2016 was the year of political shifts. Populist movements made waves in the United States, the United Kingdom, and other countries such as Italy, France, Poland, Hungary, Austria, and the Philippines. The constant deluge of headlines may have convinced the casual observer that it was a rocky year for investment markets. The opposite, however, was the case in that political risk failed to translate into prolonged investment risk. U.S. and emerging market stocks both provided positive returns to investors, with the S&P 500 gaining 11.96% and the MSCI Emerging Markets Index advancing 11.19%. Bond markets experienced very strong returns through the first half of the year, only to be challenged by rising interest rates in the second half. Despite the recent upward surge in fixed income yields, traditional bonds still provided modest positive returns for the full calendar year. The Barclays U.S Aggregate Bond Index inched ahead 2.65%.
What was perhaps most interesting in 2016 was this phenomenon: patience rewarded in 2016 those investors who stuck with investments that struggled in 2015. For instance, we noted in the preceding paragraph double-digit returns in emerging market stocks last year, a welcome rebound for an asset class that we continue to think is undervalued due to recent struggles. The Alerian Master Limited Partnership (MLP) Index jumped 18% in 2016 after the commodity price downturn in 2015. High yield bonds, which also suffered in 2015, due to the commodity downturn, rewarded investors in 2016, with the Bank of America U.S. High Yield Master Index rising 17%. Conversely, areas like municipal fixed income and alternative investments, which provided positive returns to investors in the last few calendar years, struggled in 2016.
Last year provided a reminder to investors that chasing the latest hot investment and fleeing the underperforming asset often makes for poor investing. In short, the year taught lessons in discipline and patience with a diversified portfolio. The significant number of political headlines may have at times seemed worrying, but they were certainly not cause to make a rash decision with respect to the long-term plan for our portfolios.
To be certain, we are closely monitoring and analyzing the potential effects of political events such as President-elect Trump’s potential policy maneuvers amid continuing Republican control of Congress. Fiscal stimulus, tax cuts, and trade renegotiations are all areas that could alter the global economic and investment picture, and so present risks to avoid and opportunities to seek. There is also the matter of Brexit, which has implications for European investment markets, depending on which pathway the U.K. takes in renegotiating its trade union with Europe.
With that in mind, we turn to our outlook for 2017. We will touch on our views on the U.S. and global economy, the potential policy pathways that the incoming Trump administration may take, the outlook for the Federal Reserve and interest rates, and the implications that all of this may have for your portfolio in the coming years. Because it is impossible to capture all of the items that could affect investor portfolios, we will do our best to provide our perspective on what we believe to be the most pressing matters.
Heading into 2017, we believe that global economic conditions will be generally positive. We anticipate a continued modest economic expansion in the U.S., improving growth in Europe and Japan, and continued stabilization in emerging market economic growth. In the following table, we map out our base case for 2017 and include two other scenarios that we judge to be possible but less probable than the base case (one more adverse, another more positive).
We have organized our thoughts around the three regional complexes—U.S., Europe, emerging economies/China—that are dominant economic and market spheres. We find this organizational approach a helpful way of viewing potential developments over the next calendar year.
The major theme in 2016 was the rise in populist political movements, both in the U.S. and abroad. This element is likely to evolve in 2017, with President-elect Trump sending warning shots to companies, countries, and everything in between. In Europe, there are also presidential elections in France and Germany, both key cogs in keeping the European Union stable. Despite political risks both in the U.S. and abroad, economic growth remains on firm footing, and labor markets continue to improve. Although health care costs have risen for consumers over the last few years, wages have also finally started to rise at a notable rate, and consumers have not taken on much leverage or overextended their spending ability. Although political division remains sharp in the U.S., consumer confidence has moved towards new highs for the current expansion over the last month, hitting 107.1, well above estimates of 101.5.
In essence, continued improvement in the job market and improving consumer balance sheets, among other factors, are a recipe for continued steady growth in the U.S. and abroad. This remains the case, in our opinion, even if Trump and other politicians do not make good on their promises to cut taxes and introduce a fiscal spending package.
The U.S. Economy
In short, we believe that 2017 will see continued, if less pronounced, improvement in the U.S. labor market, which is already near full-employment, and modest GDP growth that ends the year between 2.0 to 3.0%. If we see a combination of tax cuts and fiscal stimulus, the growth rate may improve above 3.0%; however, we prefer to err on the side of caution and assume that some bill is passed but that the economic effects occur on a lagged basis, and not the instantaneous shot in the arm that bond and equity markets seem to be anticipating. Republicans are generally in favor of tax cuts, but they have a very slim majority in the Senate and could face a filibuster. On fiscal stimulus, many Republicans are loathe to increase the deficit even if it may provide a boost to growth. Democrats may get behind a spending package (for which Obama has advocated in the past), but it remains to be seen whether or not they wish to position themselves in line with Trump. If Trump pursues these two agenda items and gains widespread support for a growth package of tax cuts and fiscal spending, economic growth and corporate investment could accelerate, which would be a positive. If, however, Trump abandons these items and instead pursues a more protectionist trade policy pathway and seeks to impose tariffs on imported goods, then economic activity could slow markedly. It is admittedly difficult to handicap the likelihood of a trade war. Instead, Trump may choose to jawbone companies (as seen with Carrier, GM, and others) rather than pursue an actual hard and fast policy.
If Trump pursues both fiscal easing, tax reform, and deregulation, on the one hand, and protectionist trade policies, on the other, then it remains to be seen how well, if at all, both policy sleeves would complement each other. In fact, it is possible that trade protectionism would raise prices of foreign imported goods and slow the U.S. and global growth that fiscal easing, tax reform, and deregulation would seek to promote. All of this bears scrutiny.
The Fed and U.S. Interest Rate Policy
Heading into 2016, the Fed projected four rate hikes for the full year. This estimate proved too aggressive. Only one rate hike was implemented, and it occurred at the most recent December meeting. With the potential for economic stimulus in the pipeline, and the potential for higher inflation as a result, some are projecting that the Fed will raise interest rates more regularly this year than last. The Fed itself is currently projecting three rate hikes in 2017. From our perspective, we think it will continue to act cautiously and err on the side of hiking at a slower rather than faster pace. Janet Yellen has consistently voiced caution with respect to central bank policy and its effect on the global economy and markets. At previous points, when there was an expectation of a Fed rate hike, markets began to increase in volatility. Subsequently, the Fed cited “global concerns” as a reason for not hiking. This is likely to continue to be the case unless inflation begins to move substantially higher. There is much uncertainty regarding whether fiscal stimulus will occur and, if so, what its size will be, as well as the timing and magnitude of a potential package’s implementation and economic effects. For these reasons, we believe that the Fed will employ a wait-and-see approach to hiking rates rather than act in a manner that tries to pre-empt the economy.
U.S. Stocks in 2017: Modestly Positive with Potentially Bumpy Ride
In light of our expectations for the economy and the Federal Reserve, we expect U.S. equity returns in 2017 to be positive, but modestly so. 2015 and 2016 witnessed 10% “corrections” in the U.S. stock market (as measured by the S&P 500 Index) due to geo-political events and recession fears; however, the S&P 500 Index ended both of those years in positive territory. We anticipate that U.S. equities will also end the coming year with positive returns, but we also think that they will experience pullbacks along the way. Although the economy is on firm footing, the potential for headline risk, both at home and abroad, remains. If a correction does occur, it may be unsettling for investors, but we would urge them to remain disciplined and stick with their equity investments for the long-term, since volatility may be short-lived.
Despite the heightened political risk, the Eurozone economy has continued to grow and is in the early stages of economic expansion. Eurozone employment is performing quite well, and consumer spending is improving as a result. Germany recently reported its strongest level of retail sales in five years.
International developed markets are experiencing improvement in economic growth, have equity valuations that are lower than the U.S., and have central bank policy that is very supportive. While investors have been rightly concerned with the political risk that has shaken out across developed countries, we are encouraged by the resilience within European economies and believe investors will begin to notice.
Emerging Market Stocks
Emerging markets reversed three years of lackluster returns with solid positive performance in 2016. Since the election, emerging markets have experienced heightened volatility and some retracing of returns, as investors have weighed the potential for tariffs on Chinese manufactured goods, or the abandonment of NAFTA by the Trump administration. As we noted in the outset, it is incredibly difficult to pinpoint exactly how the Trump administration will approach its agreements with our emerging market trading partners. If the administration decides to make a domestic growth agenda its first priority and only deal with trade through pointed directives at major U.S. manufacturers, it may actually be very positive for EM stocks and bonds because they are closely tied to U.S. growth. If the Trump administration finds a way to implement costly tariffs – which, it is important to note, are difficult to do through executive actions alone – then it would be a negative for EM stocks and bonds. This is an area of portfolios that we are monitoring closely because there could be direct positive and negative ramifications depending on how U.S. political policy evolves.
