Q4 2016 Commentary / 2017 Outlook – December 6, 2016
The adage goes, “time flies the older we get.” I have always found that to be true, yet somehow feel like 2016 was the longest year in recent memory. Fairly certain this perception comes from the surreal election process we all just lived through. My brain feels like it has been through at least 2 years of a Trump presidency – and the last 4 years of Obama – all during the course of only this year. Maybe it’s just me, but curious if anyone else feels the same…..
At any rate, we ended 2015 by sharing an outlook of “interesting times ahead” – and 2016 most certainly did not disappoint. Here are some exact words from our 2016 Outlook published last December:
“If you forced us to make a ‘prediction’ for stocks and bonds in the coming year, we would say that the Fed has very little resolve in of consistently raising rates in the short-term, for a multitude of reasons. As a result, it would be less than shocking to us for both stocks and bonds to have favorable outcomes in 2016 - mainly in reaction to the “free money” party still rocking.”
For most of this year, the above blurb made us look much smarter than we actually are. After a rocky (to say the least) beginning of the year in equity markets – which produced double-digit losses in many indices – the Fed immediately reversed course on their projected “multiple rate hikes” for 2016. In fact, the Fed has yet to hike rates even once this year. Surprise, surprise (please insert heavy sarcasm). Par for the course, stocks also reversed and headed higher following the Fed commentary. Accordingly, bond yields fell back to historically low levels during the year. Precisely what we had expected.
Then came November 8th. Between approximately 9:00pm – 2:00am EST, it became known that Mr. Donald J. Trump was about to shock the world. Futures were showing that the Dow might fall 1,000 points or more when it opened the next day. After all, Mark Cuban repeatedly told us that the market would definitely “be down 50% or more” should Trump win the election. By the way – has anyone seen Mr. Cuban lately? Just hoping his portfolio is OK….
Surprising to some, the sun did in fact rise the following morning. And then, something strange happened. The market opened lower, but not nearly as low as most had assumed. By the end of the day, the market had not only erased all losses – it was up significantly. Crazier still, stocks have continued their path higher ever since. Turns out that potential for lower taxes and less regulation – otherwise known as more money in the private sector and less in the hands of politicians – is actually perceived as a positive for economies and stocks. Who knew?!
At the same time – while little has been said about it in the media (although we expect that to change) – interest rates spiked “big league”. The yield on a 10 year US Treasury went from approximately 1.7% before the election to a recent high of almost 2.5%. While that might not seem like much due to the miniscule rates involved, that is a vicious move in a very short amount of time. Remember – as we have spouted over and over again - when interest rates rise, bond prices fall. So while the media was making it sound like portfolios were achieving historical gains – conservative investors were actually experiencing flat to even negative returns because of their bond holdings (especially those holding longer maturities). Furthermore, the anticipation of lower tax rates made investments offering tax-free income understandably less attractive. Accompanied by rising rates, this resulted in rapid outflows (and declines) in most tax-free municipal bonds.
Interest rates rising after the election results was not surprising to us (see our last quarterly update) – but the immediacy and force of the move was. Which leads us to what we are certain has you “hanging on the edge of your seats in anticipation” (reference to the Jerky Boyz for our readers in their 40’s) - our outlook for 2017. As always, this year’s outlook will favor themes rather than predictions. Doing this accomplishes two important goals. For one, it keeps it honest. For the millionth time, anyone telling you that they can predict with certainty what will happen in financial markets is completely full of (insert favorite expletive ending in “it”). Because you ask for it, we will make our general forecasts for the coming year at the end of this rant – and will refer you back to the previous sentence for appropriate disclaimer. Additionally, discussing “themes” rather than “predictions” allows us to present information in a format we hope proves most useful to both novice and experienced investors alike – without becoming overly technical in the process.
With that, we present our “Major Investment Themes for 2017”. There are only two of them – clear as day to us and creating an epic “Heavyweight Championship” bout pitting Fed-induced valuations against pro-growth fiscal policy. Without delay….
“In the Red Corner - Interest Rates, the Federal Reserve…..and more Interest Rates”
Our clients – and anyone who has been reading along over the past several years – are less than shocked to hear us leading with this one. We are going to tackle this topic in much too simplistic fashion for the sake of space, time, and redundancy – but its importance is ignored at one’s own peril.
