This is the time of year when traders, portfolio managers, and economists all weigh in with their views and predictions. It is a time for reviewing the past to look for clues about what may come next. 2016 was a year full of surprises that none of us saw coming and 2017 will bring us more.
The coming year holds both optimism and uncertainty. Politics, culture, and economics all impact our hopes and dreams for the future. It is an exciting time, but many of the rules and maxims that analysts have found useful in the past may not work as well in the future. We thought it would be useful to examine what we see and wade in with our own view.
The Financial Crisis of 2008 wiped out retirement savings, devastated real estate values, and cost many people their jobs. Several banks failed and for a brief time it looked like there would be a full-scale collapse. It was a dark time for many, but things turned around.
The road back during the last 8 years has not always been even and steady. But once underway, the recovery gained momentum, and for a few years, it looked like markets could only go up. We had strong stock market returns, particularly from 2012 to 2014, and employment, house prices, and retirement accounts all bounced back.
But during 2015 and early 2016 there was a shift, and some economic indicators showed red flags. We had reached a trough in the economy and the recovery stalled. Investors moved to recession-watch and stock markets experienced several corrections, with the most severe in January 2016. Doom and gloom predictions were everywhere.
Momentum returned in June as U.S. economic measures showed improvement. Investors re-focused on the fundamental strength in the economy. Consumer sentiment improved, higher employment and increased wages all contributed to a shift in mood. Corporate profits leveled and productivity improvements began to have an effect.
Today the warnings of recession in Europe and Japan appear to be softening. Concerns that China’s slowdown may result in an Asian economic crisis are softening and many now believe China may have turned the corner.
While all of this is good, it helps to have some perspective. Economies are cyclical, and we are past the early growth stage. The 8 year recovery cycle is maturing, and while there will be growth; it will be selective across sectors of the economy and geographies of the world.
The economist Sir John Templeton once talked about markets growing on pessimism, maturing on optimism, and ending on euphoria. Since 2008 we have had several years of pessimistic growth. More recently we have seen an optimistic shift, even as the recent election left some in our country shocked and scared about what will come next, this market optimism is a maturing development. We are definitely not at a stage of euphoria.
2013 and 2014 delivered incredible returns to investors and markets reached an All-Time High in early 2015. But momentum stalled . . . and the market stumbled. The picture below shows the three-year period from late 2013 to late 2016. During this time the S&P 500 was bracketed within a Consolidation Box, or range, and within the box you can see the severe corrections in October of 2014 and the summer of 2015 and February 2016. The last of these corrections found lows a full 15% below the All-Time-Highs logged in May 2015.
The important thing in this picture is the breakout of the S&P 500 from the box in July 2016 just prior to the US presidential election. Since the election we have seen a strong market rally into the end of the year.
Research by Ciovacco Capital indicates that this kind of breakout activity can be the precursor of a new trend. Periods like the last three years are not unusual, and a common pattern as the market exits these flat periods is to briefly breakout and return. This breakout often is an indicator of the next long-term trend.
Below is a chart showing another Consolidation Box in the 1990’s that occurred over a similar time frame. You can notice the breakout at the end of this Consolidation Box, which signaled a significant upward trend for the next year. There are several examples of periods that lasted more than a year “in the box” which ended a sideways trend and the beginning of another long trend to follow.
During the summer of 2016 we witnessed a significant event in the history of the Bond market as the value of bonds moved higher than ever before.
The price buyers are willing to pay for a bond… a US treasury bond, a corporate bond, or a municipal bond is inversely related to interest rates. As interest rates go down, the value of bonds goes up and vice-versa.
During the last year, we have seen the lowest interest rates in the U.S. in 70 years, and accordingly, we have probably seen bonds and bond funds reach their peak in value.
When U.S. interest rates reached a new low, many foreign sovereign bonds went even further, moving to negative interest rates. Foreign central banks, hoping to pull their economies out of recession, encouraged this unusual situation. Investors in Europe paid for the privilege of owning a bond rather than receiving interest – not at all the way lending usually works. This irrational extreme situation in July 2016 will probably mark the low in the interest-rate cycle for some time.
This behavior in the bond market is a departure from the experience of most investors. For the last 30 years we have, for the most part, only seen interest rates go downward causing bonds and bond funds to be worth more year after year. We have been conditioned to view bonds as the safe and solid part of an investment portfolio while stocks were seen as risky.
