In the fourth quarter, the US presidential election results had a positive impact on equity markets. Investors anticipate a more business-friendly environment under the Trump administration, including looser regulation and lower taxes. In the short run, Trump’s policies are expected to boost corporate earnings from the recent low growth trend. Analyst are currently estimating 12% corporate earnings growth in each of the next two years. As the market assesses longer run risks, we may see more volatility in the market. Longer-term risks to be cautious of include inflation, global tariffs, and increased systemic leverage.
For some time now, market analysts and researchers have been warning that the benefit of international stock diversification was declining as asset returns increasingly moved together in our more globalized economy. The last three years have shown that international returns can still diverge sharply from US returns, however. The S&P 500 index of US large cap stocks returned 8.9% annualized over the past three years, while the EAFE index of international large cap stocks fell 1.6% annually over the same period (in USD terms). The past year and past quarter have extended this trend. Regardless of whether a comeback in international returns is now due, or whether the current trend has further to run, it is clear that the case for diversification reducing portfolio risk still stands.
The Global Economy
It has been a tale of two cities for the global economy for several years now. The US Federal Reserve has been seeking to accelerate rate increases as US GDP growth strengthens, unemployment falls, and inflation slowly begins to rise, but other central banks are still pursuing strong easing programs. In December, the European Central Bank extended its bond buying program, and the Bank of Japan continued to pin the target 10 year bond rate to zero as part of its monetary easing programs. Conversely, the US Federal Reserve pushed up rates by a quarter point in December and projected three more rate rises in 2017.
In the third quarter, the US economy expanded at an annualized rate of 3.5%, the highest in two years, which was a solid improvement from the weaker early 2016 readings of 0.8% in the first quarter and 1.4% in the second quarter. Fourth quarter GDP is generally expected to rise by a little under 3%, which would mean we had strong second half growth for the US. Global growth is expected to be somewhat weaker. Japan and the Euro Zone both posted only 0.3% annualized GDP growth for the third quarter.
The US expansion is well into its eighth year now, and there are some signs that we may soon be entering the late part of the economic cycle and job growth will likely decelerate as we approach full employment. Consumer confidence remains strong, however, and consumer spending continued to make the largest contribution to growth this year.
For the year, the S&P 500 index of US large cap stocks’ total return was 12.0%, while the EAFE index of international large cap stocks net total return was only 1.0%. For the fourth quarter, the S&P 500’s total return was 3.8% compared to the EAFE index net total return of 2.0%.
Small cap stocks outperformed in the fourth quarter, with the Russell 2000 outperforming the S&P 500 by 5.0% (8.8% vs. 3.8%). Small cap value stocks, in particular, performed extremely strongly with the Russell 2000 Value index posting a 14.1% quarterly total return and a 31.8% total return for the full year.
The US Federal Reserve finally raised rates at its December meeting, completing just one rate increase in 2016, compared to the four increases it had been projecting at the start of the year. Slower economic improvement and global concerns caused the Federal Reserve to pause in 2016. Looking ahead, the Fed currently looks poised to raise three times in 2017.
At year end, the US 10-year Treasury bond rate was 2.4%. The 10-year bond yield had jumped sharply from a July low of 1.3% leading up to and immediately following November’s election results, hitting as high as 2.6% in mid-December before falling back a bit. US government bonds continued to yield significantly more than peers such as Germany (0.2% at year end), and Japan (just above zero, at 0.04% as of the end of 2016).
Overall, commodities rose in the fourth quarter and for the full year 2016, with the S&P GSCI Index returning 5.8% in the fourth quarter and 11.4% for the year. Energy commodities rebounded from their sharp drop in late 2014 and 2015, with crude oil registering a 45% increase over the course of the year as OPEC agreed to cut production for the first time in eight years. The GSCI Energy Index overall returned 18.1% for the year. Other commodity returns were mixed, with strong annual returns for metals but negative returns in agriculture and livestock.
Overall, commodities have fallen sharply since 2008, and this year’s returns have done little to reduce the double-digit annualized declines we have seen since then. A substantial comeback will likely be linked with any future inflation in the US economy (see our recent paper titled “Inflation and the Case for Real Assets” for more on this).
US markets reacted positively to the outcome of the presidential elections, and investors seem to be expecting strong growth in corporate earnings partly driven by lower taxes and looser regulation despite ongoing growth challenges in many other developed countries. Smaller stocks, especially value stocks, benefitted the most following the election.
There are many risks that bear watching, however. Early 2017 should bring more insights into US fiscal policy, trade policy, regulatory policy, and tax policy, all of which will have a significant impact on the outlook for growth and inflation in the longer run. Maintaining a portfolio that is diversified in asset class, size, sector, geography, and sensitivity to inflation/deflation will be more important than ever as we enter a period of increased uncertainty.