2016 Year in Review: What happened? – Q4 2016

2016 Year in Review: What happened? – Q4 2016

Dylan B. Minor PhD, MS, CFP®, ChFC, CLU

Chief Strategist and Chief Investment Officer

“Final Projection: Hillary Clinton Will Win 323 Electoral Votes” Headline Princeton Election Consortium

“Polls and Early Vote Show Hillary Poised for Victory” Headline US News

“I do not believe the Brexit will happen” Gideon Rachman, Financial Times

“”I’m confident that as we get closer to the Brexit vote, the ‘remain’ camp is getting stronger…markets are not always right, but in this case I agree with them.” George Soros predicting that Brexit would not happen during a Wall Street Journal Interview.

This past year was not a good time to be an “expert,” as so many seemed to get it wrong. Two major events—Brexit and the US Presidential Election—made this ever so clear. And this is despite having access to the best information and technology we have ever possessed. So what is the take-away? As Prime Minister May marches towards a completion of Brexit and Donald Trump is sworn in as the President of the United States of America, I am again reminded that we really don’t (or at least I really don’t) know what’s going to happen in the future. And often the future turns out quite different from what we imagined.

Similarly, back in January of 2016 the pundits were calling for another 2008-like period in the stock markets, as US stocks had begun to fall precipitously. What ended up happening by the end of the year? Remarkably and despite radical, unexpected outcomes throughout the year across a myriad of events, large US stocks, as measured by the SP500, ended the year garnering a total return of almost 12%. Small and medium companies did even better. Meanwhile, most bond asset classes had returns in the low single digits for the year. Similarly, developed international markets had returns in the single digits, whereas many emerging markets exceeded 8%. Alternative assets, such as hedge funds, REITs, and managed futures, fared the poorest, which is not uncommon during a strong US equity market. However, all of these returns were affected dramatically by Trump’s win: from election night through the balance of the year, US equities rallied sharply, while bonds and most international markets sustained significant losses. This represented a rotation of winners; US companies, especially ones with less international exposure, were seen as the biggest winners from a Trump win, while bonds and international markets were the losers.

Looking beyond the past few months, many of you have asked me what will happen under a Trump presidency in terms of the economy and financial markets. While admitting the fragility of any forecast, since Trump was inaugurated last Friday, January 20th, we should at least make an educated guess. Indeed, the markets always do and have already done so. President Trump’s proposed policies offer a variety of potentially negative and positive economic outcomes. On the positive side, reducing taxes and regulation and increasing investment infrastructure should add to economic growth and support employment. On the negative side, restricting immigration and global trade could prove harmful. The trillion-dollar question is what are the net effects of all of these policies? Employing the Fed staff’s FRB/US model to this question shows that the net effect will be positive or negative, depending on the severity of the positive and negative policies. For example, taxes could be reduced a little or a lot and trade duties could be modestly increased or largely increased, triggering a trade war. The difficult part is knowing the magnitudes. There is some hope that the negative policies will be implemented less severely than what was promised on the campaign trail. For example, the wall between the US and Mexico no longer seems like the major policy goal it was before. In contrast, it seems fairly certain some form of tax reduction will be implemented, with the support of a Congress where Republicans control both chambers.

For the financial markets, they have clearly bet that mostly positive and few negative aspects of Trump’s policy will be implemented. If this proves right, we can likely look forward to additional gains this year in equity markets. However, if it proves markets were overly optimistic, revising beliefs downward would likely result in material market losses, reversing the strong so-called “Trump Rally” that ensued after his electoral college win. For either scenario, however, it seems likely that interest rates will continue to climb; indeed, the 10-year government bond has already climbed sharply from about 1.8% the time of the election to about 2.4% currently. And the Fed has begun raising rates. Although it’s true that the current price of bonds fall as rates rise, a rising rate environment is actually welcome news to the savvy bond investor. In particular, those that have shorter term bonds and some corporate bonds, as opposed to only government bonds, can earn higher returns compared to had there not been a rise in interest rates: as bonds mature they are rolled into higher yielding bonds, which can overcome a modest loss from the rising interest rates. All the while, targeted tax harvesting can help subsidize the transition to higher yields. Indeed, within just few years, long-run annualized returns can become greater with rising interest rates as opposed to flat ones.

A final point that should be stressed is that all of these outcomes are still quite uncertain. Ironically, price volatility, as measured by VIX, has been subdued. However, this belies the great uncertainty we all have on what will actually happen by the end of this year. Thus far, most any time a market pullback has happened post-election, it is often blamed on “investors reassessing their bets on a new presidency.”

In light of these observations, we have engaged in several adjustments to help prepare for the new Presidency and Congress. First, we continue to maintain below-market duration in our fixed income. That is, we are maintaining a short-term bias. Truth-be-told, we have done this for several years in anticipation of rising rates. Happily, this bias has already begun to pay off since Trump’s win. Second, we slightly increased our US versus international exposure, anticipating a less favorable global trade environment. Third, we continue to maintain our small/ mid and value biases in our equities, which we have had for some time now and have also especially paid off since the Trump win. Fourth, because of the increased uncertainty, we are using above current-level risk assumptions for our financial forecasts and planning models, which allows us to better stress-test your financial plan. Fifth, we continue to remain committed to our proprietary States of the World® wealth management approach which partitions your portfolio for different potential states of the world: up markets, down markets, and flat markets. As always, should you have any questions or concerns don’t hesitate to write or call us.



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