We began 2016 with a market sell-off that was the worst ever start to a new year, but recovered to end the year firmly in the black. The strong year-end rally was the result of a change in investor expectations for improved economic growth, stronger corporate earnings, and higher capital investment.
The 2016 rally extends the current bull market that has tripled stock prices from their lows 8 years ago. Stocks weathered several shocks in 2016, including a recession scare, Brexit, and the election of Donald Trump as U.S. President. Investors quickly bet the Trump administration would usher in more business-friendly policies. Tax cuts, including the corporate tax rate which is the highest in the developed world, lower regulation which is expected to free up new business formation and investment, and new fiscal stimulus in the form of infrastructure spending all appear to be on the table and generating enthusiasm in stocks.
That enthusiasm, however, has generated angst in the bond market as interest rates have begun to rise on the expectation of higher inflation to come. Bonds struggled in the second half of the year, as the yield on the 10 year US Treasury rose from an all-time low of 1.36% to 2.5% at year-end.
After several quarters of sub-2% GDP growth, the economy grew at 3.5% in the 3rd quarter, its best rate in two years. The Fed held off on raising interest rates until year-end marking only the 2nd increase in 10 years. Increasing optimism about the U.S. economy should allow the Fed to move back toward normalization sooner with the result being more increases to come. While higher interest rates can have a dampening effect on the economy, we believe that current rates are still below the level that would cause problems in the near-term.
The key for stocks in 2017 will be the ability of earnings to grow enough to support stock valuations. Remember, a P/E ratio has both a numerator (P, price) and a denominator (E, earnings). Recent market gains have been a function of prices going up while earnings have been flat for two years, which is unsustainable. For stocks to continue to rise and valuations to remain the same, the denominator or earnings (the E in P/E) needs to kick in. This appears to be occurring, setting up 2017 to be a potentially good year for stocks. While valuations are higher than their historical average which limits upside, earnings growth of 10% or more in 2017 will provide a tailwind for stocks, no doubt, with some new shocks along the way.
Looking Back at 2016
- World equities (↑8.4%) were led by US Small Cap (↑20%) and US Large Cap (↑12%)
- Non-US equities were mixed with Emerging Markets equities (↑13%) outperforming International Developed equities (↑3%)
- 2016 was another tough year for high quality bonds with Municipals, US Treasuries and Corporates all barely positive (↑1-3%)
- Credit strategies performed well from oversold levels with High Yield Corporates and Emerging Markets Debt both positive (↑14%)
- Hedged equity strategies had mixed results with those most exposed to equities outperforming (↑12%) and those with the highest short exposures underperforming (↓8%)
- Multi alternative strategies with bond-like risk performed well (↑7%) but without the downside associated with increasing interest rates
- Managed Futures strategies underperformed markets (↓5.5%) given few strong asset price trends but made up some ground in the last two months of the year
- MLPs performed very well (↑36%) recovering from oversold levels seen at the oil price lows in February
Chief Investment Officer