Market Commentary - January 2017

Posted on Wednesday, January 18, 2017

Strong Finish for Stocks

By Kevin O'Keefe, CIMA, AIF | Chief Investment Officer

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For U.S. stocks, 2016 was a tale of four markets. The first six weeks belonged to the bears (S&P 500 down 10.5%). The next six months was won by the bulls (S&P 500 up 19.7%) despite the short sell-off in late June after the Brexit surprise. The next three months went to the bears (S&P 500 down 4.8%). And then the bulls took charge for the last seven weeks of the year (S&P 500 up 7.4%).

Although much of the attention lately has been on the surprising year-end surge,  the bounce from the mid-February low, when pessimism was at its greatest, contributed the most to last year's double-digit percentage gains.

A Year of Surprises, Inflection Points

Small company stocks in the U.S. outperformed large and value stocks clobbered growth stocks across the market-cap spectrum. The impressive performance of value stocks last year may continue for a while as investors requiring portfolio income look for alternatives to bonds. Internationally, the MSCI EAFE Index (non-US Developed markets) barely managed to finish in the black on a total-return basis. Emerging Markets performed much better.

Central Banks have been the primary stimulus for stock price gains in recent years, and that stimulus has effectively disappeared. If stocks are going to add to their gains going forward, they will need to do it on earnings.

Bonds performed very well in the first half of the year, but retreated in the second half. Although bonds will still be an essential asset class for managing volatility, it appears that the 35-year-long bull market in bonds is over. Returns from bonds going forward will likely be anemic by comparison.

MC- Blue Performance GraphicActive management has been on the defensive in recent years, as evidenced by the amount of column inches devoted to the subject and the tremendous asset flows out of actively managed mutual funds and into index funds. Over the last five years, index funds have received inflows averaging more than $200 billion per year. Last year, active funds saw net withdrawals of more than $200 billion.

This trend has helped perpetuate the outperformance of index funds. To the extent that a portfolio's positions have differed from that of the index, it has likely underperformed. If market-cap weighted index funds continue to benefit at the expense of actively managed funds, valuations of large positions in passive portfolios will eventually become unsustainably high. Investors who remember the dot-com bubble should keep this in mind when considering indexing versus active management.

Looking Ahead

As this publication goes to press, the overarching question among investors is: How will a Trump administration affect investment returns?
The short answer is, of course, that no one knows; but here are a few reasonable expectations.

Just like last year, 2017 is likely to be politically unpredictable, so investors should expect volatility. There will likely be periods in which markets will trade on news headlines, tweets, and speculation.

The prospect for significant policy changes in the United States has played a part in driving the recent rally in stocks. Value stocks have outperformed, with financial and energy stocks leading the way, while previously strong names in the technology and health care sectors have lagged. The surge in bank stocks reflects optimism about deregulation and further interest rate increases.

There is also anticipation of greater fiscal spending in the U.S. Stocks that would benefit from faster growth and higher inflation have done well in recent months, as have lower quality infrastructure and defense names. Global economic growth will likely be in the 3% to 4% range. Emerging markets may exceed this growth rate, while most developed countries may fall short. The U.S. is expected to be among the better-performing developed countries.

The Fed will likely raise interest rates in 2017 more than once. However, key Central Banks in other countries are not expected to follow that lead. This divergence may help pave the way for international equities to outperform their U.S. counterparts. The strong dollar may also help improve the relative attractiveness of international equities.

If Trump's campaign rhetoric translates into actual policies of lower tax rates, less regulation, and more protectionism, the effects on the economy and global trade are highly unpredictable. We have already seen that protectionist tweets can impact specific companies and industries on a short-term basis. Global supply chains are potentially vulnerable to such populist rhetoric; we will have to wait and see whether voter anti-establishment leanings of 2016 carry over to the 2017 elections in France, Germany, and the Netherlands.

