Stock market indexes finished the year with their own display of fireworks. Depending on the stock market index, it was likely that a big chunk of its total price gains was made in the last two months of 2016. Conversely, nominal bonds began a cyclical bear market, that sent the benchmark treasury yield above 2%; a psychological ceiling that seemed so impenetrable during the first three quarters of 2016.
This new year offers a renewed sense of optimism for the American economy. US financial markets and central planners are ready to celebrate. For many, a stronger US economy would come as a sigh of relief in comparison to the lackluster experiences of the past decade. The last quarter of 2016 was full of positive news. Third quarter revisions to GDP showed that the US economy grew at a 3.5% annualized rate, its biggest increase in two years. US productivity also made impressive gains, and consumer sentiment and home valuations are now above prerecession highs.
The Federal Reserve Bank took notice of the strong data, and used it as an opportunity to raise short-term banking rates a quarter of a percentage point. Policy makers cited a strong labor market with unemployment at 4.6% of the total labor force, and general prices near their 2% target. A rate increase feels like a step in the right direction given that the American monetary system can now begin to separate itself from the rest of world’s monetary debacle.
"The New Year will bring excitement as well as uncertainty."
Financial market perceptions are changing rapidly. Investors turned to riskier assets and inflation protected securities on bets that the US economy will improve. Yield spreads on US corporate debt narrowed considerably on expectations for fewer downgrades and defaults. Earning yields have compressed on strong demand for US stocks. Stock earnings perform well in a modest inflation and pro-growth environment, which makes certain valuations appear more lucrative. It will be interesting to monitor how much further valuations can go especially when the benchmark treasury yield is near 2.5%, and could move higher.
Another shift in sentiment has been seen in hard asset markets. Speculative demand sent productive metal prices higher. The price of copper made huge gains late last year, whereas; precious metals lost luster. The price of gold collapsed in the final months of 2016, but finished the year with gains. Both copper and gold are priced in dollars on the world market. The recent appreciation of the dollar makes it questionable that the divergences in these metal prices can continue for much longer.
Attitudes for risk taking and inflation hedging gained momentum late last year. Most of it on the prospects of a strengthening US economy. Although, it seems like there is plenty to celebrate, investors should take caution to some of the systemic risks that are staring down financial markets.
First, pro-growth policies that are expected to unleash the US economy are only speculative right now, and; should they materialize, they will take time to implement. Also, middle class homebuyers are at risk of being priced out of the housing market. Economists say, income growth has not kept pace with the recent appreciation of housing. Lastly, the European banking system continues to show weak spots. The latest threat is an old Italian bank that is in serious need of a bailout. Another European bank crisis could jeopardize European credit expansion and growth, and; if bailed out with public money, European sentiment could sour further, thereby, endangering the fate of the entire Union.
The new year will bring excitement as well as uncertainty. Republicans will gain control of the government, and try to raise economic growth. Budget deficits and public debt will probably rise, which will defer the prospects of higher taxes off into future years. The dollar could strengthen more, and weaken emerging markets (especially if Americans become protectionist). Surely, there will be change, but we remain optimistic and will continue our diligent search for investment opportunities.
US equity markets posted a second straight month of gains, resulting in the highest returns year-to-date relative to the other asset categories. Optimism of future growth and inflation data was recognized as a healthy signal for economic progress, increased the attractiveness of earning valuations, and drove US equity prices higher. Our diversified, Core Allocation strategies, ended the year with strong gains. Although US equities were top performers, our selection of assets across other financial markets added value to our investors. Relative to Morningstar’s World Allocation and Tactical Allocation categories, our Core Allocation strategies outperformed by an attractive margin. As we enter 2017, the Investment Team will be implementing a variety of allocation changes based on the evolving market, economic, and political environments.