The unexpected U.S. election outcome roiled financial markets, generating a wide range of three-month returns from various categories of investments. After falling by 4% through early November, large-company U.S. stocks – paced by the Financial Services sector – surged higher through mid-December before settling back to a solid three-month gain of just under 4%. Small-company stocks were a wilder ride: swooning 8% in the early going and gaining 20% later, they finished with a robust quarterly gain of nearly 9%. The foreign-exchange value of the U.S. dollar leapt in the weeks following the election, resulting in modest losses (in dollar terms) on most non-U.S. stock investments. The worst damage was reserved for the bond market: the benchmark 10-year yield ballooned from 1.61% to 2.44%, generating a three-month return of -7.3% for Treasury Notes of that maturity. Rising yields also took a toll on real-estate investments and gold, which fell in value; other commodities gained modestly.
Among large-company U.S. stocks, those in the Capital Goods, Communications Services and Financial Services sectors provided relatively strong three-month results, while Consumer Staples, Health Care and Technology names were weaker. Value-oriented stocks clearly outperformed their growth counterparts.
Benchmark Performance – Equities
|Fourth Quarter 2016||Last Twelve Months|
|S&P 500 Index||+3.8%||+12.0%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||+4.6%||+12.5%|
|Small-Cap Stocks (Russell 2000)||+8.8%||+21.3%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||-0.6%||+1.6%|
|Non-U.S. Stocks (Emerging – MSCI EM)||-4.3%||+11.3%|
Benchmark Performance – Fixed Income
|Fourth Quarter 2016||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||-2.1%||+2.1%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||-3.6%||-0.2%|
Prior to the post-election shake-up, 2016 featured many of the same macro trends that underpinned financial-market performance the previous two years. Global economic activity remained weak, with aggregate growth of less than 2% across developed markets (though the U.S. economy clearly accelerated as the year progressed: the latest reading was +3.5% in the July-September period). Generally faster-growing emerging markets were mixed: India, notching a second-straight banner year, saw its economy expand by 7%; China stubbornly avoided the feared ‘hard landing,’ with growth holding above 6%; Brazil and Russia struggled to emerge from deep recessions. Lackluster growth was accompanied by uncomfortably low inflation (though prices, too, appeared to heat up later in the year), keeping monetary-policy spigots open at the world’s central banks. The result was a growing mountain of developed-world government bonds sporting record-low (and even negative) yields-to-maturity; U.S. 10-year Treasury Notes flirted with an all-time low yield below 1.4% in early July.
After a big run-up beginning in mid-2014, the foreign-exchange value of the U.S. currency drifted lower through the first ten months of the year, as it became clear the U.S. Federal Reserve was in no rush to hike interest rates. The multi-year collapse in commodity prices abated early in the year and most staged meaningful recoveries. Falling below $30 a barrel in the early weeks of the year, crude oil doubled in price on a combination of an improving economic outlook and substantial supply curtailments, and finished the year comfortably above $50. Buoyed by improved sentiment vis a vis China, most other industrial commodities also enjoyed substantial rallies. Gold, traditionally a beneficiary of both heightened uncertainty and low yields, surged more than 25% during the first half, before settling back to a single-digit gain by yearend.
Financial-market participants were confronted with a number of unsettling political developments during the year. These included grave political scandals in Brazil and South Korea, a failed coup in Turkey, ongoing carnage in Syria and Iraq, and a series of deadly terrorist incidents in Europe and the U.S. Perhaps most surprising was a widespread upwelling of populist/anti-establishment sentiment, exemplified by the results of June’s Brexit vote, the November U.S. election and December’s Italian constitutional referendum.
Profits reported during 2016 by large, publicly-owned American firms continued to be pressured by the 2014-’15 rise in the dollar and collapse of demand from energy-/commodity-sector customers. After five consecutive quarters of year-over-year declines, earnings finally turned positive in the recently-reported July-September period. When fourth-quarter reports are completed early in the New Year, the 2016 total is likely to show a modest year-over-year gain – still some 5% below the tally for 2014.
