The fourth quarter began inauspiciously, dropping throughout October and accelerating to the downside heading into Election Day. Volatility heading into any election is usual and expected. Before moving higher at the open of trading on the 9th, the stock market futures witnessed a dramatic decline as investors had to process an element of uncertainty. By the time the markets opened, however, the futures had reversed course, and the markets moved sharply higher as the prospect of U.S.-focused economic growth began to prevail in the minds of investors.
Thanks to a strong post-election rally, the S&P 500 saw a 3.8% total return for the quarter and a gain of 11.9% for the year. Both during the quarter and the full year, smaller capitalization stocks outperformed large and value outperformed growth—reversing the results of the past few years. The best performing style was small cap value. By contrast, the Lipper Large Cap Growth Index fell -1.9% during the quarter and was up 0.5% during the full year.
International stocks, while rallying in December, were hit by a stronger dollar in the quarter. The MSCI All Country World Index (ACWI) ex-USA Index lost -1.3% in the quarter, reducing its 2016 gain to 4.5%. The MSCI EAFE Index—representing the developed economies in Europe, Australasia, and the Far East—saw a loss in the quarter of -0.7% and a total return for the year of 1.0%.
In the bond market, the Fed finally raised the federal funds rates late in the year with the result that during the quarter the 10-year Treasury Note’s yield rose from 1.63% to 2.45% and the 2-year Note rose from 0.77% to 1.20%. Barclays’ U.S. Aggregate Bond Index lost -3.0% in the quarter and -2.7% for the year. Barclays’ Municipal Index showed a decline of -3.5% for the quarter and a 0.3% return for 2016.
The biggest event of the quarter was the surprise election of Donald Trump as president. Immediately the markets reacted and began to try and price in the Trump agenda of tax cuts, including the potential for repatriated profits; renegotiated trade deals; immigration reform; regulatory reform; the choices of nominees for his cabinet; and a myriad of other pro-U.S. growth efforts. The next big event was the Fed’s aforementioned hike in the federal funds rate and its stated expectation of additional 2017 hikes.
All of the above pointed to an economy that was going to see continued growth. While the current economic expansion is considered to be one of the longest in U.S. history, investors still seemed ready to step up and put cash to work, shift funds out of bonds or, perhaps, cover their shorts. Stocks should benefit from the end of a five quarter earnings recession as profits look set to broadly expand in 2017 with estimates for the S&P 500’s earnings per share suggesting that growth could be in the 10-12% range.
With key central banks appearing incapable of stimulating their economies it is expected that fiscal stimulus will move to the fore. Certainly, that appears to be the plan of the President. In that event, bond yields will likely continue to move gradually higher, and fixed income strategies will need to reflect continued investments in bonds with modest duration and/or protection against rising rates. Our emphasis will be on companies participating in the expected earnings recovery and those that can continue to grow their dividends at a healthy pace. Our asset allocation work still suggests overweighting stocks in client portfolios.
Mr. Berglund is Senior Vice President at Pennsylvania Trust.
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