February 1, 2017 – The highly unexpected US election results dominated investor sentiment and market results in the fourth quarter of 2016. Though we, like many others, expected a different outcome, we were correct in our comment that no matter who wins, the end of an election tends to ignite an optimistic relief rally. We have seen that in spades. Since November, the doom and gloom that pervaded US markets in September and October has faded.
Despite the potential for more optimistic sentiment, we believed that if Donald Trump prevailed, markets would be rattled for at least a few weeks. Instead, reality was similar to the “Brexit” reaction, an extremely brief initial disruption followed quickly by a strong rally, in this case one that continued through 2016. Though our election forecasts erred, the optimism we expressed in our letter this time last year was more than validated by the US stock market’s double-digit return for 2016. Looking beyond investment results, we believe that well into the future, the world will look on 2016 as a memorable year not just for the US election results, but also for the rise of global populism and, most important from an investment perspective, an interest rate inflection point that, in hindsight, may be recognized as the beginning of the end for the abnormally low rate environment of the last eight years.
Pitcairn has recommended time and time again not to let politics overly influence your portfolio positioning. We stand by that recommendation, but we also acknowledge how much tougher that will be in 2017. For the first time, we have a president with no military or governmental experience who freely expresses views using alternative media platforms, i.e. Twitter. We have already seen his comments affect daily prices of individual stocks, both positively and negatively. How are we to respond? We strongly recommend that investors be patient, no matter how difficult that may be, and ignore such short-term noise until we can all evaluate the longer term impacts of the new administration’s policies.
In the wake of the election, many economic forecasters seem to have abandoned their long-held secular stagnation theory. Instead, those who told us only a few months ago that robust GDP growth was unachievable, now appear confident that proposals to cut taxes and regulations will spur stronger growth than we have seen in recent years. While I find this quick reversal curious, there is no doubt, we have already seen the surge of optimism and movement in the US capital markets and we will be watching to see if that follows through into the real growth our economy desperately needs.
After the election, US and global leading economic indicators pivoted. Notably, US and global consumer confidence and US business confidence have risen. (See Chart A.) The positive indicators seem to expect a lot to be accomplished in a short amount of time. We contend that such expectations remain speculative and that our job as advisors is to look at the facts and put them into the context of the market.
As of now, the facts are these. Global recession fears are quite low, significantly lower than they were a year ago. The US economic picture continues to improve — this is something we wrote in July and not entirely contingent on the Trump effect. We have also noted for some time that consumer confidence data readings were too low given the solid economic numbers, so the post-election gains were justified, in our view. Additionally, US companies have good earnings momentum and foreign earnings data are decent.
On the side of caution, the economy and the stock market are at advanced stages of their respective cycles. And, with the likelihood of increased government spending, we now face a nearly unprecedented scenario where we are stepping on the fiscal policy gas late in the cycle. This could be a positive – finally unleashing growth that should have been unleashed five or six years ago – or a negative, overheating the aging economic cycle and sending inflation into overdrive.
The current situation does seem to support a continuation of the bull market. It’s hard to imagine US and global stocks declining in the face of the corporate tax cuts and the easing of regulatory burdens likely to be enacted by the new administration. However, there is a danger that if the stimulative policies don’t result in real growth, the market’s optimistic sentiment would quickly reverse.
We still await clarity on the new administration’s priorities. I recently attended a conference sponsored by our friends at Strategas where I gained some insight on the quickly changing situation in Washington. President Trump has many things on his agenda, but he also has a significant runway to get things done, given Republican control of Congress and the power of the executive branch. Nevertheless, there are hurdles. What I think we can expect is regulatory reform, particularly in financial services, some sort of corporate tax reform and, possibly individual tax reform, though that may take longer.
I believe President Trump will find Washington a tremendously complicated place and, consequently, significant changes to tax policy will be a challenge. Rather, we will probably see the low hanging fruit picked first – corporate tax cuts and repatriation of foreign corporate assets, while change to personal tax rates is delayed. I expect Congress to repeal the Affordable Care Act, but delay implementation. However, even that remains to be seen given Mr. Trump’s call for simultaneous repeal and replacement. On top of everything else the administration hopes to achieve, there is also a pending Supreme Court appointment, which brings everything in Washington to a halt for months. This means that simply having the bandwidth to achieve all the changes he desires will be difficult.
