Market Commentary: Q4 2016Submitted by Axis Advisors LLC on January 26th, 2017
2016: Forecasts Foiled Again
Election drama, a Brexit storm and uncertainty surrounding the Fed all did nothing to thwart markets this year, as U.S. stocks continued their march skyward. Small caps in particular had a banner year in 2016, while value paid off substantially as well.
International developed stocks were mildly positive over the last twelve months, while some ups and downs in emerging markets ultimately lead them to match U.S. performance over the past year. Bond markets were a mixed bag, with U.S. bonds up substantially in the first half of 2016 before being cut short by rising interest rates. Currency hedged international bonds performed better, evidencing the benefits to U.S. investors of diversifying across yield curves.
An entertaining election cycle dominated the news in 2016 as polarizing battles between business mogul Donald Trump and career politician Hillary Clinton provided plenty of ups and downs for markets to contend with. While the political pundits predicted a Clinton victory, Republican nominee Trump ultimately defied the odds makers as he went on to win the Electoral College vote on November 8th to take the presidency. As a result, the knee-jerk market response was steeply negative, with S&P 500 futures markets down more than 5 percent overnight. But that reaction was reversed literally by the next day as U.S. markets quickly bounced back, and they have largely continued to climb since then. The well-known Dow Jones Industrial Average is now poised to hit a milestone mark of 20,000 points. What does that mean? It doesn’t mean a whole heck of a lot to investors looking at the long run, but on the other hand it doesn’t suggest depressed markets either.
The S&P 500 Index of U.S. large company stocks advanced 12.0 percent in 2016, with a 3.8 percent fourth quarter return. And as sound as that is, small company stocks crushed them, with the Russell 2000 Index of small caps returning 21.3 percent over the same time, riding high on an 8.8 percent gain in the fourth quarter. International developed stock performance was considerably more muted; with the MSCI EAFE Index relatively flat at around -0.7 percent in the fourth quarter and delivering a positive return of about 1.5 percent during 2016. Emerging markets lost ground in Q4, but nevertheless have brought in 11.6 percent year-to-date, based on the MSCI Emerging Markets index. The MSCI All Country World Index of global equities has returned 8.5 percent year-to-date, with about a 1.3 percent return in the fourth quarter.
You wouldn’t know it by the returns we are seeing now, but the market did not get off to a good start in 2016. Fueled by oil price declines and turmoil in China, markets were down substantially in the first couple of months. But 2016 will go down as a year for foiled predictions, and pundits warning of doom based on those headwinds were proven wrong in short order. Within a month, markets were back on track.
In what many have now deemed was a foreshadowing of what was to come in the U.S. presidential race, voters in the United Kingdom took to the polls at the end of June to decide whether their country should remain in the European Union. In what came as a shock to many, they voted not to. The so-called Brexit (British-exit) vote lead to its own market volatility, particularly in the United Kingdom. But markets proved resilient, and after some initial volatility, returned to their previous levels.
The year was mixed with respect to factor performance. Value and, of course, size (a factor definition that favors smaller companies over large) had a terrific year across geographies, while both quality and momentum underperformed relative to the benchmark. Certain factors outperforming while others underperform is to be expected. Investments like those at Symmetry Partners entail a package of factors, all of which have tended to outperform over time historically, but none of which are particularly expected to do so at the same time. Factor investing attempts to take advantage of known characteristics of capital assets that have historically delivered higher returns than the market. Not all factors provide higher returns all of the time, however, and diversifying among them means intentionally accepting that in any given year, some will do well while others may perform poorly. Much like diversifying across asset classes, it’s the long-term average across the group that matters.
The fourth quarter was mostly poor for market fixed income, with global bonds losing ground as interest rates rose. Those losses trimmed earlier gains and lead to a 2016 performance of about 2.6 percent for the Bloomberg Barclays US Aggregate Bond Index, a mainstream benchmark for U.S. fixed performance. The Bloomberg Barclays Global Aggregate ex US-hedged, a similar index for non-U.S. bonds, turned in a higher 4.9 percent over the same timeframe. Municipal bonds were relatively flat in 2016, gaining 0.2, based on the Bloomberg Barclays Municipal Bond Index.
Rising interest rates in the latter part of the year drove some of the losses in fixed income. While the Federal Open Market Committee declined to raise interest rates for most of 2016, it finally did so at its December 14th meeting, taking the target short-term Fed Funds rate range up to 0.50 - 0.75 percent. Moreover, the Federal Reserve signaled that probably three more quarter percentage point rate hikes are coming in 2017. The Fed cited gradually improving economic conditions as its rationale, evidenced in part by a drop in the unemployment rate to 4.6 percent. The Fed predicted growth in the GDP to be about 2.1 percent in the coming year.
Given that the December increase in rates came as no surprise, many may have predicted no response at all. Nevertheless, U.S. bond markets reacted poorly, possibly due to the hasty pace of increases the Fed seems to be putting in place for the future. Bond prices generally move in opposition to interest rates, such that when rates rise the value of bonds tends to fall. The one-day impact was higher in intermediate maturity bonds with a loss at the 2 to 5-Year key rates of about 10 basis points.
The rate hike news led to a strengthening of the dollar against international currencies, with the greenback reaching its highest level in 14 years. This occurs, in part, because higher rates in the U.S. make it a more attractive location for global investment dollars. However, a stronger dollar can lead to lower returns for overseas holdings, as the value of those investments denominated in other currencies declines upon translation back to USD.
All in all, 2016 goes down as a good year for markets, in spite of what might have been expected. And if there was any takeaway, it is probably to not pay attention to the predictions.
Happy New Year.
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MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
MSCI ACWI Value Index captures large and midcap securities exhibiting overall value style characteristics across 23 Developed Markets countries and 23 Emerging Markets (EM) countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
MSCI ACWI Small Index captures small cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. With 6,148 constituents, the index covers about 14% of the free float-adjusted market capitalization in each country
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MSCI ACWI Momentum Index is based on MSCI ACWI, its parent index, which includes large and midcap stocks across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
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Bloomberg Barclays Global Aggregate ex-USD Hedged is a designed to measure the universe of global non-U.S. dollar-denominated government, government agency, corporate, and securitized investment-grade fixed-income investments.
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Bloomberg Barclays Municipal Bond Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. Securities must be rated investment grade (Baa3/BBB-/BBB- or higher) using the middle rating of Moody’s, S&P and Fitch; when a rating from only two agencies is available, the lower is used; when only one agency rates a bond, that rating is used.
Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
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