Most growth-oriented investment categories recorded healthy 12-month returns. After an early-year swoon of more than 10%, large-company U.S. stocks finished the year showing gains of more than 10%, while small-company stocks rose more than 20%, on average. Among large-caps, the value style outperformed growth by almost three-to-one, and the strongest industry groups (Energy and Financial Services) bested the laggards (Health Care and Consumer Staples) by 20 percentage points or more. Overseas stocks were mixed: emerging and frontier markets rose more than 10%, as a group, while developed-market gains were mostly in the low single-digits. The best-performing markets were those most bombed-out in 2014-2015 (Brazil +64%; Russia +44%) or where currency was a benefit (Canada +24%). Commodity-related investments did well, with gains of 8% for gold and nearly 15%, on average, for industrial/agricultural commodities. Most domestic real-estate investments recorded gains in the mid- to high-single-digits; the non-U.S. category was flat. Bond-market returns were hit hard by the late-year surge in yields; most investment-grade issues generated meager 12-month returns. Credit spreads narrowed sufficiently, however, to allow solid results from the high-yield (‘junk’) sector.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the +3.8% S&P 500 total return?
|Fourth Quarter (October-December) 2016|
|+ Change in Earnings||+2.5%|
|+ Change in Valuation||+0.8%|
|= Total Return||+3.8%|
Our read: We expect to see the ‘change in earnings’ component accelerate as we move into 2017, taking some pressure off the (somewhat elevated) ‘valuation’ component.
The advent of what could be a highly unconventional political environment in the world’s leading economy dominates the near-term investment outlook (and doesn’t make writing this letter any easier, either!). Elections slated for France, Germany and the Netherlands, plus uncertainties surrounding the U.K.’s E.U.-exit negotiations, hold ample potential to up-end the picture further as we move through 2017.
The swift and largely positive stock-market reaction to the U.S. election seems to indicate investors are relatively confident that 1) the incoming administration will be less iconoclastic and unpredictable than suggested by its campaign style/rhetoric; 2) Republican control of Congress and the White House will permit rapid, meaningful policy action; and 3) pro-growth/pro-business initiatives (e.g., tax reform, regulatory roll-back, infrastructure investment) will take precedence over growth-inhibiting protectionist and/or anti-immigration measures. While these are arguably optimistic assumptions, they can serve as a basis for thinking about what lies ahead.
Even if investor assumptions are correct, we seem to face a half-full- versus half-empty-glass situation. In the positive interpretation, lower corporate taxes, lighter regulation, and stronger demand (generated by infrastructure projects and possibly investment of repatriated overseas profits) provide a meaningful boost to corporate profits. The flip-side: with the economy nearing full employment, faster growth kindles inflation and tighter-than-anticipated monetary policy; tax cuts and spending increases lead to ballooning budget deficits (putting additional upward pressure on bond yields); and a combination of stronger growth and higher yields pushes up the foreign-exchange value of the dollar. It seems prudent to plan for a combination of these interpretations: a degree of corporate tax reform and regulatory relief; a marginally more aggressive Fed, somewhat higher bond yields and a modestly stronger dollar. Finally, history cautions that change may be both less dramatic and slower in coming than investors anticipate. Accordingly, we will not be surprised if 2017 turns out to be relatively uneventful, with much action delayed until the second or even third year of the new regime.
The U.S. economy enters 2017 in solid shape, with few signs of the imbalances that typically presage a downturn. With unemployment low and falling and wage increases becoming more widespread, consumer confidence has reached a post-financial-crisis high. Financial and residential real-estate markets are supportive, but not frothy, and business owners are showing renewed optimism. Consensus forecasts call for GDP growth a bit better than 2% (the final 2016 figure is likely to be 1.6%), with expansionary fiscal policy providing potential upside. Inflation seems to be lifting from the extremely low levels prevalent since the financial crisis; to date this has been seen as a salutary development, but it bears close scrutiny. Overseas, Brazil, Russia and other important emerging-market economies will benefit from the improvement in commodity prices. Most economists are sanguine with regard to the near-term outlook for China (fingers crossed), India’s good roll seems likely to be extended, while Japan will probably continue to muddle through. Europe is a potential (negative) wild card, given growing political uncertainty and lingering financial-sector weakness. Though most prognosticators think mainstream/center-right governments will prevail in upcoming elections, we needn’t point out how reliable polls have been recently.
