This article was released on January 11, 2017. Find our latest market and economic insights here.
After a year of surprises, many may be struggling to understand how and why 2016 ended the way it did: a typical broadly diversified 60/40 balanced portfolio finished the year with a gain around 7% (net of fees). In our view this is a very strong return for the year and even slightly above what our capital market assumptions lead us to expect from a balanced portfolio in the next several years. In this review and outlook, we look at how this came about and grade some of our active positioning in 2016. We also share our expectations for 2017’s looming policy risks and opportunities and examine whether and how 2016’s gains may be sustainable.
2016: A little more flag captured
Asked to explain a good year for returns, some might cite an unexpected business-friendly election result: the S&P climbed 5% after November 8. Yet despite a couple shocks, in early February and again following June’s Brexit vote, equities gained steadily most of the year. Analyzing as part of our investment process the meaningful economic and valuation trends as well as the projected policy developments behind this movement, we find other equally compelling stories illuminating 2016 results and 2017 expectations.
It’s also worth noting the value added by asset allocation in a year like 2016. Recall that a year ago, investors tallying year-end returns for 2015 saw flat-to-moderate returns across most asset classes. Conservative, moderate and aggressive allocations likely finished 2015 about the same: close to even.
Not so in 2016. This year investors saw much more differentiation between asset classes. Some areas did very well — high-yield bonds returned 17.3%; U. S. equities returned 12.0% — and others, like core bonds, which returned 2.7%, plodded along.
It was, in our view, a year when thoughtful asset allocation mattered. More precisely, it was an environment in which relative value positions made a difference, increasingly within rather than across asset classes, and 2017 looks like it will be no different in this regard.
Grades are in
A good way to look at performance from an asset allocation perspective is to isolate key tactical positions, or views, either held as the year began or made during the course of the year, and to analyze their effectiveness. In our case, we held or initiated six positions in 2016, which we grade below.
As the year began, we had three main positions:
- First, judging Europe and Japan to be earlier in the economic cycle than the U.S., and seeing opportunity there in the form of a valuation discount that would soon dissipate, we overweighted international developed market equities and underweighted U.S. equities.
- At the same time, a slow but steady domestic economy, supported by low unemployment, GDP growth at or above its trend level compared to global growth, room for consumer spending, and an accommodative Federal Reserve led us to overweight U.S. equities against core bonds.
- Finally, within fixed income, seeing wide high-yield spreads yet expecting moderate high-yield bond defaults outside the energy sector, we overweighted high-yield bonds and underweighted core bonds to capture the dislocation.
In addition to these three initial positions, we also made three tactical changes during the year:
- In January, when high-yield spreads rose even further, we increased our overweight to high yield and underweighted both U.S. equities and cash. This was a risk-neutral trade, meaning the shift to high yield did not increase our overall risk exposure.
- Also in January, we overweighted global equities versus core bonds, supported by our belief that the drop in the stock market was not supported by economic fundamentals and that easy monetary policy would continue.
- Lastly, in June, we reversed our previous overweight to international developed market equities as populism’s potential turned reality in the U.K. and we felt there were a number of policy risks throughout Europe, including upcoming elections in France and Germany, that were not being priced into the market. Our conviction in this position later increased in December and we grew the overweight to U.S. equities at the expense of international developed equities.
As the table shows, we feel most of these calls went our way and added significant value. While, like many, we did not fully appreciate the potential for populism in Europe, we find our views of the economic outlook to have been correct, and the positions resulting from them positive.
Year-end rally: Survival odds
So where do we stand today? While it is clear that stocks benefited after the unexpected U.S. election result, it is less clear how much they benefited because of them. We must ask: how much of the rally in November and December is due to Trump’s election, and how much of it is merely a continuation of good economic data that had been coming at least since August?
The rally is likely due to a confluence of at least three factors: a business-friendly president-elect in the U.S., strong economic data developing throughout the year (U.S. GDP growth of 3.5% in the third quarter), and the 6.7% jump in U.S. corporate earnings in the third quarter. This is important to note because a strengthening U.S. economy and relatively attractive valuations have been part of the foundation of our risk-friendly positioning throughout 2016.
