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Alan McKnight, MBA, CFP®
January 17, 2017
The year 2016 started out tough for investors and brought with it many surprises. Looking only at the year’s final numbers, one may never have never known how much of a bumpy ride it was for both equity and bond investors. During the 4th quarter, stocks surged, extending the bull market that is now almost eight years old. The election of Donald Trump had investors thinking about lower taxes, less regulation, pro-business initiatives, and what could be a very bumpy ride while unwinding many of the Obama administration’s policies.
Since the November 8th election, the stock and bond markets have had large moves. The stock market finished strong after November and December post-election results drove the indices higher. Some analysts suspect that the late gains in 2016 were so strong that they may have eaten into some expected equity gains for 2017; stocks may have gotten a little head of themselves.
The Dow may have not hit the magical 20,000 mark, but it closed out the year at 19,762.60 on December 30th with a gain of 13.42%. The S&P 500 closed out the year at 2,238.83, up 9.54% while the NASDAQ closed at 5,383.12 for a gain of 7.5%. Small cap stocks were scorching hot with the Russell 2000 closing at 1,357.13, up 19.48%. The Global Dow closed at 2,528.21 and was up 8.21%.
At the December meeting, the Fed finally raised short-term interest rates again by 0.25%, lifting the Federal Funds rate to 0.50% - 0.75%. The 10-year Treasury ended 2016 with a yield of 2.44%. The 30-year Treasury closed out 2016 with a yield of 3.06%. In 2015, they closed with yields of 2.26% and 3.01% respectively.
An Overview of 2016
The year certainly proved the prognosticators wrong. In 2015, the Fed forecasted four rate hikes for 2016, but they pulled the trigger on one only. Early in the year, that forecast, along with other economic factors including a plunge in oil prices, caused equity markets to have one of the worst starts on record.
When oil hit a low of $26.21 a barrel in February, many analysts forecasted potential mass oil company bankruptcies and a possible recession, neither of which came true.
The next big miss of 2016 came when all the major polls showed that the United Kingdom was probably going to remain in the European Union when the actual vote was to leave. This event, known as “BREXIT,” caused the markets to plunge. After a sharp two day drop, the markets recovered quickly.
Perhaps the biggest prediction gone wrong was when most polls predicted a victory for Hillary Clinton, but Donald Trump was elected President of the United States instead. Many felt this would cause the markets to sell off, but instead, markets surged after some very brief negative volatility immediately following the election results.
Despite all the forecasts of doom and gloom in 2016, equity markets ended the year with solid gains. By year-end, the S&P 500 was up 9.5%, mostly due to the post-election hopes that included a loosening in regulations and tax cuts. The lesson here is that accurately predicting market movements and political outcomes is very difficult if not impossible.
Interest Rates Global and Domestic
Over the past few years, the markets have been obsessed with interest rates, and 2016 was no different. The Fed’s 0.25% rate hike in December of 2015 was followed by only one 0.25% increase in December of 2016.
Central bankers' ongoing ability to consider and offer negative interest rates was a central story in 2016. It began in June of 2014, when the European Central Bank (ECB) first offered negative interest rates at -0.10%.
Rather than demanding that the central bank pay interest to borrow its money, banks now had to pay the central bank to lend it money. Over time, the ECB reduced rates even further into negative territory. By March 2016, deposit rates were as low as -0.40%.
Negative rates grew widespread in Europe and also surfaced in Germany, Denmark, Sweden, and Switzerland. In fact, Switzerland held a target rate of -0.75% for most of 2016. Following this trend, the Bank of Japan began charging interest to deposit funds at a rate of -0.10% in January 2016 and continued that trend throughout the year.
Many 10-year government bonds also saw low rates in 2016. Germany's 10-year government bond opened the year yielding 0.63%, falling steadily to a low of -0.19% by July. Rates then rallied and finished the year in the positive column at about 0.36%.
Japan’s 10-year government bonds followed a similar path. Starting 2016 at 0.26%, they dipped to a low of -0.29% by mid-year, only to recover to 0.09% by year-end.
In Switzerland, the 10-year government bond yield actually started the year at -0.06% and fell to a low of -0.63%. In the wake of Donald Trump's victory in early November, this rate rebounded with year-end yields at approximately -0.07%, leaving rates in Switzerland essentially where they started.
