2016: Learning to Expect (and Accept) the Unexpected
When this year began, it seemed as though markets had priced in, with a good deal of certainty, a continuation of the status quo. Since the second half of 2014, the global economy appeared to be on autopilot: slowing Chinese growth had reduced demand for commodities globally, leading to a rout in oil prices and sustained weakness in emerging markets. In the developed world, Japan and the Eurozone continued to attempt to stimulate growth and stave off deflation through central bank policy. The U.S., at least on a relative basis, continued to see improving economic fundamentals and began to tighten policy. Amidst these various factors at play, there was a marked return to volatility in markets, as central bank support began to dissipate and engines of growth became less clear. The theme of “divergence”, so dominant in discussions of 2015, appeared due for an encore as 2016 began.
In the early months of the year, equity markets were yet again roiled by fears over Chinese growth, as a number of new data points suggested that conditions in the world’s second largest economy were indeed deteriorating. Investors were also concerned about falling oil prices and their potential impact on the U.S. economy. Taken together, these circumstances led to a decidedly risk-off environment for the beginning of the year. However, markets made a rapid recovery in the midst of market intervention by the Chinese government, as well as an improvement in both U.S. economic data and oil prices as the first quarter progressed.
Equities were also propped up by the reaction of central banks to this tumult. At the end of January, the Bank of Japan surprised investors with the announcement of a negative rate regime, following in the footsteps of several European central banks in using this unconventional policy. The ECB, having already had negative rates in place for a year and a half, doubled down on this position in March, pushing rates further down and expanding asset purchases. Even the Federal Reserve, the most hawkish of the major central banks, pointed to “global economic and financial developments” early on this year as reason to stand pat for the time being.
With this chaotic start to the year in the rearview mirror, markets seemed poised to take on a calmer pace. Economic data was strong enough to assuage any remaining fears about the U.S., but not so strong as to imply action by the Federal Reserve was imminent. Oil prices continued to rise, suggesting the beginning of a recovery in the energy sector, but not one that was going to change market dynamics any time soon. Corporate earnings, though rather lackluster, were by no means weak enough to scare investors away. However, this middling performance did not last long, with volatility returning amidst speculation over the UK’s future in the European Union.
Though the UK’s referendum on EU membership had been on the calendar for some time, few paid it any mind until the month leading up to it. Suddenly, it seemed as though this vote was the only thing anyone was paying any attention to. Yet the more it was discussed, the more ridiculous this so-called “Brexit” seemed. Markets were certainly spooked by the potential political and economic consequences this could have, but were pacified by the consensus view that pointed towards a victory for the “Remain” camp. Ultimately, this move seemed to be a more symbolic event than anything else, a concession by the Cameron government to the Eurosceptic elements of the Conservative Party and one which would end with the predicted outcome.
However, the world awoke to a very different result the morning after the referendum, learning that the UK had voted to leave the European Union. Markets around the world plunged as investors reacted to this unexpected development. Naturally, UK risk assets were hit particularly hard, and concerns over the future of British economy sent the pound sterling to multi-decade lows. In wake of the vote, the UK government saw changes as well, with David Cameron resigning from his position as Prime Minister, replaced in July by Theresa May. Intense as these reactions were, the truth of the matter is that it will take some time for the true consequences of this referendum to come to light. Britain’s departure from the EU could potentially take years to complete, and the actual terms remain unknown.
Interestingly, markets recovered almost as quickly as they had fallen, with the Brexit vote giving central banks plenty of reason to stick to the “lower for longer” mantra. As the summer progressed, this helped dampen volatility and lead to impressive performance in equity markets both developed and emerging. Though the summer months tend to be quiet ones for investors, this lull was quite pronounced, making the market’s ascent that much easier.
This reverie was broken to an extent as election season in the U.S. got into full swing in September, an unsurprising development given the rhetoric coming from both sides. Whether it was calls for increased taxation, protectionist policies or new regulations on business or migration, both major candidates sought to appeal to the growing populist sentiment not only in America, but throughout the West. Though the Brexit vote may have been the opener, the U.S. Presidential Election was the main event in a showcase of discontented citizens this year. Angry over the unevenly divided gains of globalization, and the rapid pace of technology and trade that has left so many behind, it was clear that regardless of who won the White House these issues were going to need to be addressed. That being said, it seemed that a Clinton win was in many ways seen as a foregone conclusion by most, with markets priced as such as we headed closer to Election Day.
