“The World Turned Upside Down” – Tune played by the British army band at the Yorktown surrender ending the Revolutionary War, 1781
Fourth Quarter Highlights
2016 ended as it had started – totally confounding many investors, economists and especially pollsters. The surprising victory of Donald Trump in the Presidential election caused a huge rotation from bonds into stocks, contrary to what had been predicted and showing some similarities to the Brexit reaction this past summer.
From Election Day until the end of the year, the S&P rose almost 5% while the Russell 2000 surged almost 14%. Meanwhile, yields on Treasuries rose sharply, with 10-year yields going from 1.85% to 2.44%. The divergence continued among other asset classes, with most commodities such as copper and steel going up and precious metals such as gold, falling.
The U. S. dollar rallied, causing a selloff in most emerging markets, especially those with significant dollar-denominated debt. China, however, continued to improve, as developed markets such as Japan and the Eurozone surged on the prospect of increased exports. Finally, oil prices rose after a better-than-feared OPEC production cut agreement, an action soon followed by major non-OPEC producers as well. Of course, the success of any agreement depends on a minimum of cheating and this won’t be known for a few more months.
Early Implications of the Election
Reasons for the sudden divergence in performance between the asset classes have varied. With a unified government for the first time in several years, most market observers believe pro-growth policies such as corporate tax reform, foreign profit repatriation and new infrastructure spending will spur economic growth, while helping to raise bond yields from historically low levels. This analysis assumes the “good Trump” policies will prevail, as opposed to the “bad Trump” policies of trade protectionism and severely curtailed immigration. Although initial signs are encouraging, the economic impact of legislation from Congress will probably not be known until later this year.
In the meantime, investors will have to rely on the present trend of economic growth, which is lingering between 2.0-2.2% on a real GDP basis. Consumers are still spending, though more online now and less at brick and mortar stores. Manufacturing, however, remains anemic. Overall corporate earnings have finally bottomed and are forecasted to grow about 12% this year, led by Financials and Energy. Bank earnings are being helped by a steepening yield curve, which boosts net interest income. Energy companies will get a lift from earlier cost-cutting and easy year-over-year comparisons.
With the focus on new fiscal policy, the role of monetary policy has somewhat diminished. Currently, the Fed is contemplating a rise in rates two or three times this year, depending on the economic data, as well as the extent to which fiscal stimulus initiatives are implemented. Keep in mind that the Fed originally intended to increase rates four times in 2016 but ended up doing so only once.
Early indications is that the economy in Hawaii may slow a bit into 2017, as estimates for tax revenue growth for the state have been cut from 5.5% to 3%. Although tourist arrivals remain good, per capita spending hasn’t kept pace, and construction spending may slow as well. Of course, the year has just begun and economic indicators may pick up as we go forward.
We continue to favor equities over fixed income, as the new Administration plans expansive fiscal policy. The stock market has come a long way since Election Day, in part from 2016’s returns being pulled forward by eager investors. Additionally, the market anticipates a great deal being enacted early in the year – probably, a stretch at this point.
As a result, we could see equity returns in the high single digits, with volatility still a factor from past years. Our upgrade on the SMID (small to mid-cap) stocks was early, but is now performing very well. Bonds will continue on the defensive, although longer rates have already moved up higher and resistance to the 10-year Treasury seems significant at the 3.00% area. Internationally, we still like developed markets, though selected emerging countries may also participate in the rally.