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FOURTH QUARTER 2016 IN REVIEW
Markets & Economy Influenced by Election Outcome
U.S. economic growth remained restrained in Q4 after acceleration in Q3. Based on data received through December 2016, fourth quarter 2016 real gross domestic product (GDP) growth is tracking to between 2% and 2.5%, following 3.5% growth in the third quarter of 2016, 1.4% growth in the second quarter, and 0.8% growth in the first quarter. Uncertainty around the United Kingdom's (U.K.) impending exit from the European Union (EU), tepid international growth, and policy uncertainty in Washington D.C. may all be contributing to some caution among consumers and businesses. Manufacturing has been stabilizing but continues to experience only a slow recovery from the impact of falling oil prices and a strengthening dollar. As the year ended, optimism surrounding potential fiscal policy stimulus was building, indicating economic momentum may have picked up some in December.
Improving U.S. economy and election a strong combination for stocks. The S&P 500 posted a 3.8% total return during the fourth quarter, bringing the full year 2016 return to a solid 12%. The quarter's gains were driven by improving economic conditions and optimism surrounding potential pro-growth policies under a Trump presidency with one-party control of Congress. Financials and small caps, in particular, benefited from prospects for tax reform, deregulation, and higher interest rates that were at least partly attributable to the president-elect's policy plans. Both developed foreign and emerging markets (EM) equities lagged U.S. benchmarks for the quarter and in 2016, though EM lagged only modestly for the year. In the quarter, political uncertainty weighed on U.K. stocks, although Italian stocks shrugged off that country's leadership transition in posting solid gains. Yen weakness hurt Japan's dollar-based returns, while EM was hurt by trade protectionism concerns, in China in particular.
Rates soar as markets digest implications of Trump presidency. The yield curve steepened and Treasury yields soared as fixed income markets priced in implications of President-elect Trump's policies. Anticipation of higher levels of growth and inflation drove longer-term yields higher. The Federal Reserve's decision to hike interest rates in December, in addition to their raising guidance of the pace of future rate hikes, drove shorter-term yields higher. The Bloomberg Barclays Aggregate Bond Index returned -3.0%. Economically sensitive, lower-credit quality sectors continued to rally, with high-yield returning 1.8% (Bloomberg Barclays U.S. Corporate High Yield Index) and bank loans gaining 2.2% (Bloomberg Barclays U.S. High Yield Loan Index). A meaningful pickup in inflation expectations was a tailwind for TIPS, which returned -2.4% (U.S. Treasury Inflation Protected Notes Index) during the quarter, outperforming Treasuries, which returned -3.8% (Barclays U.S. Treasury Index). Emerging markets debt returned -4.2% (JP Morgan Emerging Markets Bond Index) amid concerns over protectionist U.S. trade policies. The dollar's 7.1% surge during the quarter hurt unhedged foreign bonds, which returned -10.8% (Citigroup Non-US World Gov. Bond Unhedged Index) amid globally rising rates.
Distressed debt strategies continued to perform. The HFRX Distressed Debt Index increased 5.4% during the fourth quarter, for an annual gain of 19.6%. Commodity sector strength continued to support portfolios. In the managed futures space, the increase in Treasury yields earlier in the quarter weighed on quarterly performance, as the industry was broadly positioned with long exposure. Further, short emerging market currency positioning against the U.S. Dollar detracted from performance. For the quarter, the HFRX Systematic Diversified declined 3.5%. While quarterly returns were positive, on a risk-adjusted basis, long/short equity managers (HFRX Equity Hedge Index +0.8%) underperformed the S&P 500's 3.8% gain. The industry's financial sector underweight made it difficult to keep pace with broader markets, as financial related securities swiftly climbed following the election results.
Oil prices surge late in quarter on OPEC production cut. The story of the quarter in commodities was an agreement between OPEC and certain non-OPEC members to cut production. This led to surging oil prices late in the quarter and resulted in a quarterly return for WTI crude of 11.4%. The Bloomberg Commodity Index returned 2.6% in the fourth quarter led by energy and industrial metals. The U.S. dollar trade-weighted index was up 7.1% as the Federal Reserve hiked rates and growth expectations increased in the U.S.
A Look Forward
We expect mid-single-digit returns for the S&P 500 in 2017 supported by further earnings acceleration and improved U.S. economic growth, as laid out in our Outlook 2017: Gauging Market Milestones publication.* Concerns about trade, an aging business cycle, and political uncertainty may still lead to bouts of volatility. Rising growth and inflation expectations may be a headwind for bonds, but much of the impact is likely already priced in and low yields overseas may restrain how high domestic yields can push. As a result, interest rates may be range bound in 2017, allowing the potential for interest income to support positive returns for bonds.
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