Remember that stocks are ownership shares of actual businesses, and the profitability of each business has more influence on the price of its stock over the long-term than the political winds that may be blowing at any given point in time. Markets may fluctuate wildly, but over time it's fundamentals that matter most to the price of any given stock. 

Is the Bull Market in Bonds Over for Good?

From the Team at SNW Asset Management (

The past year can be characterized as having been "good, not great" for the bond market. Yields fell sharply in the first six months, but quickly reversed in November as the prospects for stronger economic growth caused interest rates to rise. A small increase in yields for most maturities was offset by income generation and gains from credit spread tightening, resulting in modestly positive full year returns.

Looking ahead, we acknowledge some market forecasters are predicting that interest rates are likely to continue their march higher as the U.S. finally breaks out of the sluggish growth and inflation environment that we've become accustomed to since the great recession. But a deeper look
at economic and policy trends suggests that significant nuances must be considered when thinking about bond investing in 2017 and beyond.

Uncertainty Reigns Supreme

Tax reform appears to be at the top of the agenda for the new Trump administration, but we haven't seen the framework in which such reforms will be structured, nor do we know over what time period they will be implemented.

The same uncertainty applies to fiscal stimulus through infrastructure spending. While it's fair to assume that lower tax rates and increased spending would be a positive contributor to economic growth, at least in the short term, other policies, such as trade protectionism and limits on immigration, would likely detract from economic growth.

Inflation is likely to remain constrained moving forward. Not only is the Federal Reserve on a tightening path (which has the largest effect on short-term bonds with limited price sensitivity to a change in rates), but the U.S. Dollar has risen sharply in recent weeks. In addition, while higher commodity prices will boost inflation early in the year, these base effect gains will lapse as we move through 2017. 

Much of the rest of the developed world is going through a prolonged growth downturn, likely causing foreign yields to stay low for the foreseeable future. The relationship between U.S. and Japanese and U.S. and German bond yields should provide support for our markets as foreign investors take advantage of the relative value opportunity that yields on U.S. bonds provide.

There is no shortage of potential risk and volatility in the global financial marketplace. Overleverage across developed market economies, a continuation of capital outflows in China and currency driven dislocations in emerging economies need to be watched closely. If these trends create volatility, high quality U.S. bonds should do quite well.

Could rates move higher during certain periods of 2017? Sure. Will the bond market enter a sustained bear market where yields correct sharply to the upside? Unlikely. And even if rates do move higher over the course of the year, bond investors can still make a positive return with relatively low levels of volatility because of the income bonds provide.

Green Bonds

Growth momentum in the green bond market increased last year. Almost $90 billion of green bonds were issued in 2016, roughly double the amount issued the previous year. These issuances were dominated by the Chinese which accounted for 37% of the total - not surprising given China's aggressive commitment to low carbon energy production.

The municipal sector saw clear increases in total issuance in 2016 compared to 2015 while the sovereign sector saw its first sovereign green bond issuance in December by Poland.

MC- Plant Growing In Jar Of PenniesInvestor appetite for green bonds continues to be high with most of the new issues being oversubscribed. Expectations of continued growth in 2017 are moderate, with the total issuance of labelled green bonds expected to be in the $120 billion range.

We believe the bright spot for 2017 will be the municipal bond market. Many states and municipalities have been vocal since the Presidential election in their continued commitments to address climate change, create more affordable housing, increase healthcare access, and ensure an inclusive and equitable community for their residents. These states and municipalities will be looking to the public markets for financing for many of these projects.

Good News: Americans Are Getting Serious About Retirement

We've all seen the alarming news flashes suggesting that most Americans aren't saving enough to live a financially secure retirement.

It's time to look at the bright side. On average, workers in 2015 put 6.8% of their salaries into 401(k) and profit-sharing plans, according to a recent survey of more than 600 plans by the Plan Sponsor Council of America. That's up from 6.2% in 2010.