At its December policy-setting meeting, the U.S. Federal Reserve raised its target for short-term interest rates (by 0.25%, to a range of 0.50%-0.75%); this was only the second increase since 2006 (the first came in December 2015). The post-meeting press conference revealed that, barring a major change in economic conditions, Fed policymakers expect to raise rates two or three times in 2017. This slightly more aggressive stance than investors had been discounting seems appropriate given the brighter economic outlook and signs of rising inflation. The 100 basis point (one percentage point) rise in U.S. bond yields since mid-2016 seems consistent with the monetary-policy outlook; if the economy (and Trump administration initiatives) allow the Fed to stay close to script, longer-term yields may not change much in 2017. Outside the US, central bank policies will continue to be highly accommodative – a divergence likely to attract investment flows to U.S markets and put upward pressure on the dollar; however, the dollar’s spike since the election may largely discount this probability.
Corporate profits are likely to expand in 2017, marking a distinct improvement compared to the past 18 months, during which aggregate earnings declined by nearly 15% (peak to trough). As noted, currency and commodity headwinds are greatly diminished, and corporate-tax and regulatory reform represent a potential boost. Moreover, higher interest rates, though a cost-increase for many firms, represent a revenue boon to the large financial services sector. Though we always take such figures with a large grain of salt, the collective wisdom of Wall Street is calling for a 20% increase on the year (we’d be content with half that).
Another year of price gains greater than earnings growth has pushed the valuation of U.S. stocks higher. According to Bespoke Investment Research, the late-December price-earnings ratio of the S&P 500 Index (based on trailing-twelve-month earnings) was in the top 8% of post-1929 observations (i.e., valuation has been lower 92% of the time over the past eight-plus decades). A return to the historical average for this measure would require earnings to rise nearly 50% or prices to fall more than 30% (or a combination of smaller changes to both). A broader, composite measure (incorporating price-to-book-value and comparisons of stock dividend- and earnings-yields to bond-market yields, as calculated by the Bank Credit Analyst) reckons U.S. stocks are more modestly overvalued (on the order of 10% to 15%). Valuation is rarely a catalyst for major market moves, and high (or low) valuation can persist for years (in fact, U.S. stocks’ trailing P/E has been above average continuously since early 2013, as it was for the better part of the 1990s). Nevertheless, beginning valuation has historically exerted a powerful influence on longer-term investment returns; an elevated level can depress prospective returns compared to the 10%-plus historical average.
An additional cautionary element is investor sentiment. In contrast to a year ago, the consensus now holds the U.S. economy to be in little danger of tipping into recession. Investors also appear to be expecting predominantly good news out of Washington. And, as noted, prognosticators are today relatively sanguine with regard to the near-term prospects for developments in China, too. The old adage says stock prices need a ‘wall of worry’ to climb; it seems to us that worries are currently in dwindling supply.
Given the environment described above, we expect stock selection, industry/sector emphasis and geographical exposure to have increasing impacts on investment results in the year ahead. As we analyze individual stock holdings, we will seek to focus on those with below-market valuation and above-market exposure to anticipated changes in taxes and regulation. Higher interest rates, a stronger dollar, and potentially fractious trade disputes argue for a tilt toward stronger balance sheets and domestic-oriented businesses. Finally, a number of non-U.S. markets seem favorably positioned due to relatively lower valuation, more conducive monetary conditions, and less ebullient investor sentiment.
We look forward to the year ahead and welcome opportunities to get together with you to review or plan. The evolving nature of our clients’ investment objectives and risk tolerances is an ongoing focus at Oarsman; we encourage your input. Please call any time.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager