Market Commentary – Market Review and Outlook Q4 2016
There were two events in the Fourth Quarter that influenced U.S. and foreign financial markets: Donald Trump won the presidential election which led to positive growth on Wall Street (1) & the Federal Reserve’s December interest rate of 0.25% signified the Fed's confidence in the improving U.S. economy (2). United Kingdom scheduled its Brexit, OPEC trimmed oil output for the first time in eight years (3), oil rallied as did the U. S. dollar (4) while precious metals were the worst performing commodities sector in the fourth quarter. On the whole, the most-watched U.S. economic indicators were encouraging.
Market indices including S&P 500, Morningstar MidCap, Morningstar Small Cap, Morningstar REIT, MSCI EAFE, MSCI Emerging Markets, and Barclays US Agg Bond are registered trademarks of their respective owners, cannot be directly invested in, and are quoted from their respective owners websites. (5)
Global Markets: Neutral with Caution
World markets are ripe for almost any outcome that can be imagined right now. The increase in terrorist activity last year can certainly continue or escalate, which puts economic pressure on the affected locale. Populist movements such as we have seen in Britain, threaten to spread to other parts of Europe, which could destabilize the region further. China, while currently less in the headlines, has produced decent results. However we are not confident in the quality of these results or their durability. The Middle East continues to evolve into an ever more dangerous and desperate zone. Recent U.S. election results have disrupted political dynamics world-wide. However, despite these weighty distractions markets continue to be somewhat resilient. Part of this resilience is certainly the global nature of markets, and resulting tempering effect of our domestic results. The U.S consumer power aids in growth across the globe. Rising US rates and general inflation are also good for foreign economies and markets, as is a string US dollar. So, while we are cautious and watchful, there is the potential for opportunity abroad.
U.S. Economy – Good
The key factors we track, unemployment, housing, and inflation, are all favorable. Unemployment remains below 5%, while wage inflation has held its slight upward trend. Even with minimum wage levels not so likely to rise by mandate, the effective minimum wage still continues to creep up in certain areas from sheer demand. Housing figures have held in the average range, with ever increasing home prices, increase in new sales, and in new home starts. The consumer may be motivated to borrow more sooner, as the promise of higher borrowing rates looms on the horizon, and as banks perceive a friendlier compliance environment. Politics have fractured the U.S. consumer into those who feel brighter days lie ahead, and those who feel the glory days of this bull market are behind us, but economic data points do not reflect anything but a healthy economy overall, if not one which is possibly in the later stages of expansion. The caution here is remains the same as in past quarters, namely world events, political disruption, higher than desirable inflation, trade wars, and other factors not yet in our line of sight.
Inflation – Good
Inflation is more and more likely to be impactful for 2017. For years, we have experienced very little inflation, running at 1/3 to ½ of the normal rate. Now, however with the recent raise in rates by the Federal Reserve, with rising energy prices, more demand in housing, historically low unemployment, signs of wage inflation, and a generally stimulating business environment we should begin to see inflation in the 2 to 2.5% range.
Interest Rates – Good
We now have heard clearly that the Federal Reserve intends to move toward more normal interest rates. This is welcome change in trend given the protracted length of time we have experienced historically low rates. While this low rate environment has made borrowing less expensive, it also leaves no moat for the Fed to apply palliative measures should the economy
slow. Low rates also squeeze bank margins, which has been a real detriment to recovery in the financial sector. An orderly march toward more historically normal rates should be a signal to markets and the economy that the Fed perceives the markets to be stable. While we don’t know how many times the Fed might raise rates in 2017, we would predict it to be more frequently than 2016.
U.S. Stock Market – Good with Caution
The market delivered far more than was expected for 2016. Leaving politics aside, the path that lies ahead is clearer today than it was in October of last year. The new President, and his more homogeneous Congress, is likely to make some moves that could be very stimulating to the economy and would likely continue to be well perceived by investors. For instance, lower corporate tax rates and a less aggressive regulatory environment should both benefit corporate earnings, and therefore equity prices. We still expect to see wage inflation, despite what might happen with the minimum wage. We would also expect some recovery in commodity prices as demand continues to increase for manufactured goods and new homes. Nonetheless, these factors are likely to push through to rising prices, netting out to a favorable earnings environment, We shouldn’t expect a redo of 2016 as far as stock prices are concerned, but it is reasonable to feel somewhat optimistic about the markets in 2017. However, there is likely to continue to be volatility, so a bit of extra cash, and a commitment to rebalancing may be wise.
U.S. Bonds: Neutral to Negative
We fully expect rates and inflation to rise in 2017. These factors could cause a selloff in bonds. If equity markets also continue to remain stable, further pressure to move away from fixed income will occur. While we hope that all investors will stay firmly committed to their target allocations, forcing a rotation from assets that have recently performed well to assets that have lagged in recent months, we know that the average investor does not always follow this discipline. Many funds will experience outflows as a result, which may put extra pressure on fixed income products. This could provide a great opportunity to average into these well run products at attractive prices.
The ETF portfolios have had a recent addition of inflation protected securities, in lieu of intermediate term debt. This move, while lowering the current yield of the portfolio, reduces risk in the bond allocation. This “risk off” in what would normally be the lower risk element of the allocation is a reflection of our stance regarding fixed income. This lower risk stance allows us to continue with a neutral allocation to equities, despite the potential for volatility in coming months. It is imperative that you maintain your target allocations, practice dollar cost averaging, and rebalance. Managing risk through the end of this bull market will be an active pursuit.
All investing is subject to risk, including possible loss of principal. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Diversification, asset allocation, and other investment strategies do not ensure a profit or protect against loss in a declining market.
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