Stocks Outpace Bonds in 2016
2016 ended up being a great year for stocks, and a so-so year for bonds. However, it was a tale of two halves in financial markets. The first half of the year saw yields collapse in the United States and globally, while equities struggled to generate positive returns. The second half of the year saw equities roar and bond yields turn higher. The Bloomberg Barclays Aggregate Return Index fell 3.31% from its high reached on July 8, 2016 to finish the year up 2.65%. The S&P 500 finished up 9.54%-after rising 11.91% from its late June low. The S&P 500 outperformed international stock indices, especially when adjusting for changes in currency. However, small and mid-cap domestic stocks came roaring back after several years of underperformance to solidly beat the returns of large cap stocks. Energy and financial services were the best performing sectors for the year. The outperformance in the financial services sector was extremely notable as all of it was generated in the fourth quarter. The financial services sector was the worst performing sector through the third quarter before rising 20.48% in the fourth quarter on expectations of higher interest rates during a Trump administration. This came after years of underperformance. Healthcare was the only sector to fall in value for the year as headline risks from the Presidential candidates hurt the sector. Additionally, healthcare had outperformed over a multi-year period and was likely a source of funds for investors who wanted to move into energy and financial services stock. Consumer discretionary and staples stocks also underperformed in 2016, as investors shifted into sectors likely to benefit from higher inflation and faster economic growth.
What a Strange, Strange Year
2016 was a strange year and one that made prognosticators, pundits, and analysts look foolish. The Chicago Cubs won the World Series for the first time since 1908; the Cleveland Cavaliers won the first title for a professional sports team in Cleveland since 1964. Meanwhile, the Leicester City Foxes overcame 5,000-to-1 odds to win the English Premier League in soccer despite having a miniscule budget. In the political arena, Donald Trump will become the 45th President after defeating the Bush and Clinton political dynasties, while earlier in the year, Great Britain voted to leave the European Union. Brexit was predicted to be a disaster for the British economy and their financial markets. Since the vote to leave, Great Britain’s economy is still sputtering along at the same low-growth rate that preceded the vote, and the British stock market is up 12.70%. Most pundits projected falling markets and an immediate recession on the slight chance that the resolution passed. The ensuing 17.05% decline in the British Pound against the US Dollar was the only outcome that even came close to the dire predictions.
In America, many people assumed that a Trump win would be the worst outcome for the economy and the equity markets. Instead, the S&P 500 rallied 4.63% into year-end, while consumer confidence levels are hitting multi-year highs (see chart).
The increase in consumer confidence cannot be completely attributed to Donald Trump. As time goes by after the Great Recession, people’s pessimism abates little by little. The strengthening labor market preceded President-Trump and clearly cannot be attributed to him. In our view, the market would likely have rallied if Secretary Clinton had won the Presidency, although the magnitude and character of the rally probably would have differed.
NPP thinks it’s clear that the United States and the rest of the world are in a transitional period. After years of slow growth, low interest rates, and rising societal tensions, people are starting to doubt accepted economic and political wisdom. Citizens around the world are pushing back against globalization in Western countries. In the United States and abroad, voters are frequently choosing the maverick or wild card instead of the status quo candidate. Candidates that used to be considered fringe candidates are winning not only a large percentage of the vote in many countries, but also elections. In sum, people throughout the world are voting for change, even if there is a reasonable possibility that change will be worse than the status quo. NPP feels that some of the anger directed at the established bureaucracy here and abroad is warranted, while some of it is misplaced. For example, one prominent reason for slower growth is the worldwide decline in birthrates. It is a trait shared globally by most developed economies, and it is not clear that anything can be done to arrest this trend.
Other problems can be remedied. The aftermath of the Great Recession was consistent with that of past financial crises. In reaction to the failure of several large financial institutions, many new regulations were rolled out. Some of the regulations were necessary and useful, but many others were overly burdensome and lead to unproductive time and paperwork, especially for small banks. The same trend has played out in many industries. The desire to prevent the next crisis has led to an environment that stifles innovation, particularly among smaller and new businesses that have a tough time raising capital and recruiting skilled labor. The regulatory backdrop can be viewed as a pendulum. We rarely reach equilibrium and have just the “correct” amount of regulation. In hindsight, federal regulators probably became overly restrictive after the Great Recession. It is probable, that many regulations will soon be rolled back. This is the nature of our Republic and the nature of democracies. The key is to react accordingly to the changed world.
Cash may not be King, but it is an Asset Class
Since the start of the Great Recession in 2008, the Federal Reserve and other Central Bankers have conducted a grand monetary experiment. Interest rates were taken to zero or astonishingly, below zero in many countries. Central bankers claimed that lower interest rates would jump-start economies and lead to faster economic growth. Rapid economic growth has not occurred, and many people question whether the policies that were put in place to promote growth ended up impeding it instead. Zero and negative interest rates hurt the financial sector which needs higher rates to earn its cost of capital and provide credit to the economy. Negative interest rates also hurt a rapidly aging global population that requires interest income to live on, while making it very difficult for many defined-benefit pension systems to sustain themselves over the long-term. Moreover, low and negative interest rates send a signal to companies and consumers that times are hard. There is a reason economists try to measure consumer and business confidence. Confident consumers and companies are more likely to spend and invest than those that are worried about tomorrow.
