EQM Capital LLC – Year End 2016 Market Review and 2017 Outlook

Posted on Jan 2, 2017

Realigning Expectations in the Time of Trumponomics

Ausblick

2016 Year in Review

After getting off to its worst-ever start of the year last January, the Dow Jones Industrial Index ended up logging its best performance since 2013, as investors bank on improving economic conditions.

The Dow, an index of 30 blue-chip stocks, gained 16.5% on a total return basis in 2016. The S&P 500 TR Index added 12.0% for the year, and the NASDAQ Composite rose 8.9% for its biggest gain since 2014.  The Russell 2000 TR Index of small cap names finished the year in double-digit territory, gaining 21.3%.

But it wasn’t a smooth market ride in 2016, as stocks weathered many bumps along the way. There was a global recession scare, Brexit, the collapse and subsequent rally in energy prices, continued uncertainty regarding interest rates and the global economic conditions, and finally the U.S. presidential election of Donald Trump.

The bulk of U.S. market gains came in the second half of the year. A rebound in corporate earnings, accelerating U.S. economic growth, and the stabilization of energy prices all helped reignite investor enthusiasm for stocks.  The rally gained further momentum after the election of Donald Trump on November 8th, as investors bet that the new administration would be able to successfully implement business-friendly policies like tax cuts, less regulation, and fiscal stimulus.

Some of the bullish tax items on table include a proposed 15% corporate tax rate and a one-time repatriation of foreign cash. The prospect of less banking regulation and higher interest rates has sent financials soaring. Energy stocks have rallied on the potential of more drilling and less environmental regulation.  And industrial names have gone up in anticipation of future infrastructure spending measures and trade reforms.

The so-called “Trump Rally” stalled at year end, raising questions how much further the rally will extend into 2017 and if and when it will propel the Dow to a record 20,000 point milestone.  Trump’s policy initiatives could fall short of expectations and the rally has made stocks more expensive by historical measures. According to FactSet, the S&P 500 is trading at 21X their past 12 months of earnings versus the 10-year historical average of 16X.

Here is a brief summary of the year:

  • A Shakey Start – The Dow gets off to worst 5-day start to a year, falling 6.2% thanks to a huge China market decline which sparked global recession fears.
  • Oil Recovers – Oil saw its biggest annual gain since the financial crisis, propelled by a deal among OPEC nations and major oil producers to cut production. Energy was the best-performing sector of the S&P 500 this year, up 24%.
  • Brexit Surprise – The market was surprised and sold off heavily in late June when the UK voted by referendum to leave the European Union. The market quickly shrugged off the news however, sparking a “risk-on” market rally.
  • Economy Improves – Q3 GDP came in at 3.5%, its strongest reading in 2 years. Unemployment has fallen to 4.6% and wage growth has improved. U.S. corporate earnings are growing after several quarters of declines.
  • Fed Raises Rates – After holding off raising rates for most of the year, the Fed finally acted in December and increased rates by 0.25%. The Fed also signaled more increases are on the way given its optimism about the U.S. economy. Expectations for higher rates has hurt bond prices, with bonds experienicing their second consecutive year of declines.
  • Dollar Strong – Brighter domestic economic prospects and higher rates have helped boost the dollar. The WSJ Dollar Index, which measures the U.S. dollar versus a basket of 16 other currencies, is up 3% for the year. The strong dollar could threaten the recent recovery in corporate earnings by making U.S. exports more expensive to foreign buyers.

Here’s a recap of investment performance by risk category and benchmark indices as of 12/31/16 (all indexes are total return):

Target Risk 4Q 2016 2016 3Yr 5Yr
Morningstar Conservative -1.84 4.67 2.35 3.46
Morningstar Moderately Conservative -0.71 6.66 3.26 5.61
Morningstar Moderate 0.38 8.57 3.80 7.45
Morningstar Moderately Aggressive 1.39 10.21 4.13 9.18
Morningstar Aggressive 2.15 11.34 4.47 10.51
Benchmark Indices
Dow Jones Industrial Index TR 8.66 16.50 8.71 12.92
S&P 500 TR (U.S. Stocks) 3.82 11.96 8.87 14.66
Russell 2000 TR (U.S. Small Stocks) 8.83 21.31 6.74 14.46
NASDAQ Composite 1.66 8.87 10.14 17.07
Barclays Aggregate Bond TR (U.S. Bonds) -2.98 2.65 3.03 2.23
MSCI EAFE (International) -1.04 -1.88 -4.20 3.58
MSCI EM (Emerging Markets) -4.56 8.58 -4.90 -1.21
Source: Morningstar 12/31/16

 

2017 Market Outlook

U.S Markets

Since the November 8th election, stocks have already climbed 6%.  And after a 7-year run, the bull market is getting tired.  Much of the 6% gain experienced this year, may have been borrowed from next year.  However, most strategists are looking for S&P 500 aggregate earnings growth of about 7% next year.  And Trump’s pro-business tax cuts and less regulation could add an additional 2% to the corporate bottom line.

