Investor enthusiasm for the newly elected president managed to trump (pardon the pun) most economic data in December.
With the imminent passing of the torch from the Fed and monetary policy to Congress and fiscal policy, investors are anticipating a more robust economy in 2017, with equity markets pricing in stronger GDP growth and bond markets pricing in higher inflation.
It may be wise to consider, however, that nothing in the current economic data set has changed much and most of the initiatives being discussed by the now Republican led Congress – tax reform, infrastructure spending, deregulation – likely won’t impact the economy until at least 2018. Should any of the above measures fall short of expectations, it may make for a bumpy ride in 2017.
Employment figures held steady in November as Nonfarm Payrolls rose by 178,000, just shy of expectations, while the Unemployment Rate dropped to 4.6%, the lowest level since 2007. Average hourly earnings dipped slightly, with wages registering a +2.5% gain YoY.
The Atlanta Fed’s Wage Growth Tracker, by contrast, shows a more robust +3.9% YoY increase in wages, consistent with the thesis that labor’s share of capital is on the rise. The Underemployment Rate dipped to 9.3% from 9.5% while the Labor Force Participation Rate fell slightly to 62.7%.
Broader measures of inflation, including PPI and CPI, continue to tick higher, but not at an alarming rate. The Producer Price Index for November ticked up +0.4% MoM, registering just a +1.3% YoY gain, while the Consumer Price Index increased +0.2% MoM and +1.7% YoY.
The PCE, or Personal Consumption Expenditure measure, was unchanged in November and is up just +1.4% YoY. The current breakeven between nominal 10-year Treasuries and equivalent TIPS is currently 2.00%, implying an expected inflation rate over the next decade slightly below longer term averages.
With the Fed having tightened short-term interest rates by 25 basis points in December, and expectations growing for strong fiscal stimulus measures in the year(s) ahead, our guess is that wage pressures will continue to increase and the broader rate of inflation will continue to trend higher.
After 7 years of battling deflationary forces, this should be a welcome change for businesses and investors alike.
Domestic Equity
The rally in domestic equities continued in December, as Large-, Mid-, and Small-Caps rose +1.97%, +2.19%, and +3.32%, respectively. While Large-Caps have lagged their smaller counterparts over the past year, the S&P 500 Index rose just shy of +12%. Mid- and Small-Cap stocks, which rose +20.46% and +26.46% respectively in 2016, have benefitted from market expectations for tax reform and a stronger dollar going into 2017.
The divide between Value and Growth stocks resumed in December, with Value stocks, as measured by the S&P 500 Value Index, returned +2.54% in December, outpacing Growth stocks by over +100 bps.
Value outperformed Growth stocks by over +10% in 2016, which was the largest performance differential between the two indices since Value outperformed Growth in the year 2000.
However, over the last 5 years, Growth and Value have had similar annualized performance, returning +14.52% and +14.66%, respectively. Domestic equity valuations expanded further in December, as the S&P 500 trailing P/E multiple rose from 20.5x to 21x.
The positive performance in market cap and style based indices stretched valuations, as domestic equities continue to look expensive relative to historical averages. Furthermore, in 2017, S&P 500 earnings per share are expected to grow by almost +12%, which will be necessary to push the market higher from here.
All 11 sectors in the S&P 500 were positive in December, with Telecoms, Utilities, and Real Estate leading the pack, returning +8.12%, +4.94%, and +4.35%, respectively. Financials benefitted from expectations that President-Elect Trump will lessen the regulatory burden, as the sector closed the year up +22.75%.
Nearly all of the positive performance in financials can be attributed to returns that were generated in the 4 th quarter of 2017. Health Care and Real Estate were the two worst performing sectors, returning -2.69% and +1.12%, respectively on the year.
Health Care was the only sector with negative performance this year, thanks to continued regulatory risks and uncertainty surrounding Obamacare moving forward.
International Equity
International equities finished the month on a positive note, with both Developed and Emerging Market equities eking out positive returns. Developed equities, as measured by the MSCI EAFE index rose +3.44% in December, which pushed them into positive territory for the year, up +1.59%.
Emerging Market equities, as measured by the MSCI EM index, were basically flat on the month, up +0.05%; however, EM equities handily outperformed their developed counterparts, up +11.27% on the year. While both Developed and Emerging Market equities posted positive returns in 2016, their 3-year returns are still negative, having lost -1.03% and -2.34% per annum, respectively. On a 5-year basis performance improves slightly, with +7.13% and +1.55% annual returns, respectively.
Regardless of time period, international equities have handily underperformed the S&P 500 by a wide margin over the past 5 years. The MSCI EAFE index has underperformed the S&P 500 by 990 and 750 basis points per year for the past 3- and 5-year periods, while the underperformance for EM equities is even more pronounced, with underperformance of more than 1,100 and 1,300 basis points per year on a trailing 3- and 5-year basis.
Moving forward, we continue to believe mean reversion will run its course, as international equities remain considerably cheaper than their US counterparts. At the country and regional levels, performance varied wildly. December’s best performing country was the U.K., as measured by the FTSE 100 index, which gained +5.37% in local terms, and a whopping +19.15% for the year.