How the markets respond to the administration’s agenda remains to be seen. We believe the market will applaud traditional supply-side economics actions, but be disconcerted by flashpoints that could ignite a trade war, such as some Trump statements that have already put China on edge. Longer-term, we think markets will change significantly over the next three to four years. Catalysts for this change include a likely trend toward higher interest rates, global economic shifts, and the policies of the new US leadership. The political process is going to be different with this administration, but no matter how loud the chatter gets, we believe investors should take a deep breath and maintain focus on their long-term goals.
While we, here in the US, have questions about economic policy following the election, it is clear the rest of the world has many questions as well. Most of the commentary I have read from around the world is of a more pessimistic bent regarding the incoming US administration. Nonetheless, the global economy is clearly in better shape than it was only a year ago. As questions persist through 2017, the world will be looking toward Washington for answers.
In all probability, we expect to see the global economy follow the US lead in 2017, with improving consumer confidence and leading economic indicators pointing toward economic health. Still, trade policy will undoubtedly be a major determinant of future success for individual economics. The big questions revolve around China and Mexico. These two markets are most at risk in the current environment given Mr. Trump’s pointed comments on trade. We believe it is in the best interests of the US to have a stable and prosperous neighbor to our south and we hope the administration agrees that our foreign policy should support that.
The Trans-Pacific Partnership (TPP) was, at its best, an effort to make sure countries around the world were held to certain labor standards and to create a single market similar to the European Union. At its worst, it codified a less competitive position for the US. China shunned the TPP not because it was a good or bad deal for the US, but because they weren’t sure they wanted to be held to the same standards as other countries. Regardless, failure of the TPP pales in comparison to President Trump’s potential impact. What matters now is whether he will ultimately be more moderate than his rhetoric. If he is not, there could be significant dislocation in the global economy.
In Europe, politics are currently worse than the economy, but either could influence the other. Populist trends, like we saw in the US and UK, are present in Europe, notably in France and Italy. Angela Merkel’s leadership of Germany is probably not at risk, but that could change. Going forward, there will be an interesting push and pull between the recovering core European economies and the changing political situation.
Here in the US, we will be watching interest rates, GDP growth, and Federal Reserve policy in relation to those interest rates. Some have made the case that the Fed has been too easy in its monetary policy. We have been more generous in our view of Fed policy over the past few years. It’s hard to say how bad the economy and the markets could have gotten without Fed intervention. However, the consensus among Trump advisors seems to be that the Fed is dovish with a tendency toward looser monetary policy. As a result, we could see a change in Fed leadership, with a greater bias toward tighter monetary policy in the coming years. A changed mindset at the Fed might not be bad if we are about to face real inflation. New Fed governors might be more willing to get out in front of inflation, whereas Janet Yellen is comfortable trailing the real inflation data. I have written in the past about the potential risk of a Fed policy error. That risk still exists, but the nature of it has changed. Last year, the fear was that the Fed would react too slowly to inflationary pressures. Now the risk is that a hawkish Fed may move too aggressively and hinder the acceleration of GDP growth.
Immediately following the election, expectations were that Mr. Trump would push for significant spending, potentially blowing up the federal budget. However, the core of his economic team actually includes powerful budget hawks who could balance reductions in tax rates with eliminations of deductions and other revenue producing tactics.
What concerns us most is economic dislocations that could result from policy actions. In the past, some well-intentioned tax code changes have had momentous and not necessarily positive effects on particular segments of the economy. Take for example the 1980s when the elimination of a tax incentive for real estate led to a sharp decline in commercial real estate values, precipitating the savings and loan crisis. Policy issues can have unintended risks and certain segments of the economy could suffer. Though the US economic backdrop is positive, it’s foolish to think the new administration isn’t going to attempt big changes and the consequences are something no one can really speak to at this point.
Following the US election outcome, international equity markets (represented by the MSCI All World ex US Index) had a modest fourth quarter decline, but delivered a positive return for the year, up 4.5% in US dollar terms. Developed international markets outperformed emerging markets for the quarter, but emerging markets had built up quite a lead and came out far ahead for the year.