However, much like the Brexit vote, the U.S. elections proved a total departure from consensus expectations as Donald Trump was elected president, and the Republican Party retained control of Congress. Yet unlike Brexit, the market reaction to this surprise outcome was nowhere near as turbulent. As a matter of fact, U.S. equities rallied in wake of the news, given that many believe the incoming administration will increase infrastructure spending and reduce taxation and regulations. With higher expectations for both growth and inflation, interest rates rose as well, while corporate bonds saw spreads tighten, especially in more cyclical industries. While many continue to debate whether this post-election rally was overdone, with the President-elect not even in the White House, we believe it is far too early to say.
As we moved into December, increased expectations for growth and inflation combined with a continued stream of solid economic data led the Federal Reserve to raise rates by 25 basis points. Widely anticipated by most investors, this first and only rate hike of the year had little impact on the markets. Yet the Fed’s projections for 2017 did prove quite interesting against the post-election backdrop, with expectations for a slightly faster than anticipated pace of monetary tightening for the coming year. While this makes sense given the environment, many were surprised by the extent to which the central bank’s statements became so decidedly hawkish.
Elsewhere, we saw yet another victory for populist movements, this time in Italy. Though technically a vote on whether to implement parliamentary reforms, it unofficially became a referendum on Matteo Renzi and establishment politics in Italy. With voters coming out overwhelmingly against Mr. Renzi’s proposed reforms, the Italian Prime Minister ultimately chose to step down following the referendum. Though this series of events was not as dramatic as the Brexit vote or the U.S. elections, it did signal that populist, Eurosceptic causes and candidates are likely to continue to gain mainstream support on the Continent.
For all of 2016’s major surprises, perhaps the largest of them all was the performance of equity markets, particularly in the US. The S&P 500 finished up an impressive 12.0% for the year, in spite of a great deal of volatility spurred by events both at home and abroad. Other major developed markets saw similar gains, in spite of a major rout created by the aftermath of June’s Brexit vote. Emerging economies, thanks to rising commodity prices and inflation expectations, also staged a notable recovery after several bleak years. On the fixed income side, though monetary policy remains accommodative, rates in developed economies rose in the latter half of the year, particularly in the U.S. Like many other assets, credit benefitted from greater expectations of reflation and growth. As we enter 2017, many are wondering whether this rally in risk assets will ultimately prove warranted.
2017 Outlook
As we acknowledge each year, predicting the trajectory of markets for the next twelve months is, at best, an entertaining intellectual exercise and at worst, a frustrating (and futile) undertaking. Nevertheless, it seems that every January we find our inboxes filled with pages and pages of prognostications and forecasts from market analysts from across Wall Street and beyond. While some of it makes for quite interesting reading, it all too often feels as though these pieces turn into a homogenous set of predictions, all too often accompanied by buzzwords. Admittedly though, this year has been somewhat different, with marked variety in the scenarios being explored and predictions for how they will play out. We cannot help but wonder if this is due to the frequent disparity between consensus expectations and reality in 2016, but regardless of what drove it, we feel there are some interesting developments occurring as this new year gets under way.
Undoubtedly, there has been a great deal of attention since the election on the incoming Trump administration and what it means for everything from finance and economics to geopolitics and trade. While conjecture abounds as to what is in store, we think it is important to remember that Mr. Trump has not yet taken office, and it will be some time before the bulk of his administration’s policies become clear even after January 20th. That being said, we do believe some things are certainly probable, and worth consideration.
As we mentioned, markets have risen considerably since the election on the expectation that the new administration will unleash a wave of fiscal spending, reduce taxes and deregulate certain industries like energy and financial services. If such expectations become a reality, we can certainly see where there could be a noticeable tailwind to GDP growth. However, it must also be recognized that fiscal policies will not be felt until late 2017, early 2018 at the earliest, and the tax and regulatory reforms proposed could be delayed in Congress, even with a Republican majority. What’s more, some of the policies proposed by the Trump administration could prove ultimate headwinds, namely reduced labor force growth (due to immigration policy), or lower imports due to a stronger dollar (driven by higher budget deficits and inflation). Finally, with trade such a hot-button issue in this election, it is likely that the Trump administration will have to make good on some of its promises to constituents. While some have discussed the worst case scenario here, namely a trade war with China, we view even a more moderate set of protectionist policies as potentially damaging not only domestically, but to the global economy as a whole. That all being said, it is still far too early to tell which policies will be shelved and which will ultimately come into being, with a wide variety of scenarios potentially playing out. Yet regardless of what happens, constructive or otherwise for U.S. economic growth, we do expect investors to reassess the progress of the “Trump trade” as the year progresses.