It is important to note that those returns would need to have been hedged, as the Pound fell more than -17% against the Dollar post-Brexit. Japanese equities, as measured by the Nikkei 225 Index, rose +4.53% on the month, and finished the year in positive territory, up +2.35%, all in local terms.
This comes after the Yen went on a wild ride in 2016, strengthening more than +19% through August 18th , only to weaken -14.5% into the end of the year.
Lastly, the Eurozone, as measured by the MSCI EMU Index, rose +6.98% in December, and +5.46% on the year in local currency, thanks to a weaker Euro. Finally, at the sector level, Energy, Utilities, and Financials led the way, gaining +6.38%, +3.95%, and +3.28%, respectively in December. Real Estate and Technology were notable laggards, returning -0.21% and +0.05%, respectively on the month.
Fixed Income
The broader bond market managed to eke out gains in December despite president-elect Trump’s pro-growth agenda AND a Federal Reserve interest rate hike. Alas, it wasn’t enough to salvage the quarter as bonds finished largely in the red.
Having touched all-time lows in mid-summer, bond yields are widely expected to begin a slow drift higher, ending the 35+ year bond bull market. While the terminal point and the rate of change are anyone’s guess, by our lights higher interest rates should prove a boon to savers, while modest inflation should return some degree of pricing power to corporate America.
In a tight race all year long, US high yield managed to pull out a slight win over emerging market debt to claim the championship for 2016. The Merrill Lynch US High Yield Master II Index returned +17.5% on the year, followed closely by the ML USD Emerging Market Sovereign & Credit Index, which gained +16.0%.
Taking 3 rd place honors was the ML Municipal High Yield Index, which recovered nicely from various defaults and near-defaults to return +6.3% on the year (tax-free!). US corporates were close behind as the ML US Corporate Master Index gained +6.0%. With the November elections behind it, the Federal Reserve finally managed to raise the Fed Funds rate a quarterpoint in December. The latest Fed dot-plot would seem to indicate an additional 2-3 interest rate hikes are likely in 2017; however, as always, the FOMC will remain “data dependent”.
The market doesn’t appear to be waiting for the Fed, however, as the 2yr Treasury approaches a 1.25% yield and the 5yr touches 2.0%.
Any sort of inflation scare, or revolt by the bond vigilantes (thought to be extinct, but still very much alive), could end badly for bond investors as the limited liquidity evident in the market won’t prove nearly enough to absorb any large amount of selling.
As mentioned above, the end of the long bond bull market appears upon us.
Absent some extraneous exogenous shock to the system (geopolitical strife, domestic terrorism, severe recession), it would seem to us that bond yields have begun a slow but steady march higher. Not accustomed to losing money in the bond market, it will be interesting to see how many investors react when they begin to see losses pile up.
Our advice, as always, is remember why you own them, and if you hold on til maturity, you should be okay.
Alternative Investments
Alternative Investments mostly finished 2016 on a high note, with West Texas Intermediate (WTI) crude oil, Real Estate, Commodities, and the Dollar posting positive returns in December. The lone laggard was Gold, which fell -1.8% on the month.
WTI crude oil was the year’s top performing alternative, rising +45.0%, from $37/barrel to nearly $54/barrel, after bottoming near $26/barrel in February. Crude has rebounded on hopes that OPEC follows through with planned production cuts, and an uptick in global growth will drawdown stockpiles and spur demand.
While this remains to be seen in 2017, it is important to point out that WTI crude oil is currently trading at its highest monthly close in more than 18 months, with strategists forecasting continued gains this year.
The rally in crude buoyed Commodities, as measured by the Bloomberg Commodities Index, by +1.8% in December and +11.4% in 2016. Additionally, Real Estate, as measured by the FTSE NAREIT All REIT Index, rose +3.5% in December, and +5.0% on the year.
Real Estate returns were diminished in the second half of 2016 as interest rates bottomed and rose sharply higher; however, moving forward, REITs should continue to do well, even in a rising rate environment, as the asset class remains highly sensitive to economic growth, which is expected to increase in 2017.
On the currency front, the Dollar rose +0.7% in December, and +3.6% on the year, which pushed major international currencies lower.
Diverging monetary policies in the U.S. and Europe, coupled with the sharp interest rate rise after President-elect Trump’s victory, helped push the Euro lower against the Dollar to the tune of -3.2% in 2016, but more noticeably by -6.4% in the fourth quarter alone.
Other currencies that weakened sharply against the Dollar were the Pound and Yen, which lost -4.9% and -15.4% against the Dollar in the fourth quarter. For the year, the Pound shed -16.3% against the Dollar thanks to the sharp decline post-Brexit, while the Yen actually strengthened against the Dollar by +2.7% for the year.
As for Gold, the precious metal lost -1.8% in December, but managed to gain +8.6% on the year, despite higher interest rates and a stronger Dollar.
Finally, Hedge Funds had another tough year, with most strategies underperforming the S&P 500 (again). The standout strategies were Distressed Securities and Event Driven, which gained +20.64% and +11.12% respectively on the year.