February 23, 2017
This is how future market historians may describe 2016. After global stocks posted their worst-ever start to a year, evidence emerged that the global economy would avoid a major slowdown. As a result, global stock markets recovered. By mid-summer, bond yields also began to rise from all-time lows, and we questioned whether and how stock markets could make further gains. The fourth quarter answered this question decisively: yields spiked sharply higher and stock market momentum accelerated after Donald Trump was elected president and Republicans regained control of Congress.
That 2016 “began with a whimper and ended with a roar” understates just how many unexpected outcomes the year delivered. Whether it was the sharp rebound in oil prices from record lows in February, the European and Japanese central banks’ dalliance with negative interest rate policy, or China’s avoidance of an imminent credit market implosion, consensus at the start of the year was routinely debunked. Two well-known pieces of stock market folklore, the “January effect” (a bad January is supposed to lead to a poor market for the rest of the year) and the “Super Bowl indicator” (when an American Football Conference team wins, the stock market is supposed to end the year lower), were also invalidated in 2016.
In perhaps the sharpest repudiation of professional forecasters and pollsters, the United Kingdom voted to leave the European Union in June, and the outsider Donald Trump won the U.S. presidency in November, riding a wave of populist dissatisfaction and impatience which had been brewing for years. With the prospect of cooperation among the executive and legislative branches of government and the expectation of a more “business friendly” administration, investors quickly ratcheted up their expectations for economic growth and corporate earnings in 2017, propelling positive sentiment toward stocks. Underlying economic growth had already improved enough for the Federal Reserve to raise short-term interest rates in early December, while increased expectations of higher wage growth and inflation led to a bond market selloff.
Looking forward, capital markets and the economy appear to be undergoing several important transitions. After seven years of anemic economic growth induced by artificially low interest rates, the economy seems poised to grow at a higher rate. Hyperactive monetary policy is no longer “the only game in town,” and fiscal stimulus is ready to take the baton. Deflation concerns receded as wage growth and inflation reached much healthier levels, allowing the Federal Reserve to continue to normalize monetary policy. Stock markets have broken out from the stagnant, volatile range in which they traded since late 2014, driven by improvements in underlying fundamentals rather than artificially low discount rates. All of this creates a recipe in which it will likely be easier to capture upside without taking undue risk in the coming months.
As always, it is more important to ask what can go wrong than it is to ask what can go right. The risks to our brighter outlook include:
- Concerns the new administration’s pursuit of “fairer trade” may devolve into an overly protectionist stance, undermining global economic growth.
- The administration may undershoot current expectations of a timely and efficient boost from fiscal policy and deregulation.
- Rampant U.S. dollar appreciation as the domestic economy’s growth rate ratchets higher, which in turn may destabilize overly indebted countries within the emerging world.
- An unforeseen shock emanating from many of the world’s geopolitical tinderboxes.
For these reasons, we remain committed to diversifying portfolios across a range of asset classes. Consider these facts:
- From 2008 to 2016, the U.S. stock market gained a cumulative 86%, far surpassing the 1% return of international stock markets and the 11% decline in emerging stock markets.
- Over the preceding eight-year period of 2000 through 2007, cumulative U.S. stock market gains of 14% were far outpaced by the 55% appreciation of international developed market and the 213% gains of emerging market stocks.
- Over the “lost decade” from 2000 to 2010, U.S. stock markets achieved no gains at all!
Those who call into question the efficacy of a diversified approach today may fall victim to the behavioral traps of “home” and “recency” bias. We expect this trend will cause greater asset class dispersion across and within neighborhoods of risk. As such, disciplined, diversified approaches will be poised to capture more upside without taking excessive risk.