January 4, 2017
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
Regardless of how you celebrate the holiday season, whether it be Thanksgiving, Christmas, Hanukkah, or something else, there remains one constant: food. Our childhood memories are filled with family gatherings, great feasts, and a tendency to overeat. “I’m stuffed!” is a commonly communicated statement throughout the holiday season. It is natural to overeat when there is so much good food available. Our eyes are bigger than our stomach, and the desire to taste everything overrides the limited space available on a dinner plate.
When we look back on the fourth quarter of 2016, and particularly the period following the presidential election, it is possible that the “feast” of good news may have led to overconsumption in the stock market. The election of Donald Trump and Republican majorities in both the House and Senate created a fairly strong narrative for the near-term future of the economy. Particularly, there is an expectation of increased infrastructure spending, deregulation, lower personal and corporate taxes, and overall higher growth in the U.S. economy. However, as we said in our post-election commentary, nothing has happened yet. While it is natural for stocks to be priced based on expectations of future growth, we think the market may be a little “stuffed”.
The chart above shows the performance of various sectors of the market from election day through the end of November. The two highest returning sectors are financials and industrials, reflecting the expectation of deregulation, higher growth, and infrastructure spending in particular. While those expectations are reasonable, they are unlikely to have resulted in an immediate 10% or more increase in earnings for those sectors. Instead, investors who have bought those stocks consider the aforementioned policy statements a certainty and that earnings growth will materialize. If we relate this to our holiday food consumption, many of us have made New Year’s resolutions to exercise more and eat better; however, we’re unlikely to buy new clothes until we actually follow through on some of those promises.
We Are Not Complaining
Of course, as advisors we are not complaining about reporting strong performance for portfolios in 2016. Furthermore, our implementation has added additional value beyond what the market has provided. Our strong outperformance relative to indexes across equities can be attributed to our tilt to value stocks and our overweight to small cap and emerging market stocks. Fixed Income markets pulled back substantially during the fourth quarter due to change in investor sentiment. Our taxable fixed income allocation is outperforming the Barclay’s Aggregate Bond Index by holding a more diversified allocation. Finally, our multi-strategy investments including MLPs, Reinsurance, Farmland, and Life Settlements have all contributed nicely to overall portfolio returns. There have been times in the past few years where diversification has worked against us; however, in 2016 almost every position had a meaningful contribution to overall portfolio return.
Looking Ahead to 2017
While we see several reasons to be optimistic following the election and into the new year, we do not think the expected policy changes are a foregone conclusion. Until President-Elect Trump takes office and begins to pass legislation through Congress, investors should operate under the assumption that the current environment will persist. At least in the case of 2017, the current environment is a conservative expectation, with the potential for reality to exceed our expectations.
U.S. equity markets may be volatile in the first quarter, particularly if fourth quarter earnings reports do not support the change in pricing that occurred during the fourth quarter. Nevertheless, the economy continues to grow and improve, and we expect the combination of investor optimism and some (if not all) policy changes will result in positive equity returns.
Internationally, there are concerns that renegotiated trade policies may impact foreign market performance, which have already caused the dollar to strengthen against foreign currencies. President-Elect Trump created a council of CEOs, co-administered by Stephen Schwarzman of Blackstone, to help him address many of his policy promises such as job creation and deregulation. Many of these CEOs derive substantial revenue from overseas operations and will provide meaningful insight into the impact of changes in trade policies, which we believe reduces the risk to international markets.
As has been the case over the last several years, we remain concerned with fixed income. Rates have finally started to increase, supported by strong economic data and the anticipation of higher inflation. The expectation is that rates will continue to rise in 2017, creating headwinds for returns in fixed income. Our investment department continues to look for the best approaches to investing in fixed income, to ensure our clients benefit from the diversification and are also compensated fairly for the risk that exists in markets today.
New Year’s Resolution: Optimize
During the first quarter of every new year, MRA Associates revisits our portfolio optimization process. Through this process, we evaluate each portfolio to determine if any changes should be made to the investments within the portfolio and the allocation of those investments. Portfolio changes would be driven by changes in expectations around return or risk in various asset classes, which we generate from the dozens of relationships we have in the industry. Additionally, we consider new ideas or solutions to see if they can add value to client portfolios. We are constantly monitoring and evaluating markets and client portfolios throughout the year. However, this first quarter process sets the foundation for our ongoing analysis. While we have made changes in past years, particularly in response to changes in interest rate expectations, we would not be surprised if no 2017 changes were warranted and existing allocations were appropriate for the current environment.
In the third quarter of last year, we held our first Quarterly Market Commentary webcast, which we plan to continue for future quarters. This is a unique opportunity for clients to review our quarterly slides, ask questions during the live call, and listen to a recording of the call at their convenience. In addition, last quarter we provided clients with a personal performance commentary, uploaded to their personal ShareFile portals, along with performance reports that outlined portfolio returns and identified particular contributors and detractors. By providing these resources to our clients, we hope that meetings can be more efficient and reserve time for other topics of interest.
As we look back on 2016, we want to express our gratitude to all our clients. We truly love what we do and consider it a privilege to serve you.
To download a PDF version of this Market Commentary, please click here.