In a world where interest rates go up, holding bonds or bond funds comes with risk. A 1% increase in interest rates can cause bond funds to decline in value by 8%-20%. The loss can be equivalent to 3-6 years of lost interest.
The yield on the10-year bond bottomed at 1.37% in July, today it is about 2.4%. Historically, interest rates average between 3.5% and 4.5%... so increases in interest rates to more normal levels could bring significant losses to bonds.
Bond funds are no longer safe and secure, but can be risky. This includes any fund that holds bonds, including Target Date funds, bond funds, income funds, growth and income funds, and balanced funds.
This shift will take some time to play out and interest rates will not rise in a steady controlled way. There will be ups and downs, and it will take some time to play out…we may even see interest rates at the July lows again before bouncing higher. But the trend will shift and the value of bonds and bond funds will decline over time.
We believe that the classic 60 / 40 split between stocks and bonds found in most portfolios is not going to perform like it did during the past 30 years. The world is changing and how we manage portfolios for income will need to change too.
The stock market was up just 3% going into the presidential election. Gains during the prior two years were about the same— up 3% over 24 months but the surprising post election rally helped the market higher, up 7% from the election into year-end.
The Fed should remain on track to slowly normalize interest rates. Unless stock market volatility forces the central bank to lose its nerve, we expect the Fed to stick with its plan to gradually increase rates, even if “gradual” takes longer than a few quarters. It is important to get the economy back to a normal situation in lending rates. We are seeing the Fed recede into the background as new Trump policies and fundamental economic news become more important to investors, another change.
The Trump administration begins with an ambitious agenda, including tax cuts, regulation rollbacks and the repeal of Obamacare. While Donald Trump ran on a Conservative Republican ticket, his policies will not always be consistently conservative. He is a populist and a pragmatic. Decisions will be made on a case-by-case basis according to what the new administration deems to be best suited to the political situation and the economic health of United States. This will be an administration with a US-centric global view, and rather than a rigid set of policy maxims we believe the Trump White House will remain flexible and somewhat unpredictable.
We have already seen how Trump’s campaign rhetoric can play differently after the election. Threats to deport large numbers of illegal immigrants and enact draconian security policies will go the way of reticence to pursue Secretary Clinton for alleged misdeeds. Pragmatism will win out over policy. Populism will win out over conservatism.
As the Trump presidency shapes the markets, financial firms should benefit, as will telecoms and IT. Healthcare investing will be difficult with the repeal of Obamacare and focus on insurance and consumer costs, which have risen dramatically in the last 3 years. We will see sectors roll in and out of favor depending on shifting political developments throughout the year.
Above all, there will be volatility. “Trump’s Tweets” will continue to occupy the headlines and create surprises for everyone. The financial markets will react and over-react to each of these events, and it will be a challenge to hold on to positions for longer periods of time. Fundamental economics and company profitability will re-emerge as the basic investing tools.
Expect the dollar to be strong throughout 2017, with multiple Fed interest rate hikes, making dollar-denominated assets attractive and bonds risky. Most of the rest of the world’s economies appear to be in varying stages of recovery cycles, but Europe is still having difficulty, as this past summer’s experiment in negative interest rates highlighted.
The oil rally of the last few months will hold at current levels, with prices fluctuating between the high $40’s and $60. This will be good for the economy, providing historically inexpensive energy, but still sufficient incentive for new domestic production, and decreasing US dependance on global supply. Stronger energy prices will also support global commodity markets, though the strong dollar will temper outsize gains abroad.
Elections this year in France and Germany may bring continued pressure on the European Union as a monetary bloc, as will Italy’s continuing political and banking crisis. Britain will emerge from Brexit in a strong position as broker to the rest of Europe, while avoiding European regulatory costs and financial entanglements.
Trade agreements worldwide will come under pressure as the US seeks to renegotiate free trade in favor of US job protection. Immigration will be a key security issue, and while keeping jobs at home may seem like a populist idea, protectionism can easily create trade barriers that inflict inflation and import taxes.
For investors, this is the time to focus on selective opportunities while waiting for the trend to clarify. Patience is always the best investment.
God bless you,
Ed & Branson
At Calyx, we help families protect and manage their financial resources. We are a financial advisor and investment manager that partners with our clients to administer their financial affairs with personal attention and active risk management.
Calyx is also an advisor to several not-for-profit charitable trusts and endowments, working with committees of faith based organizations to preserve their legacy while providing operating income. We are sensitive to the investment needs of these clients while working within the guidelines they have established to reflect their principles.