US Market Viewpoints: Fourth Quarter 2016Submitted by Castlebar Asset Management on January 6th, 2017
The outcome of the US Election dominated the fourth quarter market performance. The results of the US election were the second big miss by polls and pundits in 2016, with BREXIT being the other. Stocks reacted favorably post-election with the S&P 500 adding 4.6% after the results. Small cap stocks were the big winner in the post-election rally, surging 13.5%. 2016 was an above average year for stock returns and the second longest bull market which continues to march on.
Besides the election, the other big market event was the Federal Reserve (Fed) raising interest rates by 0.25% in December. This was only the second time the Fed has raised rates since the financial crisis eight years ago. 2016 may also mark a generational low for interest rates. The US 10 year treasury bonds reached their lowest point of 1.37% in July. They ended the year at 2.55%. This caused bonds and preferred stocks to sell off in the second half of the year.
Financials, energy and industrial sectors were the strongest performers this quarter. Financials rallied 20.4% on the back of higher interest rates and the expectation of lower regulation under the Trump administration. Energy stocks rose 6.7% as OPEC nations agreed to cut their production of oil. This should bring some stability to oil prices in the near term. Industrial stocks rallied 6.6% in anticipation that better economic growth and potential uptick in infrastructure spending will help their bottom lines. Real estate (REITS), healthcare and consumer staples posted negative returns for the quarter. REITS fell 6.2% as higher interest rates impacted them in multiple ways. Given the increase in interest rates, investors demand for REITS dividends and distributions declined causing the sell off. Higher rates also impact some REITS profitability since they usually have more debt than other businesses. Healthcare stocks can’t seem to catch a break. A Clinton presidency was thought to be bad for healthcare stocks but it seems that investors think the Trump administration will not be positive for them either. Expected changes to Obamacare and pressure on drug pricing caused shares to sell off 4.4%. Consumer staples declined 2.8% over concerns about their valuation.
We remain positive on stocks in the near term (next 12 months). Investors are optimistic after the election results. The thoughts that lower individual and corporate taxes, less regulation and a large infrastructure spending initiative should be a net positive for businesses and stocks. There is one tax policy which could have a direct impact on stocks in the near term. US companies who earn profits overseas are not taxed on those profits in the US unless they return that cash to the US. Currently, the tax rates are 39% to repatriate that money and there are proposals which would reduce the tax temporarily to a substantially lower level. Companies are expected to take advantage of this opportunity. We expect to see an increase in share buy backs, special dividends and acquisitions if this reparation tax plan comes to fruition.
Fundamentals for stocks remains good, but not great. Economic growth is expected to be between 2.2% and 2.5% in 2017. This is by no means robust and about the same pace we have averaged during this economic recovery. The S&P 500 is trading at a forward P/E of 17. This is above average, but puts us in the fair to full value status we have been trading in for the past 2 years. Corporate earnings are expected to grow in the low teens in 2017. This is by far the most positive thing going for stocks.
While we are positive we do have some concerns. Stocks and investors are pricing in a high probability that the changes the Trump Administration would like to make are going to happen quickly. The political process is slow and grinding. There will likely be some quick wins but many of the big promises will take time and many will not pass. If some of the changes are not passed or the political process takes longer than expected it could derail the Trump rally.
The Fed is expected to increase interest rates several times in 2017. This is overdue since we have had emergency monetary policy in place for over 8 years. The market is pricing in the moves but what matters more to investors is the timing of the moves. If the Fed moves in consecutive meetings this is typically bad for stocks. History shows that average returns are negative in this environment. In cases where the Fed slowly raised rates or took a pause between meeting, stocks posted above average rates of return. The later is the setup we are expecting to play out.
You can read our 2016 Third Quarter US Market Viewpoints here.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.