4th Quarter 2016: Market & Economy

MARKET & ECONOMY

2016 was a productive year for investors, with most major asset classes finishing in the black. Stocks had a good run with the S&P 500 posting an 11.96% gain, while bonds held onto small increases with the Barclays US Aggregate Bond Index up 2.65%. However, that doesn’t quite tell the whole story. The year had its share of twists and turns. Looking at the CBOE’s S&P 500 Volatility Index, we had three sharp spikes in volatility during 2016: one to start the year, one at the end of June, and one leading up to the US presidential election. As you can see in the accompanying chart of the S&P 500, those spikes in volatility were short-lived in 2016.

Here’s a quick look at what happened in 2016 and some thoughts on 2017.

The Three C’s Bring a Rough Start

2016 brought one of the worst beginnings to a year ever for stocks. The three C’s (China, commodities, and central banks) raised recession fears, and the S&P 500 fell more than 11% during the first six weeks of the year. Stocks began to rebound in mid- February as oil prices moved higher from their 13-year lows and the US Federal Reserve signaled delays in raising interest rates. Bonds were the stronger asset class in the first half as uneasy investors pushed prices up and yields lower. The US economy was as unsteady as stocks early on with GDP growth of just 0.8% and 1.4% in the first and second quarters respectively.

Brexit Surprise

Shocking the vast majority of experts, the United Kingdom sprang the first major political surprise of the year when British citizens voted to leave the European Union on June 23. From an investment standpoint, it is generally believed that global economic integration is preferable to isolation and trade barriers and markets responded swiftly to the vote. The S&P 500 fell 5.3% over the next two trading days. However, the drop was short-lived, even in the UK, as it became apparent that Brexit would take time, possibly even years to occur. The Brexit vote and similar moves toward populist candidates in other EU countries remain on investors’ worry list as we move into 2017.

The Trump Rally

We, of course, had our own surprise in the US in November when Donald Trump claimed victory over Hillary Clinton in the presidential election. As it became apparent Trump would win, markets began to plummet. Dow index futures were down over 800 points on election night. Markets reversed much more quickly than with Brexit and actually rose the next day, and kept rising through year-end on optimism based on Trump’s pro-growth policies. With the inauguration quickly approaching, we will soon see what President Trump and a Republican Congress can accomplish.

Central Banks

Perhaps lost in the fray of all the election headlines is the fact that 2016 was another extraordinary year for central banks. Just when it seemed they had used up all the tools in their toolboxes, central bankers found ways to step on the gas. Both the Bank of Japan and the European Central Bank took the unusual step of pushing interest rates below zero last year as they desperately tried to stimulate growth in their respective economies. The Bank of England cut rates and restarted quantitative easing in August to combat the weakness following the Brexit vote. Even the US Federal Reserve waited until December for the first and only rate hike of 2016 while acknowledging the belief that the US economy was probably strong enough for more increases.

Corporate Earnings

Corporate earnings, the driver of long-term stock returns, improved in 2016. Earnings for the S&P 500 components had fallen for 5 consecutive quarters on a year-over-year basis through the second quarter on net losses in the energy sector and weak GDP growth. That trend finally reversed in the third quarter, as those same companies posted a 3.1% gain, with a 3.2% gain projected for the fourth quarter per FactSet. FactSet’s analysts are even more optimistic for 2017 with a 12% jump in earnings projected for the year. Market valuations remain at elevated levels, but the market is forward-looking and it appears much of next year’s earnings gains may have been priced in during the recent rally.

Looking Ahead

2016 demonstrated that stocks and bonds don’t always move in the same direction, despite what we have seen in recent years. While an improving economy and Trump optimism helped bolster stock returns, bonds gave up much of their first half returns as it became apparent that the Federal Reserve could no longer delay rate hikes. If this trend continues, diversification will be very important going forward.

In our view, the past year was a particularly humbling reminder that it’s difficult to predict the future and reinforces the need to have a plan and stick to it. Many experts much smarter than we are were wrong about Brexit and the US election. As the earlier chart of 2016 S&P 500 performance demonstrates, investors who fled the market following the Brexit vote or preceding Trump’s election would have been disappointed with their year-end results.

There is much more investor optimism entering 2017 than we saw in early 2016 but the issues that moved markets last year (China, oil, central banks, Brexit, President Trump) remain very much on the table as we move forward. As such, we still think it is important to maintain an appropriate, long-term allocation to be prepared for whatever lies ahead.