Quarterly Commentary

4Q 2016

How will we remember 2016? The rise of populist politics as exemplified by Brexit and Trump? The long-awaited turn to higher interest rates? Or, perhaps just as a year that confounded expectations in so many ways?

These questions remind us of the difficulty – some might say folly – of investing based on forecasts made by even the brightest minds in the business. Even if someone had been able to predict the political and macroeconomic events that would unfold in 2016, it’s hard to see how they could have foretold how markets would respond. Sure, we can write about it with precision and wisdom afterwards, but there is no way of getting around that this was a year that delivered a surprise at every turn.

Many identified the British referendum and the US presidential election as events that would roil the markets. Though neither has yet destabilized economies or markets (so far), the events are nonetheless meaningful. They have illuminated a growing sentiment around the world that the economic status quo is simply not good enough. Anti-establishment and anti-globalization sentiment may remain on the upswing until world leaders show courage and consider measures that address the grievances of the disaffected. It’s still early of course; neither Brexit nor the Trump presidency is yet a reality. We will be well into 2017 before we understand the economic impact of these new political directions.

Recall how the year started: Chinese markets were reeling amid fear of an imminent currency devaluation. Oil and other commodity prices were collapsing. US stocks fell 8% in the first two weeks of the new year. The tumult continued into February – investors were confused and on edge – a momentary dip evolved into a worldwide “growth scare.”

Back then, we identified two dynamics behind the stress. First was concern that the US Fed was signaling its intent to increase short-term rates four times during 2016, while in China central bankers were rumored to be weighing significant currency devaluation. Both monetary authorities seemed to be out of step with the rest of the world’s fragile economic condition. Second was the oil price collapse. Increasing production in the US and elsewhere along with slackening demand explained by improving energy efficiency combined to create an oil glut of epic proportions. At sea and on land, reservoirs were full and Wall Street was racing to slash price targets – $40, $30, $20 a barrel. Lists of banks exposed to failing oil businesses were circulating and investors were transfixed by the drama.

But by mid-February, the market had overshot to the downside and oil prices bounced off their lows. Attention shifted to Europe and the UK’s vote on continued EU membership. Defying warnings of an economic meltdown, British voters expressed their desire to exit the EU. US stocks responded by selling off 6% in two days, and bouncing back in three. Investors then set their sights on the US elections. With both candidates supporting infrastructure spending, financial markets began to anticipate a shift from monetary to fiscal stimulus. Stock market leadership passed from interest-sensitive securities such as high dividend-payers, utilities, REITs and, of course, bonds, to financial stocks and other beneficiaries of higher interest rates.

Pre-election uncertainty gave way to the consideration and celebration of potential pro-growth reforms and measures. The performance of the US stock market over the balance of the year surpassed that of all other post-election periods. The recent surge in industrial stocks is signaling a fundamental shift in the outlook for the US economy. Changes to the corporate tax code, including the introduction of a destination-based tax system, may inspire increased capital investment at home, leading to accelerated growth in US-based manufacturing and export volume.

We acknowledge that this more optimistic scenario comes as a surprise – one that may not yet be fully reflected in stock prices. Much depends on how easily the tax and trade initiatives gain sufficient support in Washington. The rest of the Trump agenda will no doubt face stiff opposition on many fronts – health care, energy, education, among them. Policy changes in these areas may be incremental or nonexistent. The idea of a US industrial renaissance is captivating – it could mean better jobs and help address income inequality. But we’re not waving our pom-poms just yet. The world is already awash in manufacturing capacity, and it’s not as if our trading partners are lining up to “buy American.” Moreover, it may be months before tax and infrastructure spending measures are approved – we think it’s likely that investors’ patience will be tested by then.

Mindful of the caveats we shared at the start of our letter, here’s our prediction for 2017: By year end, neither the bulls nor the bears will have had their way – 2017 may be even more volatile than 2016, yet will ultimately yield an acceptable result – modest returns. Actually, that’s a slightly revised version of our forecast for 2016. It’s as good a guess as any.

Alternatively, we might ask, stocks are near record highs, but are risks elevated as well? Were stocks riskier as the market was falling a year ago than they are today? The short answer – it depends. The longer answer will be determined by events yet to take shape, high among them:

  • How much of the Trump agenda will be enacted and will it be viewed as effective reform?
  • Will the Fed follow through with its telegraphed rate hikes?
  • Will we see a “hard” Brexit or one that supports continuing trade between Britain and the EU?
  • Will the populist agenda be supported by election outcomes in France, Germany and elsewhere?
  • Can China finesse its way to sustained growth?
  • Are other economies around the world finally ready to grow on their own, independent of global economic and political developments?
  • Could the negative impact of an even stronger dollar (up almost 5% since the election) outweigh the pro-growth policy benefits for large US multinational businesses?

For all of the financial innovations that make investing seem so complicated (even though many are meant to simplify), the markets reflect the composite behavior of human beings. It’s increasingly the case that the humans involved with much of the day-to-day buying and selling are reading the same stuff and absorbing the same data, all at about the same time – and much of this information is created by those same investing humans! Emotions drive the markets in the short-term. Today’s welcome optimism may well be the flip side of last year’s unfounded pessimism.

We can’t say with any certainty how 2017 will unfold and can’t predict when or how the current investing climate will shift.  However, we can dedicate our efforts to assembling all-weather portfolios of securities that our research team has identified to be trading below their intrinsic value – portfolios created with the aim of meeting needs and objectives.

The holiday season is a time to reflect on our good fortune. All of us at RPA wish you good health and much joy throughout 2017!