After the election, the bond and stock markets ended 2016 moving in opposite directions. Stock prices moved up and bond prices fell as yields increased. So the central question here is: Will the central banks be able to keep markets stable as the Fed tries to lift rates?
The underlying strength of the labor market and the steady improvement in the economy have led the Fed to forecast several interest rate hikes for 2017. Interest rates hit a low of 1.36% for a 10-year Treasury in July of 2016 and increased to over 2.4% by year-end. In December of 2016, the Fed’s “dot plot” showed the central bank penciled in three rate hikes in 2017 instead of two under its prior forecast.
Although Chairwoman Janet Yellen called the shift “very tiny,” she acknowledged that Fed officials took President Trump’s economic plan into account when making this new forecast. Still, she suggested that higher inflation and a lower unemployment rate than the Fed had expected were bigger factors in the change. What’s more, she stressed the Fed would take a wait-and-see approach for now since the outlines of Trump’s plans were not finalized. “I wouldn’t want to speculate until I were more certain of the details and how they would affect the likely course of the economy,” she said.
According to Forbes, these projections are not a firm commitment, and most likely, they will hike rates another quarter point in early 2017. The thought is it will occur at their March meeting or possibly even at the January meeting. They forecast that further interest rate hikes are unlikely because after March some disquieting news will come out about business capital spending.
David Payne, Staff Economist at Kiplinger’s Magazine, feels that, “despite the Fed’s expectation of three rate hikes, figure on just two in 2017 because economic growth won’t be strong enough to warrant a faster rise in interest rates. The fiscal stimulus effects of President Donald Trump’s proposed tax cuts will be mostly pushed into 2018, while the high value of the U.S. dollar and rising long-term interest rates will weigh on the economy in 2017.”
Most diversified portfolios usually have exposure to bonds or interest rate-sensitive investments. Even in a rising rate environment, interest rate-sensitive investments could play a role in most portfolios. Many times, they offer investors the potential to possibly offset losses in the event of a stock sell off. Even so, investors should monitor their bond and yield sensitive exposures in 2017 because rising rates can cause bonds to experience a short-term price loss.
Even with a rate increase, the bad news for savers is that there still isn’t a lot of yield to be found, at least not from investments that are safe enough to be considered as an equivalent to cash.
We will continue to monitor interest rates and how they affect markets as we head into 2017.
Outlook for 2017
Due in large part to recent gains, investors need to be watchful of the current valuations of equities. As of January 13, 2017, the S&P 500 was trading at 24.97 times trailing 12 months earning and 17.55 times forward 12 months earnings. Based on historical statistics, this is considered high, but not ridiculous. Recent corporate earnings have shown slight growth after a year of shrinking, and energy stocks are still not near their all-time highs. FactSet tallied estimates for earnings growth of 12% in 2017, but some analysts are less optimistic. Investors have been riding this bull market for eight years, and while the ride may not end, they should stay vigilant.
China and Europe are still facing many obstacles as we head into 2017, and we need to keep an eye on a possible global recession.
China's main challenge is making the shift from an export/manufacturing economy to a consumption/services economy. Right now, the biggest problem is the weak yuan. Chinese investors are scrambling to convert their cash into dollars and move it out of the country, gradually weakening the treasury of funds needed to make the transition to a more mature consumption-based economy.
In Europe, there are a slew of elections due to take place in 2017. There is also the potential for bank failures in Italy, Europe's third largest economy. This could be problematic for Europe and could possibly disrupt global markets. Any major global crisis will only add to uncertainty and investors know that the equity markets do not like uncertainty.
Even as I am writing this, British Prime Minister, Theresa May, is speaking and wants to leave “The Single Market” and accelerate the BREXIT. This may rile the markets as the process was expected to take a bit longer.
Some Thoughts as We Head Into 2017
Heading into 2017, many investors are concerned. The year kicks off with a new president, higher rates, stocks at all-time highs and new risks as well as opportunities. In their 2017 Outlook, Goldman Sachs predicts that, “while we recommend clients remain invested, we have modest return expectations. We expect that a moderate-risk well diversified taxable portfolio will have a return of about 3% in 2017.”