Commodity and resource rich countries such as Brazil, Russia, and Canada led the international results in 2016. Brazil and Russia advanced on rebounds from earlier weakness, while Canada benefited from the oil price recovery. Currency meaningfully affected individual country returns in US dollar terms. (See Chart B.) Canadian and Brazilian currency added to 2016 returns. Though the UK was one of the world’s best equity markets in local terms, the pound’s mid-year tailspin following the Brexit vote kept its 2016 return flat in US dollar terms. Overall, the nationalist spike in the US dollar following the presidential election hurt international returns on a dollar basis.
We think Japan is nearing the end of its negative interest rate experiment, which didn’t work. It appears that Japan’s debt-laden economy may finally be turning a corner. I am excited to be traveling with the Wigmore Association to Tokyo in March so we can gain firsthand insight to form our own opinion of the situation there.
In light of the turnaround in emerging market equity performance in the last quarter – largely due to the strong dollar – we think it is still essential to view emerging markets as a basket of different countries rather than a homogenous asset class. Even as the Trump administration poses risks to China and Mexico, there may be opportunities in places like India and in some emerging markets in peripheral Europe that are on firmer footing.
Although international equities have not been the best performers on an absolute basis over the last three years, we think that on a risk-adjusted basis, a globally diverse portfolio has been – and still is – the place to be and we reaffirm our commitment to that strategy. If the dollar continues to rise for another year, absolute returns on non-US markets will be hurt, but we maintain a favorable outlook because economic conditions in many countries are improving.
US equities, as represented by the Russell 3000® Index, returned 4.2% in the fourth quarter and 12.7% for the year, the eighth straight year of positive US equity returns. Continuing the third quarter trend, higher beta, higher volatility stocks led almost from the outset of the fourth quarter, but flattened or retreated in the final three weeks of the year, taking away a small percentage of gains.
Buoyed by the strong fourth quarter, small cap stocks outperformed large/mid cap stocks for the year. Value outperformed growth by a meaningful margin in 2016, a trend that was pronounced across all market capitalizations. President Trump is generally considered pro-growth and a pro-growth environment tends to favor higher volatility, smaller size and value stocks. (See Chart C.) The new president’s projected policy changes seem likely to benefit the financial, energy, and materials sectors, which also performed well in the fourth quarter.
The past year has been a very interesting one. During the first part of 2016, we had a peculiar stock market where investors were willing to pay high prices for utilities and dividend-paying stocks, not out of euphoria, but because these were the only assets investors considered reasonable given the possibility of rising interest rates and the near-irrational fear of stocks that still lingers from 2008. Then came Brexit and a period of market choppiness.
By September, utilities, dividend stocks, and safety had stopped working, but most money managers were still defensive. If they had been able to foresee that Mr. Trump would be elected and that US manufacturing, small cap and financials stocks would rip through until the end of the year, managers could have performed very well. Understandably, not many were making that call. As a result, active managers struggled mightily against passive investments in 2016. We believe in a smart combination of active and passive investments. We also believe that a year like 2017, with potential for dramatic change and a rising interest rate environment, could be a time for active to outperform passive.
The current US bull market is now the third longest of the last 117 years. For some time now, we have pointed to three things that would signal the bull market’s end:
- Recession as predicted by an inverted yield curve
- Excessive US stock valuations
- Excessive optimism on the part of US investors
Recession fears have further subsided, with the yield curve steepening rather than inverting, and predictions are for a stable US economic picture through 2018. Valuations, for the most part, haven’t moved as earnings kept pace with price gains. What has changed is the lifting of the pervasive gloom and doom of September and October. Even with better sentiment, we think it will take a while for retail investors to aggressively move into stocks, but if it takes hold, that would be a caution flag for us.
As advisors and macroeconomic forecasters, we tend to be on the contrarian side, away from the crowd. That was the case in 2008 when we thought it was the time to buy US equities. Now, however, our outlook is more closely aligned with the consensus, and I ask myself why. The answer is that there is a momentum element in the market now and it wouldn’t be prudent to step away given current data. The probability is that this will be another good year for US equities, but there are still many unknowns. Markets don’t go forever and we will be alert to signs of an eventual recession and market pullback.
The fourth quarter saw a surge in bond yields as markets were caught off guard by the surprise election results. The belief that market-friendly policies from the new administration would boost inflation drove expectations for a rise in key market interest rates (See Chart D), just three-tenths of a percent below the Fed’s 2% target.