NPP believes we have begun the transition to the normalization of interest rates. In the months ahead, short-term rates will likely move higher, and the importance of cash in a portfolio will increase. In the past, cash has served as a portfolio hedge while earning a return for investors. For most of the past eight years, stocks and bonds have moved in the same direction (see chart).There have been times when stocks went up and bonds went down, but those periods were the exception, not the rule. Looking ahead, we think there will be times when cash outperforms bonds. NPP would not be surprised if longer-term rates moved down or ticked sideways for a couple months. Nevertheless, we expect interest rates to rise across the board in 2017. We continue to target portfolio duration that is shorter than the benchmark. The Federal Reserve currently forecasts that the Federal Funds rates will rise three times next year. If this happens, short-term bonds and floating-rates bonds are likely to outperform longer-term bonds.
Proposed Tax Policy Implications
President-elect Trump has proposed broad corporate tax reform including lowering the tax rates. The initial reaction to the proposal contributed to the recent market rally. NPP thinks that a cut in the corporate tax rate is highly likely and desirable to make U.S. businesses more competitive with global businesses. However, not all companies will benefit and the market has started to differentiate between companies that will benefit from a change to the tax system, and those that won’t. Companies with a large percentage of revenues based in the United States will benefit more than global multi-national companies with a large percentage of revenues derived overseas. Many companies carry large deferred tax assets or liabilities on their balance sheets. Those with deferred tax assets will see their book value drop if tax rates fall, while those with deferred tax liabilities will see their book value rise. It is probable the deduction for interest expense will disappear if the tax rate decreases. If so, industries and companies that are highly levered are going to be adversely affected as they lose their tax deduction. There are also proposals to allow companies to expense capital investments instead of depreciating them over time. Capital intensive manufacturing businesses would benefit from this change much more than asset-light businesses. Another feature of the proposed tax plan is a border-adjustment tax. In essence, a border adjustment tax will help companies that are net exporters, while hurt companies that are net importers.
NPP thinks that tax reform is welcome and a long-term plus for the economy and American businesses. It must be remembered that there will be winners and losers and it is unwise to assume that a broad improvement in the corporate tax regime is a benefit for all companies. Some companies will benefit from the new system, some will be hurt, and for a lot of businesses, there will be pluses and minuses.
NPP thinks that some of the investment themes that worked in 2016 will continue to work in 2017. Equities should move higher for the year, although we don’t expect returns as strong as in 2016. At some point, the market is likely to see a pullback as it digests the implications of policy changes and realizes that not all changes can or will happen at once. NPP thinks Treasury yields will move higher, but we don’t think rates will rise as precipitously as they did during the second half of 2016. We would expect intermediate to long-term rates to rise between a quarter and a half a percent over the year. The upward move in intermediate to long-term interest rates has been rapid, and we would expect that higher yields coupled with institutional rebalancing will lead to a rotation from stocks to bonds in early 2017. Accordingly, we would not be surprised if equities pull back early in the year and would use that as buying opportunity should it occur.
In terms of sectors, we think that after years of underperformance, financials will continue to perform well in 2017, helped by gradually rising interest rates. Technology, which tends to be a sector that performs well in a slow growth environment, lagged in the 4th quarter of 2016 and finished the year in line with the S&P 500. NPP feels technology will do better in 2017 as economic growth lags current expectations. Healthcare stocks were particularly bad performers in 2016 and they tended to hurt our performance in 2016. The valuations were clearly held back by the political pressure to reign in rising costs. However, the valuations for many of these stocks are very reasonable relative to their lowered growth expectations. NPP believes we will see a recovery in this area as the new year begins and that healthcare will likely end next year as a market performer. NPP was also positioned too conservatively in the energy sector in 2016. We were surprised at the quick rebound in the pricing of oil after it dove 29.23% in early 2016. Oil prices appear to have settled in the mid-50s. We expect them to be range bound in the coming months and think that the energy stock rally will moderate. Industrial stocks were a big beneficiary of the Trump rally and we believe this should continue into 2017. However, we will need to see the expected pickup in global growth for many of these companies to be good prospects at current valuations. Finally, the economic backdrop and interest rate environment that we anticipate should not be conducive to the more defensive sectors as investors shy away from interest sensitive stocks and move into more cyclical stocks.
Market outlooks and economic projections are always subject to a great deal of uncertainty. This is especially true in 2017 as we approach a Presidential transition. Nevertheless, NPP remains optimistic while being cognizant of the risks to our outlook. We expect 2017 to bring high-single digit returns for stocks, while being a trying year for bonds. At some point in time, inflation and rising rates will become a headwind for equity markets, but we don’t believe the markets will reach that point in 2017.