Russel Kinnel from Morningstar.com cautions that, “With transitions in the White House, Fed policy, and the inflation outlook, it feels particularly precarious to make predictions. On the plus side, investors have enjoyed tremendous gains in recent years as equities have had one of their all-time great runs, especially in the United States. In addition, unemployment and inflation are low.” He adds that, “given the cyclical nature of markets, the chances for a bear market grow the longer a rally lasts. There are signs that inflation is on the rise, and the Federal Reserve has acted accordingly. It raised rates in December and signaled it expects to raise them three more times in 2017. That doesn’t mean that markets or the economy will hit the brakes, but it could signal more sobriety in the markets. The bond market has noticed the potential for even more inflation and rates are rising.” His advice is that, “the best response to uncertainty is diversification.”I agree!
A USA Today review of predictions from 15 Wall Street strategists finds that America's fortunes won't add up to big stock market gains in 2017. They report that the group’s average year-end 2017 price target for the S&P 500 should produce a gain of approximately 4.5%. One prognosticator sees the S&P 500 gaining more than 10% next year, on top of the gain it has posted in 2016. Not one of the 15 strategists sees the stock market posting losses next year. The lowest 2017 year-end price target of 2300 equates to a gain of less than 2%.
John Velis, Vice President of Global Macro Strategy for State Street Global Markets warns investors that in 2017, caution is warranted because markets are betting big on the best possible developments in fundamentals. He feels that at this time it’s unclear what form the new president’s policies will take and how much his policies will be accepted by Congress. He also maintains that investors need to beware of analogies between 1981 and 2017 when stocks took off under Ronald Reagan. In 1981, interest rates were historically high and set to fall for several decades. The opposite is true now. Also, stock market valuations were orders of magnitude cheaper than they are now, too.
Michael Sonnenfeldt, the Founder and Chairman of TIGER 21 feels the only certainty in 2017 is uncertainty. He shares in Forbes that, “perhaps the biggest lesson of 2016, one which certainly carries over into 2017, is that there is no safety in safety. The traditional assets investors sought refuge in for predictable cash flow, dividends or distributions have all been bid up to the point where their returns are no longer considered as attractive or safe.”
Still, the fact remains that in a low-interest rate environment, if you are trying to stay “even” by sitting on the sidelines and not making any investments, you are probably going backward on an after-tax, inflation-adjusted basis.
Sadly, safety comes with a big price. According to Deposit Accounts January charts, the rates on 1-year certificates of deposit (CD’s) were 0.50%. Investors’ portfolios do not grow fast when they concentrate on interest rates of less than 1%. Albeit “safe”, CD’s paying 1% will certainly help savers grow poor slowly over time. This is not a good thing!
So for 2017, investors need to be prepared. Market volatility should be a concern, but panic is not a plan. Market downturns do happen and are part of the natural market cycle, but recoveries occur as well. This is the ideal time to ensure that you fully understand your time horizons, goals and risk tolerances. Looking at your entire picture can be a helpful exercise in determining your strategy.
As experienced financial advisors, part of our job is to help make your life simpler and easier. Our goal is to understand our clients’ needs and then try to create a plan to address those needs. We continually monitor our clients’ portfolios. While we cannot control financial markets or interest rates, we keep a watchful eye on them. No one can predict the future with complete accuracy, so we keep the lines of communication open with our clients. Our primary objective is to take the emotions out of investing for our clients. We can discuss your specific situation at your next review meeting, or you can call to schedule an appointment. As always, we appreciate the opportunity to assist you in addressing your financial matters.
If it has been more than a year since your last financial review, please give Jan Berkholtz a call at our office to schedule an appointment so we can make sure everything is in order. If you feel the need to discuss your situation before our next scheduled review, please call our office at (770) 951-9001 or e-mail me at email@example.com,
Alan McKnight, MBA, CFP® is Vice President of Kays Financial Advisory Corporation. He has over 20 years of experience working with retirees and pre-retirees. He is an Adjunct Faculty Member and Professor of Finance and is an Ed Slott Master Elite IRA Advisor. Currently he is a doctoral candidate, and his area of research interests include: Investments, Securities Analysis, Behavioral Finance, Asset Allocation and Risk Management. He can be reached at (770) 951-9001 or at firstname.lastname@example.org.
This report and Mr. McKnight’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any company and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned herein.
Sources: Fidelity.com, Wall Street Journal, Barron’s, Forbes.com, Goldman Sachs 2017 Outlook, Seeking Alpha, Kiplinger’s, Marketwatch, USAToday.com, Forbes, Depositaccounts.com, Morningstar.com, Reuters; APFA, Forefield.com, BBC.com.