Higher interest rates favor stocks over bonds. While higher interest rates should be a positive for financials, they are typically a negative for highly levered and smaller cap companies who borrow at a higher rate.  But less regulation may prove to be an offset and help keep the “free money” flowing.  Other interest rate sensitive stocks such as utilities may also be hurt by rising rates.

Investors who have piled heavily into infrastructure and material stocks may be disappointed as a fiscally conservative Republican Congress is unlikely to approve big spending plans that require borrowing and an increase to the national debt.

Consumer staples stocks (think Coca-Cola and Procter & Gamble) and multi-nationals will encounter an earnings headwind thanks to a strong U.S. dollar.

Outside the U.S.

Investment prospects outside the U.S. in places like Japan and Europe appear favorable in the coming year as valuations are more reasonable and central bank policy is likely to remain very accommodative. In Japan, Abenomics continues to strive to push up inflation by keeping interest rates and the yen low. While Europe is not without its political risks with elections in Germany, the Netherlands, France, and potentially Italy in 2017, it is still likely to benefit from stronger profits, a weak euro, and supportive ECB policy.  Given the likelihood of a continued strong dollar, investors may want to consider hedging their international return exposure.

The outlook for Emerging Markets is more uncertain. Rising U.S. interest rates and a stronger dollar provides headwinds, but a number of emerging economies are benefiting from stronger exports, lower inflation, and central bank support.  China’s leading indicators are starting to pick up for the first time in nearly 4 years.  But trade tensions with the new U.S. administration could put that in jeopardy.

Key Takeaways

  • Trumponomics Trump administration policies are directionally pro-growth and pro-inflation. The U.S. economy is already operating at close to full capacity. Trumponomics has the potential to nudge inflation high enough to support a return to more normal interest rate levels and keep the bull market going.
  • The Fed –Corporate profits have recovered, but a strong dollar and rising wage costs could continue to hinder economic growth. As a result, future rate increases will be small, measured, and limited in number. Another key consideration for the Fed is given that other central banks are not raising rates, this global divergence, amplifies the impact of any U.S. tightening measures.
  • Bonds – Higher interest rates and inflation are a negative for bonds. However, there is still much inherent uncertainty with a new Trump administration. Bond exposure is still necessary as an overall risk dampener in portfolios should equities sell-off.
  • US Small Caps – While investors have been piling into financials and infrastructure stocks, small caps also look attractive in the coming year. Rates may be going higher, but more favorable banking regulations and better credit availability should be a boon to small cap companies. Fiscal stimulus will also be more impactful for small cap companies. A $10 million contract may not be a big deal for a large megacap company, but it is for a small one. And thanks to risking rates, “risk-on” is back on, forcing a rotation away from large-cap dividend payers to smaller, more growthier names. Small caps will also be less exposed to strong dollar headwinds.

Based on these assumptions, investors should consider being positioned as followed:

  • Overall allocation: Overweight stocks, underweight bonds
  • Equity allocation: Overweight Technology, Financials, and Energy; overweight Small Caps, underweight Large Caps
  • International allocation: Overweight Developed Markets, underweight Emerging Markets; currency hedged exposure
  • Fixed income allocation: Overweight High Yield and Bank Loans, underweight long-duration

Of course, as the future often proves to be unpredictable, investors should ultimately remain focused on their long-term goals. Here’s hoping 2017 will be a happy and prosperous year!

DISCLOSURE: Returns in percent. Past results are NOT an indication of future performance. The opinions expressed above should not be construed as investment advice. This article is not tailored to specific investment objectives. Reliance on this information for the purpose of buying the securities to which this information relates may expose a person to significant risk. The information contained in this article is not intended to make any offer, inducement, invitation or commitment to purchase, subscribe to, provide or sell any securities, service or product or to provide any recommendations on which one should rely for financial, securities, investment or other advice or to take any decision. Information provided, whether charts or any other statements regarding market other financial information, is obtained from sources deemed reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.