First Quarter 2017

The Year of the Improbable

In his 2007 book titled, The Black Swan, former Wall Street trader Nassim Taleb termed a black swan “an event or occurrence that is extremely difficult to predict and is random and unexpected.”  In our view, 2016 was a year of black swans.  Internationally, the UK departed the European Union (“Brexit”).  In the sports world, the Chicago Cubs won their first World Series in 108 years.  At home, Donald Trump became the 45th President of the United States, winning the electoral vote but not the popular vote.  Although it was a roller coaster ride, the financial markets performed well.

 

Benchmarks

 

12/31/2015

 

12/31/2016

 

% Change

Dow Jones Industrial Average (DJIA)

17,425.03

19,762.60

↑ 13.4%

Standard & Poor’s 500 Index (SPX)

2,043.94

2,238.83

↑ 9.5%

NASDAQ Composite Index  (COMP)

5,007.41

5,383.12

↑ 7.5%

Russell 2000 Index (RUT)

1,135.89

1,357.13

↑ 19.5%

Federal Funds

0.25%

0.50%

↑ 100.0%

10Y US Treasury Bond

2.27%

2.45%

↑ 7.9%

30Y US Treasury Bond

3.01%

3.06%

↑ 1.7%

London Gold PM

1,062.25

1,145.80

↑ 7.9%


Remember, when bonds prices rise, yields fall and vice versa.

2017 Outlook

As we look at 2017, our outlook centers around the Trump presidency and its effects on the markets.  Republican-dominated executive and legislative branches suggest a traditional pro-business growth platform, which appears to be the case.  Further, early indications are that Trump is far more willing to use fiscal policy to drive growth, pledging higher defense and infrastructure spending with lower taxes and regulation.  Discussions of funding costs aside, such fiscal levers typically are the drivers of economic growth.  Given the post-election stock market surge, it is reasonable to assume some of this has been discounted, especially in those sectors that would most benefit from infrastructure spending and reflation (energy) and deregulation (financials).

Conversely, pulling these fiscal levers may lead to inflationary pressures and cause the economy to overheat.  The Fed appears concerned about both, given its December rate hike and telegraphing of more hikes in 2017.  Some Fed watchers suggest the Fed is getting ahead of itself since much of the recent market movement is driven by Trump rhetoric.  However, many leading indicators of inflation – wages, core services, shelter costs, and energy prices – have been rising since last summer.  For students of history or those with long memories, putting the inflation “genie back in the bottle” is far more difficult than not letting it out in the first place.  We believe slow and steady increases are justified.

Equity Outlook

In 2017 and beyond, we see two offsetting measures driving stock performance.  First, the proposed fiscal stimulus is typically good for the economy and stocks.  That, combined with low growth concerns around the rest of the world, suggests U.S. stocks are on strong footing.  However, given Trump’s protectionist rants and antagonist nature, we expect to see greater volatility going forward.  Putting it all together, the proposed fiscal stimulus should drive stock prices up, but the variability around that movement will increase.

Stocks appear slightly over-valued with the S&P 500 selling at 17 times estimated earnings, compared to a 10-year average of 15 times.  Given strong fiscal policy and an improving economy, this is expected.  As always, we are investing for the long haul, focusing on high quality companies that can sustain their business models through a business cycle.

Fixed Income Outlook

As noted above, the Fed increased rates in December and telegraphed more to come in 2017.  Generally speaking, this does not bode well for bond prices, especially those of longer-term and lower quality.  To offset this, we are buying a laddered portfolio of short-term bonds and holding them to maturity.  In effect, this neutralizes any underlying price movement and allows us to reinvest proceeds at progressively higher rates as they emerge. 

Summary

If the events of 2016 taught us anything, it is that the future is unpredictable and black swans do exist.  However, going into 2017, there are three predictions we believe we can make with a high degree of confidence.  First, the new administration is willing to greater leverage fiscal policy to drive growth, and this bodes well for the economy and stock market.  Second, for years, the Fed has used monetary policy to drive employment to low rates.  Now, the Fed will be using it to manage inflation.  Third, presidential rhetoric will increase the volatility of the stock and bond markets.  Tying these points together, we expect stocks to perform well, bond yields to rise (and their prices to fall), and greater volatility in all financial markets.  Lastly, given the future is unpredictable, we continue recommending a well-diversified portfolio as a means of mitigating risk.  

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