Fixed Income Investments
One of the chief questions on investors’ minds after the jump in interest rates toward the end of 2016 is how to position their fixed income investments if rates continue to rise throughout 2017. In our view, we would not be surprised to see a continued move higher in yields, although we do not expect a sharp acceleration from current levels. Our primary reason for this view is that markets were not expecting a Trump victory and a Republican sweep during the presidential election last year. In the wake of that outcome, the bond market necessarily repriced the potential for stimulus and inflationary policies (rather than the gridlock that many expected).
On Sage’s positioning within fixed income, it is important to note that not all bonds are created equal, and the prospect of higher interest rates does not necessarily mean negative returns across fixed income positions. The following graphic from Nuveen Investments illustrates how various bond investments have performed during three periods of rising rates in the mid and late 90’s and the mid 2000’s.
In the 1994 to 1995 period, short-term corporate bonds, securitized debt, and high yield corporates were the best-performing U.S. fixed income sectors. In 1999 to 2000, entering the end of the tech bubble, short-term corporates were one of the best performers. Ironically, Treasuries also performed well during this period, but primarily because the Fed Funds rate was already at 5.0% at the start of this period. That is not the starting point today. Then, mid-single-digit income returns blunted price declines. High yield bonds underperformed during this stretch because economic growth was deteriorating.
Finally, the 2004 to 2006 is the most striking in terms of illustrating the outperformance of high yield bonds during a rising rate period. This period of time seems to align most closely with our current economic environment: the Fed is coming out of a low rate regime, economic growth is steady at the mid-to-late point in the cycle, and corporate financial health is improving. Sage has made a point to emphasize areas like high yield corporate bonds and unconstrained fixed income strategies, which invest in short-term corporates, floating rate bonds, and high yield bonds, in order to minimize the interest rate sensitivity of our portfolios and maximize the return potential even if interest rates do rise in the future.
Alternative investments, which are meant to enhance portfolio diversification were negative in a year when many assets delivered positive returns. At the start of the year, Sage used two alternative investment strategies – a multi-asset alternative investment and managed futures. We exited the multi-asset alternative investment during the year due to a change in manager process and an opportunity to invest in other, more attractive assets. We have maintained the managed futures strategy despite negative returns for a few reasons. First, managed futures has a long, proven track record of providing positive long-term returns to investors with low correlation to equity and fixed income markets. Despite the poor year from managed futures, the asset class provided positive returns to us in the four consecutive calendar years extending from 2012 through 2015. Alternative investments are attractive because they can provide additional portfolio risk-reduction in the form of a different return source from core bonds that similarly has a relatively modest risk profile. Similar to how we encouraged investors to stick with investments that were disappointing in 2015, we would encourage investors to be patient with managed futures as we anticipate continued, positive long-term returns in the future despite negative short-term returns over the last year.
One other area of note, outside of traditional stocks and bonds, is Master Limited Partnerships (MLPs), which Sage began allocating to in the second half of 2015. MLPs moved lower after our investment but rebounded nicely in 2016. They are an investment that provides an attractive yield well in excess of Treasuries and could participate in a rebound of U.S. energy investment. The incoming administration has already signaled a willingness to support the buildout of pipelines and energy production, which would be positive for the asset class. We continue to favor this area of the portfolio and believe it will provide attractive long-term returns to investors.
In conclusion, we are confident that our diversified investment approach across U.S. and international stocks and bonds, as well as alternative investments, will over time continue to serve investors well. The presence of geo-political risks is unlikely to subside overnight and poses a wide variety of potential outcomes for investment markets going forward. Because it is impossible to predict the future, we believe that a diversified approach offers investors the best potential to minimize singular, specific risks while maximizing their ability to generate positive returns under a variety of scenarios. As investing legend Peter Bernstein emphasized: “You must weigh not only the alluring probabilities of being right, but the dire consequences of being wrong.” Disciplined use of diversified portfolios is the best way to implement this principle. We appreciate the confidence you have placed in us and look forward to the opportunity to work with you and help you realize your financial goals.
The information and statistics contained in this report have been obtained from sources we believe to be reliable but cannot be guaranteed. Any projections, market outlooks or estimates in this letter are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of these investments. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. These projections, market outlooks or estimates are subject to change without notice. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. All indexes are unmanaged and you cannot invest directly in an index. Index returns do not include fees or expenses. Actual client portfolio returns may vary due to the timing of portfolio inception and/or client-imposed restrictions or guidelines. Actual client portfolio returns would be reduced by any applicable investment advisory fees and other expenses incurred in the management of an advisory account. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Sage Financial Group. To the extent that a reader has any questions regarding the applicability above to his/her individual situation of any specific issue discussed, he/she is encouraged to consult with the professional advisor of his/her choosing. Sage Financial Group is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Sage Financial Group’s current written disclosure statement discussing our advisory services and fees is available for review upon request.