Meanwhile, on the other side of the Atlantic, we see several major elections this year that will be important to the global economy. In the first half of the year, both the Netherlands and France will be holding elections that polls suggest could usher in populist, Eurosceptic parties into positions of power. Victories by such parties would certainly threaten cohesion within the European Union, which in addition to economic and financial issues, faces the continued burden of the refugee crisis. Later in the year, elections in Germany may signal similar sentiments in that country as well. Though Merkel is expected to remain Chancellor, it is likely that the populist AfD party will gain seats in the Bundestag. All of these elections bear watching in light of their impact on the future of the European Union.
Further east, we believe there are a number of geopolitical risks worth monitoring. Russia, in spite of sanctions and low oil prices, has continued to take a rather belligerent stance towards the West. Whether it is over Russia’s handling of the Syrian Civil War or acts of aggression towards its neighbors, we feel that the possibility of a confrontation with the country cannot be discounted. In a similar vein, we believe that Chinese military posturing will continue to be an issue in the South China Sea. We believe much of this is an attempt by Beijing to distract from a slowing economy at home, yet another issue that, though we have explored in depth in the past, remains no less important this year. We intend to remain vigilant for signs of waning growth in China and the potential impact this could have on the global economy.
Amidst all of this tumult in both developed and emerging economies, the U.S. remains one of the more compelling growth stories in our eyes. Economic data, particularly employment numbers, are quite strong, and it is clear that the Federal Reserve recognizes this and has begun to take action to markedly tighten monetary policy. While we believe this is certainly a good thing, albeit perhaps a bit late in coming, this does come with its own set of risks. The speed with which the Fed raises rates may have an impact on the stability not only of fixed income markets, but on risk assets as a whole. Volatility is likely to rise, and there may be dislocations in some corners of the market. However, we welcome the end of this period of unprecedented low interest rates, and feel it will ultimately create opportunities for investors like ourselves.
Moving Forward: Our Direction For 2017
With risks and opportunities both likely to be more plentiful this year, there will certainly be plenty to do in 2017. On the one hand, risks have not only increased in scope, but arguably in scale as well, especially given the age of this bull market. We definitely feel that much of our time will be spent assessing which risks could create secular headwinds for the assets we own and which are likely to dissipate in the next 24-hour news cycle. As such, it is likely that a good deal of our time will be spent monitoring a number of developments and considering their primary impact, but also their secondary and tertiary effects. Positioning the portfolio to manage risk will undoubtedly be of the utmost importance this year, given our expectation with regard to volatility.
At the same token, we do feel that markets, though choppier, will also behave slightly more rationally than they have in years past. As monetary policy tightens, investors are likely to become more selective in terms of the risk assets they choose to own, eschewing speculative growth for tangible value generation. Given how we form our investment theses, we feel that the portfolios we have constructed would likely benefit from such a shift. Furthermore, any major market gyrations this year could provide us with excellent opportunities to purchase other quality assets at reasonable prices. We have made it no secret that finding compelling investments has become increasingly difficult in recent years, but this may well be changing. Overall, we are cautiously optimistic about 2017, while at the same time prepared to leverage our investment due diligence and risk management processes regardless of what markets have in store.
In addition, it is our goal this year to further enhance the client experience. Along with providing further insights into our investment process, it is our goal as this year progresses to also offer an enhanced technology platform allowing you to better track your existing portfolio and financial situation along with a wider variety of investment solutions where appropriate. If you are interested in learning more, or have a suggestion about how better to leverage our resources, we encourage you to get in touch and we will set up a time to talk.
As always, we thank you for your continued support and trust, and wish you all the best for 2017.
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This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Drum Hill Capital, LLC (“Drum Hill Capital”) has no duty or obligation to update the information contained herein. Further, Drum Hill Capital makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Drum Hill Capital believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Drum Hill Capital, LLC.
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