US investment grade bond markets benefited from global demand during the first three quarters of 2016, but were negatively affected by the fourth quarter surge in bond yields. The Barclays Aggregate managed to generate a 2.7% return for the year. Meanwhile, high-yield bonds delivered a solid return in 2016, due in part to higher commodity prices, particularly oil.
Pinpointing the end of a 40-year bull market in fixed income is no easy task and I fully realize that I am the boy who cried wolf on the bond market reversal. However, 2017 seems like the year when many of the forces behind low and negative yields across the globe will finally shift: a pick-up in the US economy and the likelihood of increased government spending suggest a reflationary environment; unemployment has declined in the US and Japan; and there is the possibility noted above that the new administration will bring about a changed mindset at the Fed. People who have been buying fixed income at these yield levels may well begin selling out of those positions, causing some volatility. This bond market inflection point will have implications not just for core fixed income, but also for active managers and hedge funds.
Global REITs were down 5.6% in the fourth quarter of 2016, as measured by the FTSE EPRA/NAREIT Developed Index, reducing their 2016 return to 4.1% in US dollar terms. US REITs ended the year as one of the top performing countries within the REIT index.
Up until the fourth quarter, global infrastructure had been aided by the same factors boosting REITs, namely low interest rates and yields higher than those available from global equities. However, as interest rates began to rise, infrastructure pulled back just like other income producing assets. It will be interesting to see how President Trump’s policies affect the infrastructure segment as states and municipalities increasingly look to private enterprise to address infrastructure needs.
MLPs rose slightly in the fourth quarter, as measured by the Alerian MLP Index, and finished the year as one of the best performing asset classes. Tortoise, an MLP manager on the Pitcairn investment platform, returned over 40% for 2016. MLP performance tracked changes in crude oil prices fairly closely as crude oil closed the year around $52/barrel, far above the high $30s at the start of the year. Commodities, as represented by the Bloomberg Commodity Index, rose in the fourth quarter and for the year, largely due to strong returns from energy and industrial and precious metals.
Favorable results across the spectrum of real assets further support our case for a diverse portfolio. During the past year, having exposure to a wide range of asset classes benefited investors from both a risk and return perspective.
During 2016, hedge funds, as a class, were flat. However, there were some big misses, along with strong performances. At Pitcairn, some of our hedge fund debt strategies delivered extraordinarily good returns with low levels of volatility.
The same conditions that hampered active managers this year also affected hedge fund managers. For the last few years and most of this year, investors paid up for securities that were pretty pricy and not growing very fast because there were few other options. That’s not typically how active managers think. Active managers aim to pay lower prices for investments that should improve. Such value approaches have gone unrewarded for many years.
The coming year could be a period of dislocation and disappointment for hedge funds as many institutional investors are so disappointed with recent performance, they appear ready to capitulate on the asset category. We maintain that it’s a mistake to go to zero in hedge funds and hold to our view that rising interest rates and a more normalized market will be friendlier to hedge funds’ active management. We see hedge funds as an insurance policy against an inflationary environment. If interest rates rise and inflation takes hold, that insurance policy may well pay off in 2017.
Last year, capital markets had one of their worst starts ever, plagued by anemic global growth and plummeting commodity prices. However, some of the weakest performers in those early weeks of 2016 – commodities, MLPs, and global equities – proved to be some of the year’s top performers. There is no better argument for diversity and against market timing.
Markets got off to a calmer start this year, but 2017 may still be one of the most difficult years for long-term investors in recent memory. We have little basis on which to anticipate the policy actions of the new administration and there is substantial potential for large scale change. Along with that comes a natural human desire to adroitly exploit that change, something that can be very tricky to do. It is exceedingly difficult as a long-term investor to take advantage of actual dislocations, but not speculate against your wealth structure.
Yes, there will be opportunities to make money, but there will also be many red herrings. Investors, money managers, and wealth advisors will all be challenged to have discipline this year. Pitcairn’s responsibility is to counsel toward that discipline. We believe investment policies exist for a reason and that responding to emotion and minutia is detrimental to your financial picture. We also understand how hard it is to stay on course. All of us at Pitcairn are here to help you put your hands over your ears when necessary so that together we can focus on your long-term plan.