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Question of the Week - December 28, 2015

Question of the Week - December 28, 2015

Guest Post - Monday, December 28, 2015

2016 (Part 2): How is the investment environment shaping up?

Now that we have the Fed policy move out of the way, talk has shifted to what's next. As usual, the year-end holiday season encompasses optimistic hopes and dreams for the coming year.

Fixed income. Bondholders are focused on the quantity and timing of Fed rate movements. Through futures markets, market participants have assumed 2 x 0.25%, so 0.50% worth of increases in 2016, while the Fed 'dot plot' (which shows expected ending rate levels at various time periods) assumes 4 x 0.25%, or 1.00% over the next year. Certainty a difference of opinion, much of which will be dependent on economic and inflation data during the year. It's important to note other components that can affect bond returns as well. Fed funds rates affect the shortest part of the yield curve, so T-Bills, CD's, etc., so rates there will rise based on timing and magnitude of Fed action. Longer-term rates, such as the bellwether 10-year Treasury are more affected by inflation expectations, and more recently, by Fed QE purchases (which have kept rates dampened). If the Fed begins to eventually unwind their massive portfolio of Treasury holdings, as is expected eventually, pressure could mount on longer-term rates. Naturally, the Fed is careful about not wanting to disrupt markets pegged to longer-term Treasuries, such as corporate lending, auto loans and home mortgages. So, the yield curve could see some flattening, but it's important to remember that due to much higher duration, small changes in yield can affect pricing for long bonds much more significantly than larger yield changes in shorter bonds. This takes us to potential returns—a good gauge of multi-year forward looking bond total return is your starting yield—and these are low across the board. This environment, as well as recent dislocations in areas like high yield debt due to the energy component, make segments such as credit attractive, where incremental returns could contribute in relative terms. U.S. equities. We've discussed before how higher rates doesn't have to mean disaster for stocks. Intuitively, higher rates mean an economy that is growing, and that typically translates to positive earnings growth—necessary for stock fundamentals. While stocks are a bit expensive relative to history based on certain price ratios, they're fairly valued based on dividend discount modeling. While valuations aren't as attractive as they were in recent years, this doesn't necessarily indicate a risk bubble, either. If earnings recover/grow at an acceptable rate, and stock prices move upward in line with that growth, positive total returns can result while price ratios don't change all that much. This isn't a bad outcome, and looks relatively attractive compared to potential for other asset classes like bonds. Foreign equities. Non-U.S. stocks suffered in relative terms due to slow growth abroad and a strong U.S. dollar in recent years, but as quantitative easing efforts persist in Europe and Japan, and valuations are discounted due to these economic growth uncertainties, stocks could experience a positive boost if growth improves. Emerging market equities are among the cheapest assets available—having struggled due to commodity price declines and worries about China as well as the impact of Fed action. However, overall growth in these nations continues to surpass that of the developed world. These are markets too large to ignore, and investors have largely given up on the entire group—we know these types of sentiments create value opportunities. Real estate. Over time, real estate investment trust returns should loosely match those for underlying real estate hard assets. Those prices are dependent on economic conditions for inputs such as tenant demand, while they can be undermined when business cycles reach extremes, which can result in exuberance, overbuilding, etc. Right now, tenant demand has been strong, while supply activity has been kept tempered, perhaps in conservative reaction to the past cycle. While short-term factors such as interest rate path uncertainty can increase volatility for all types of real estate, which has resulted in attractive discounted valuations, fundamental conditions are quite good. Commodities. While some view this asset class as the bane of the portfolio's existence over the past several years, much of the performance is directly explainable by what has worked in other assets. By the nature of the commodities group and long-term lack of correlation to other assets, we should expect that it will not track the return pattern of other asset classes, nor would we want it to. Overall, we can narrow down recent conditions to a few key points: (1) oil prices, which plummeted due to a supply glut (part of the insurance value of commodities has been to protect against supply shocks, such as seen in the 1970's, which can be disastrous for other assets like stocks); (2) a strong U.S. dollar, which has been the result of a stronger recovery at home relative to many other developed nations like Japan and Europe; (3) favorable harvest conditions and/or lack of formidable weather (drought, etc.) which can ruin crops, and drive up supplies/prices; and (4) lack of geopolitical turmoil, which can affect safe-haven real assets like gold and other precious metals. So, it's been a perfect storm due to 'lack of bad things'. Should any of this change, commodity returns may experience some positivity, as sentiment is extremely low. One element this winter appears to be a developing El Niño weather pattern, that could cause northern states to be warmer than normal (reducing the need for heating fuel) and wetter in the southern U.S., which could have crop effects. All-in-all, expectations for 2016 are tempered, but no doubt tempered sentiment is actually a much better starting place than exuberance. If any current issues are resolved, we could even see a few positive surprises.

Read our Weekly Review for December 28, 2015.

Read the previous Question of the Week for December 21, 2015.

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