An increase in retirement savings of 0.6 percentage points may not seem like a lot, but a 10% increase in the amount of money being invested into financial assets over
the last five years is significant - billions
of dollars.

If this trend continues, more plan participants could begin meeting the savings recommendations of retirement experts by setting aside at least 10% of compensation regularly over the course of their career.

Nearly six out of ten retirement plans surveyed allow for automatic enrollment, meaning that employees only need to take action if they do not want to participate. This "opt out" feature has probably helped increase the retirement savings rate more than anything else.

MC- Retirement On The BeachMore Americans contributing more money into their retirement accounts could also help offset the potentially negative effect of what some are calling the "liquidating demographic bulge." In other words, there is a risk that millions of retiring baby boomers who are spending down their retirement savings over the next several decades could put downward pressure on stock prices. A good demographic balance of net buyers and net sellers should help reduce this risk.

Portfolio Rebalancing: Does It Really Help?

One of the core tenets of the First Affirmative Investment Philosophy is belief in the value of periodic rebalancing - periodically adjusting portfolio allocations such that they are brought back into alignment with each client's Investment Policy Statement (IPS).

Periodic rebalancing is widely considered a best practice for reaching one's long-term financial goals. However, Michael Edesess, Chief Investment Strategist at Compendium Finance, argues that rebalancing is no better or worse than a buy-and-hold approach. He asserts that the academic reports showing a financial advantage for rebalancing are the result of improper and selective analysis of the data.

Proper analysis shows that there a number of possible outcomes from rebalancing, ranging from much worse to much better than buy-and-hold. Our experience at First Affirmative is consistent with this observation. Our timing could not have been better in 2016 as we were net buyers of stock mutual funds on February 11, 2016, which was the market low for the year, but this has not always been the case. In a long bull market, without any significant corrections, rebalancing does not beat buy-and-hold.

MC- Stock Superiority Comparison ImageSo why rebalance? Periodic rebalancing helps clients achieve their goals; but the way in which it helps may not be self-evident. We believe that periodic rebalancing helps support optimal investor behavior. There is a saying: "If you don't rebalance your portfolio, the market will do it for you." This refers to the fact that if stocks become significantly overweight in your portfolio, when a nasty bear market arrives, you are likely to experience a bigger loss than you otherwise would if your portfolio allocations were more closely aligned with your IPS.

You may be better off or worse off by rebalancing, as compared to the buy-and-hold approach, but the experience of a greater decline will be more painful, which increases the likelihood that you will abandon your financial plan. We believe in rebalancing because it improves the likelihood of our clients achieving their long-term goals.

Kevin O'Keefe, CIMA, AIF is Managing Member and Chief Investment Officer of First Affirmative Financial Network, LLC. He chairs the First Affirmative Investment Committee and is responsible for due diligence and monitoring of mutual funds and separate account managers.

SNW Asset Management is an independent investment advisor and certified B Corp focusing exclusively on managing low-cost, tax-efficient fixed income portfolios based in Seattle, Washington. SNW is a fixed income separate account manager for certain clients of First Affirmative Financial Network.

Information was obtained from third party sources which are believed to be reliable but are not guaranteed as to their accuracy or completeness. The indexes mentioned in this Economic Commentary represent unmanaged groups of investment assets, such as common stocks or bonds, and are often used as proxies for various markets. Index performance does not include the impact of cash, fees, or transactions costs. Investors cannot invest directly in the S&P 500 or the other indexes mentioned, but may purchase mutual funds or other products designed to track the performance of various indexes. Investing in bonds involves risks such as interest rate risk, credit risk, and market risk, including the possible loss of principal, and income may be subject to the alternative minimum tax (AMT). Mention of specific companies or securities should not be considered a recommendation to buy or sell that security. This commentary is not intended to be specific investment advice. For information on the suitability of any investment for your portfolio, please contact your investment advisor. Past performance is no guarantee of future results.