Since 2009, the Federal Reserve has embarked on never before attempted monetary policy. It included taking short-term interest rates all the way to zero, followed by “creating money” and using it to purchase bonds in the open market as a way of also manipulating long-term rates (which they do not directly control) lower. According to their rhetoric, this was done to spur economic growth. According to reality, this was done to raise asset prices. According to Ben Bernanke, the two are one in the same – he correctly explained that higher home and portfolio values would make the consumer more likely to spend rather than save. In turn, this would create economic growth.
During the same period, the burdens of both taxes and regulations have become significantly greater for business and consumers alike. Growth has been anemic at best. Employment – when one factors in participation rates as well as the types of jobs being created – and wage growth have been less than desirable to put it nicely. Still, the S&P 500 has more than tripled from its lows in 2009, and is currently sitting at all-time highs. Perplexing to many.
I can hear the chorus now. “The market is always forward looking, and the housing crisis was a Black Swan event that skews all analysis.” OK – true to an extent and certainly something to consider. So, let’s take it back further. The 1990’s were known for a booming economy and stock market fueled by the beginning of the internet revolution, reduction in taxes and politicians that actually worked together. However, we also had a Federal Reserve chair in Alan Greenspan who did not want to anger his Wall Street friends by raising interest rates in attempt to slow growth (or markets) to a manageable pace. He did finally begin to raise rates, which was ultimately followed by the S&P 500 losing approximately 50% at one point during the period of 2000-2002. Of course, low interest rates worked so well in the 90’s that the Fed decided to repeat the process. Rates were lowered significantly as the economy and stocks declined, and kept low even as the economy began to recover. Stocks gained, but the real story was the explosion in real estate prices as they became the new home for all of the “free money” floating around. Rates eventually were allowed to rise, and I don’t have to remind anyone of what happened to both stock and real estate prices shortly thereafter. Now, go back and re-read our discussion of the past 7 years. Anything sound familiar?
We could write 100 pages on the potential pitfalls of interest rates kept too low for too long. Housing prices are in no small part affected by the monthly costs of a mortgage. Big ticket items such as cars, TVs, computers, etc. are all regularly (if not mostly) purchased using “0% interest” financing these days. Corporations have been consistently using cheap money as a way of purchasing their own stock and driving up the prices in the process. And the government is now accustomed to rolling over almost $20 trillion of government debt at historically low interest rates. What happens when it all comes to an end?
Pay close attention to the Fed and interest rates. I promise you, they matter.
“In the Blue Corner - The Election and Opportunity for Pro-Growth Policy”
You can love the election results or hate them – makes no difference if you are an investor as the policies of the next several years are going to affect your portfolio one way or the other. The stock market’s reaction to this election almost writes this section for itself. If the market could speak, it said on election night “oh crap, a reality TV star is now the leader of the free world”. It then slept on it for a night, and by 10:00 the next morning (and through the writing of this outlook) said “oh yeah – lower taxes, less regulation, and smaller government have always been great for the economy and stocks!”
The questions about the election itself have all finally been answered. Two important questions remain and will be answered in the not-too distant future. Will President Trump stand and push for the same policy as Candidate Trump did? Will establishment House and Senate Republicans accept the fact that this was a vote for change rather than a vote for either of the existing and ridiculously corrupt political parties – then get out of the way?
Let’s assume the answers to the above questions are “yes” and “yes” – recognizing fully that both are hefty assumptions. Lower corporate taxes (along with reduced regulation) means greater resources for businesses to expand and hire. They are also eventually forced to pay more to retain employees based on increased demand for their talent and experience. Ultimately, this means higher wages for workers. Consumers have more money to spend and invest due to lower personal taxes and higher wages. Sure feels good to be writing such positive thoughts!!
There are potential negatives to those assumptions for sure. Trump is not beholden to corporate donors the way other politicians have been – so he is less inclined to protect their bottom lines in favor of the greater good of the country. “Making America Great Again” (as described) could prove harmful to international economies on a variety of fronts – especially those of emerging markets. And Trump himself – based on his rhetoric – may give political cover to the Fed causing them to raise interest rates faster than they may have otherwise.
All-in-all, we believe the positives of the election results far outweigh the negatives when it comes to your portfolio…..for the long-term. Of course, the long-term is what we care about most. But this is an outlook for 2017 – not the next 10 years. So, here goes…..
As mentioned, we are staring at an unexpected and epic clash between Fed-induced asset prices and pro-growth fiscal policy for the first time in years. Let’s put that in the most simple of terms. On the one hand, we have stock and bond prices that are (arguably) inflated due to Fed manipulation of interest rates. That is bad. On the other hand, we are now anticipating lower taxes, less regulation and more money in people’s pockets. This is obviously good. It is the intersection of the two that will most likely determine portfolio values in the short-term. Making sense of that intersection is not an easy task….
