valuation multiples expand. Based on the current forward price-to-earnings ratio of approximately 17, investors could reasonably expect returns from stocks in the mid-to high single digits going forward. The potential for positive legislation related to business regulation and corporate tax reform could boost the earnings picture, but remains uncertain.
The bond market made its own headlines throughout much of 2016, as interest rates moved sharply in both directions. Despite this volatility, it’s interesting to note that the yield on the 10-year U.S. Treasury ended the year only slightly above where it began. Investors purchased bonds in the first half of the year due to economic uncertainty and the precipitous fall in oil prices, and later sold those bonds as the price of oil recovered and economic data improved.
Movements in interest rates from here depend primarily on economic growth and inflation. Current growth in the economy stands at about 2% a year. Policy changes have the potential to improve the pace of growth, but details remain uncertain and any impact is not likely to be felt immediately. Inflation, as the Federal Reserve recently noted, has improved, but remains low by historical standards and below the Fed’s target of 2%. A tightening labor force and increased fiscal spending in Washington have the potential to accelerate the pace of inflation this year and are areas we will be watching closely.
A secondary but material factor impacting U.S. interest rates is the current level of interest rates in other developed nations. With 10-year government bonds in Germany, Japan, and Switzerland all yielding less than 0.20%, foreign buying of U.S. Treasuries creates somewhat of a floor for bond prices, and a likely ceiling level for yields in the short term. Given this picture, we think it’s likely that interest rates remain range-bound until the fundamentals of global growth and inflation change. Even if interest rates rise from here, rising rates from very low levels are historically associated with economic growth and improving stock prices. As such, we do not view a slow increase in interest rates in 2017 as a significant threat to stock prices.
In summary, our outlook continues to favor global stocks, hedged equity, and private real estate investments over bonds, where we remain underweight. Despite the recent rise in interest rates, bond yields remain below levels that we feel justify a more traditional bond allocation.
v Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.