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Question of the Week - December 27, 2016

Question of the Week - December 27, 2016

Guest Post - Tuesday, December 27, 2016

What are the biggest takeaways from 2016?

This has been a unique year, to say the least, but we can say that about every year to some degree. This one began on a difficult note, with the continued concerns over low oil prices carrying over to low earnings results and tempered expectations for stocks and a higher default risk environment for the debt of commodity-related companies such as energy.

Through summer and fall (along with a few hiccups including Brexit and Presidential candidate uncertainty in the U.S.), recovering energy prices drove sentiment and risk asset pricing higher. While it was assumed that Hillary Clinton would end up winning the election, and markets rallied in advance of election day, a surprise Trump victory resulted in futures markets quickly plummeting overnight before oddly recovering and embarking on a bullish trend line for U.S. stocks ever since. This change in sentiment is in response to campaign promises for fiscal stimulus, lower taxes and regulatory reform—all of which are hoped to boost economic growth towards a faster rate.

In fixed income, bellwether interest rates, as measured by the 10-year treasury note, are ending the year just a bit higher (at 2.5% last week) from where they started (2.3%)—but the move seems much more dramatic due to the extreme lows reached during the summer (1.4%) and subsequent rebound. Due to such a dramatic year, returns across the bond landscape were quite divergent with, shorter- to intermediate- duration bonds outperforming long-term bonds, which started the year strong but suffered as a result of recent rate volatility. The opposite situation impacted high yield bonds and floating rate bank loans, which under performed earlier in the year, due to the added stress in certain segments of those markets from low energy prices. However, as the year progressed, high yield and, later, bank loans came into their own with gains as energy became less of a concern and economic data strengthened. Foreign sovereign bonds in major developed markets similarly started strong earlier in the year, including often-discussed debt from nations like Japan and various locales in Europe where yields declined from already low levels down to and below zero. The negative rate environment was unprecedented, but, as expected, such bonds were on borrowed time as that same negative rate virtually guarantees a capital loss if affected bonds are held to maturity. Larger emerging market debt issues saw positive returns early also as investors sought out yield wherever it could be found, driving up the price of that segment. Then, almost on a dime later in the year, this trend reversed, and foreign bond indexes dramatically lost ground as interest rates rose, the dollar strengthened, and investors fled a variety of emerging markets due to perceived impacts of Trump administration trade policy.

In equities, the most important comparison begins with that of U.S. vs. foreign stocks. For yet another year, U.S. equities outperformed foreign—naturally, strong momentum goes hand-in-hand with positive news (e.g. U.S.), while lower valuations go along with more pessimistic prospects and greater degrees of uncertainty (e.g. overseas). However, eventually these trends end, and, as has often been the case with valuation-based return tendencies over time, underwhelming expectations coupled with an eventual catalyst of some improvement can be enough to switch momentum from one segment to another. An important question to ask when comparing a more diversified global equity portfolio to one simply compared to the 'Dow', is 'Would you rather be overexposed to Asset A that has experienced relatively good news and an extended stint of strong performance momentum already, or Asset B, that has been beaten-down, has substantially under performed in relative terms and is surrounded by negative investor sentiment, but yet offers higher intermediate- to longer-term return potential?' This is the ongoing internal battle of the value investor, where owning less popular assets never seems to feel 'good' at the time. Active management was also tricky in 2016 in several areas, including U.S. large cap and foreign equity strategies that over-weighted higher quality fundamental factors relative to the shorter-term 'beta' which rewarded more cyclical firms this year, including those in energy, materials and industrials. Small cap stocks performed largely in line with large-caps until around the time of the election, but accelerated sharply afterward and have ended up being the winning asset class for the year with hopes that stronger domestic growth and less exposure to foreign trade will benefit the group.

Other assets have experienced interesting years as well. Real estate benefited initially from a preference by investors for low volatility and higher dividend stocks, backed by attractive fundamentals such as strong tenant demand and rising rents, which have coincided with slow but steady economic growth. As the year progressed, REITs encountered some challenges, as is common during rising interest rate environments; however, rising rates have generally proven to be positive for real estate in the quarters following hikes (when the hikes are within reason), as this corresponds to economic growth. Additionally, a lack of supply in the development pipeline, a surplus of which can destroy real estate cycles, appears to still be at bay, which could elongate the current cycle.

Commodity indexes are dominated by energy prices, and crude oil is the key global component of that segment. Crude prices hit a low of just under $30/barrel in February after an extended stretch of deterioration thanks to rising production and inventories. Once this situation reversed, and oil rebounded back to $50 as OPEC production cuts were debated, indexes naturally reflected those gains. Industrial metals also gained more recently, due to restocking demand in emerging markets and other supply/demand factors. Precious metals have retained some gains following strength early but more lackluster investor interest as other assets began to 'outshine' gold and silver, which lagged as investors moved to riskier financial assets instead, the dollar gained ground and bond real yields increased.

In terms of the 4th quarter specifically for portfolio, we will have the usual asset allocation summary out in the first part of January.

Read our Weekly Review for December 27, 2016.

Read the previous Question of the Week for November 28, 2016.

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