Investors betting on growth in 2017 will need to sort out what elements in 2016’s rally will have staying power. Much is in the air. So far markets seem to have shrugged off the shock of Brexit, but the U.K. has not actually left the EU yet. Likewise, business-friendly optimism following Trump’s election may be based on policies that will take some time to be enacted (or may never be, given Trump’s frequent about-turns).
Below are our expectations for Trump’s main policy plans, and our thoughts on their likely effect on the aggregate economy.
- Trade: We expect protectionist measures, particularly in the manufacturing sector. For certain sectors this could be positive at least in the short term, but overall we view this as negative in both the short and long term.
- Taxation: We expect cuts for both individual and corporations, and we expect the corporate side to have a potentially larger effect. Lowering the corporate tax rate and simplifying the code could boost investment while increasing repatriation of foreign profits, which could help Trump fund some of his promised infrastructure spending.
- Government spending: Deficit spending should increase, which should boost growth in the short-term, but in the long-term such spending will need to be paid for. The best-case scenario is that it will begin a virtuous circle, substantially increasing economic activity. But, given long-term demographic and productivity trends, which we think spell lower long-term growth, we expect the overall effect to be slightly negative.
- Regulation change: Some regulation will likely be scaled back, and the results should vary by industry. Anti-trust regulations, for example, have proven over the long term to be beneficial to the economy, so scaling these back would likely have a negative effect. Overall, however, it should be positive for the economy in the short term.
- Foreign policy: We expect a more hawkish administration, though longer term there is more downside risk in entanglements in the Middle East and China.
- Immigration: Trump will likely target lower-skilled workers in any deportation measures, and removing these will bring up the cost of labor, although certain groups among lower-paid workers may see some benefits.
The question remains of how Trump will prioritize these policy changes, and whether they will all come to pass. Like items on any to-do list, these changes will lie on a spectrum of feasibility: some may be easier to accomplish than others. Given our outlook here, an ideal scenario would be that tax, regulatory and government spending changes are enacted first, while trade, immigration and foreign policy changes take a back seat.
Back to the future for growth
Tax cuts and increased government spending, in any case, will need to be paid for somehow — some say with increased growth in the future. Hopefully those predicting an eventual 4% growth rate are right, or have precognitive abilities at least as accurate as those of the creators of Back to the Future II, who in 1989 were only a year off in their prediction of a Chicago Cubs World Series (in the movie, the Cubs won in 2015). But there is evidence that shows growth may slightly decrease instead: an aging demographic is shrinking the working population and technology-driven gains in productivity, which dominated the twentieth century, are moderating.
U.S. debt levels, meanwhile, remain historically high, as the government has largely taken on debt the consumer has cast off since the Great Recession. Budget deficits are also widening on a year-over-year basis for the first time since 2010, leading to a slight climb in the closely watched debt-to-GDP ratio. The U.S. government carries little explicit credit risk and debt servicing costs are currently low, but debt could eventually act as a drag on the economy if levels continue to rise and growth stalls or falls.
Valuations not overdone yet
Turning from the economy and policy, we find support for risk assets in 2017 in our analysis of valuations as well, particularly in our view of U.S. equities. Here it is worth pointing out the limits of judging valuations by any one metric — many assessments use price-earnings ratios and only price-earnings ratios (P/Es). We think our process goes a little deeper: it combines P/Es with price-book ratios and discounted earnings to get a composite view of value. While P/Es alone show an overvalued stock market, in our more detailed view prices are at or near fair value.
Looking ahead into 2017, we are pleased to find confirmation of our process in what we judge to be a solid record of tactical views in 2016. As well as Cubs Manager Joe Maddon seems to sum up 2016 with his line that “you have to have a little bit of crazy to be successful,” investors are better served by a different Maddonism: “The process is fearless.” The BMO Multi-Asset Solutions Team’s disciplined process has remained steady and fearless throughout a dramatic year. We look forward to a 2017 in which stable if slow economic growth and attractive relative valuations should support an overweight to equities versus fixed income, and U.S. equities versus equities in Europe, where policy risks are more immediate.