We begin by looking at history, to see how economies and markets have reacted to such environments in the past. There is plenty of data to absorb on historical reactions to pro-growth fiscal policies. However, there is exactly zero historical data to analyze concerning long-term effects of Fed policy of the past 7 years…..it has never before been attempted. Analysis of the past 30 years (as described previously in this outlook) can provide some context – but even that period did not include Fed Funds at zero for more than 6 years along with three rounds of quantitative easing.
In light of the above, we will now lay out three scenarios as to what we might see in 2017 – along with our projected probabilities of each. You can call this a cop-out. You can tell us we are trying to cover our rear ends. We call it honesty.
The following scenarios are once again condensed for the sake of space, time and clarity – through we welcome the opportunity to discuss in greater detail with any interested in doing so.
Scenario 1 (highest probability) – Rates continue to rise, Stock and Bond Prices fall as a result
In essence, this scenario means that over-inflated asset prices resulting from Fed activity ultimately overwhelms the opportunities created by pro-growth fiscal policy. We assume stocks would take the brunt of the beating and suffer significant losses, while the damage to bonds would likely be muted for a variety of reasons. This scenario may well include in-fighting amongst Republicans resulting in policy not as desirable as what was hoped for. While obviously negative for portfolios, we would welcome the outcome as a significant positive going forward – end result being pro-growth policies in place along with more reasonable prices on both stocks and bonds going forward. This my friends is known as opportunity! Under this scenario, inflation (real and expected) concerns would likely remain muted - at least for the time being.
Scenario 2 (less probable) – Rates once again pull back, Stock and Bond Prices both rise
Likely the result of continued inaction on the part of the Fed – or demand for our yields vs. the rest of the world keeping longer-term rates lower than otherwise expected. In this case, we would expect stocks to be the main benefactor, while we would project gains for bonds to be minimal. Passage of pro-growth fiscal policy occurs, and rates staying contained would buy Washington time and flexibility in the process. We would also expect future inflation concerns to be a heavy part of the narrative during the year. This is the best case for one’s portfolio for the coming year, but comes with muted return expectations going forward.
Scenario 3 (unlikely but possible) – Rates continue to rise, Bond prices fall while Stocks continue to rise
Likely the result of extremely swift and better than expected, pro-growth policy out of Washington. Also requires the Fed to finally follow through on multiple rate increases which we expect them to announce later this month. We would expect bonds to take the brunt of the pain under this scenario for obvious reasons, while stock gains would likely be somewhat contained. Inflation would remain a concern, although slightly tempered by rising interest rates.
It should be noted that the Fed could have avoided all of this confusion, simply by following through on their statements from December of last year. If they had stuck to their projections of multiple rate increases for 2016, stocks would likely have continued their early trend lower - at least until the surprising election results. Rates would have drifted higher during the year, instead of spiking in a span of three weeks. Put simply, it would have completely changed the narrative of this outlook for the better. We would be talking about stock and bond prices at much more reasonable levels, while anticipating pro-growth policies. The ambiguity described above would have been replaced with a sense of opportunity. Unfortunately – as usual – the Fed decided to kick the can down the road.
End result - we continue to suggest the reduction (not removal) of stocks from one’s long-term target equity allocation. On the international front, we prefer developed vs. emerging markets mainly due to uncertainties around trade policy under the incoming administration. On the fixed income side, we continue to favor reducing interest rate risk by using shorter maturities as well as other interest rate hedging strategies. That said, we are targeting 2.9% 10-year treasury yields as an opportunity to add some longer-term exposure. While risks remain, we tend to view the municipal bond space as a source of opportunity rather than one that should be sold into weakness. Finally, we view TIPS and other inflation-protected vehicles as a prudent addition to one’s portfolio given the current landscape.
Yes, we still perceive the overall environment as one where short-term risk outweighs potential return. At the same time, I hope we have adequately expressed our newfound sense of optimism for the longer-term. While some level of short-term pain might very well prove inevitable, it will now assumptively be met with policy designed to promote private sector growth - rather than more manipulation by the Fed. We will take that each and every time.
Wishing you and your family the very best for the holidays, and for the coming year. And to all of our clients – as always – we thank you for the trust and confidence you have placed in Round Hill Wealth Management.
Douglas Brymer David Swanson
President & Wealth Advisor Principal & Wealth Advisor
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Municipal bond interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury Inflation-Protected Securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes them more sensitive to price declines associated with higher interest rates.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
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