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December 2016 Market Commentary

Sunday, Jan 1, 2017

The rally in equity markets that began with the U.S. Presidential election continued through December, allowing most markets to finish 2016 higher. And unlike in November when bonds and non-U.S. equities fell in response to the policy implications of a Trump administration, both produced positive returns for the month as did the dollar and oil.

The following table contains a summary of December and the year’s market performance:

Index December YTD Index December YTD
S&P 500 (Total Return) +1.98% +11.96% All Country World Index (Net) +2.16% +7.86%
MSCI EAFE (Net) +3.42% +1.00% Barclays Aggregate +0.14% +2.65%
MSCI Emerging Markets (Net) +0.22% +11.19% 60/40 Blend* +1.35% +5.92%
* 60% All Country World Index/40% Barclays Aggregate

The Fed’s December 14th 25 basis point increase in its policy rate was widely expected, but less well anticipated was the likelihood that the Fed will increase rates three times instead of two in 2017. The change in outlook is due to members of the FOMC (Federal Open Market Committee) believing Trump's proposals could push the economy into “a higher gear” in the short run, pushing inflation higher and necessitating higher real rates. Treasury prices have fallen since the election on anticipation of higher deficits, higher inflation and tighter Fed policy. The yield on 10-year Treasury bonds climbed from 1.85% to 2.55% before falling back to 2.44%.

OPEC’s agreement to cut production sent oil prices climbing over 20% in December to $55 a barrel. While bad news for drivers, the news is welcomed by credit markets and owners of energy companies. Stocks in the energy sector climbed nearly 8% since the OPEC announcement. High yield bonds gained on improved prospects of issuers in the energy sector.

With the S&P 500 finishing the year nearly 12% higher, long forgotten is how the year began, with the S&P 500 down 11% from January 1 to February 10. Or how June’s Brexit vote caused the S&P 500 to fall by 6% over the next two days. The rally in equity prices following the Presidential election reflects a change in the market’s expectations for economic growth, inflation, interest rates and corporate profits from those held at the beginning of the year. 2016 began with concerns about global recession and deflation, and was observed in falling oil prices. Central banks around the world responded by driving sovereign bond rates to negative yields, leading equity and credit markets to sell off.

Over the year, market sentiment improved on signs of positive economic news. Oil prices began to recover, relieving stress in credit markets, and contributing to positive estimates of corporate earnings over the next year. Prior to the November election, the S&P 500 was up over 6% in 2016 on estimates of positive earnings growth in 2017 following six quarters of falling earnings.

Since the November election, U.S. business, investor and consumer market sentiment have risen further on expectations that expected tax reform, deregulation, increased fiscal spending on infrastructure, and trade reform will be good for U.S. GDP and corporate earnings growth. Since the election, consumer confidence has climbed to a post-crisis high. An index of CFO confidence climbed from 60 to 65 post-election. Estimates of 2017 S&P 500 earnings growth have been revised upwards to over 12%, and investors have noticed. The percentage of investors who are “bullish” about the market’s outlook has climbed from 25% at the beginning of the year to nearly 60% today.

All of this before a single defined policy proposal has been announced by the Trump Administration. An expected reduction in corporate tax rates and a tax holiday on foreign generated profits would directly raise after-tax earnings, making equities appear less expensive. It would also likely lead to a round of special dividends, stock buybacks and M&A activity that would all be supportive of equity prices. However, a tax proposal known as “border adjustment” would treat imports and exports differently for tax purposes, making exporting more profitable while raising the cost of imports. A border adjustment tax would alter the profitability of industries relative to one another, creating winners and losers.

Both equity and bond markets as well as the Fed have made it clear that they believe economic and earnings growth will be higher than forecast prior to the election. But with the specific policy recommendations unknown at this point a new risk to market valuations is introduced in the year ahead: over-optimism. To the extent that the policies eventually enacted support the market’s beliefs about earnings, improving fundamentals and sentiment could drive U.S. equity markets higher. To quote Bridgewater founder Ray Dalio “regarding igniting animal spirts, if this administration can spark a virtuous cycle in which people can make money, the move out of cash to risk on assets could be huge.”

On the other hand, to the extent that policy changes fail to raise growth and earnings as the market believes they will, or if macroeconomic responses to policy drive interest rates and the dollar higher (hurting earnings), disappointing news will likely cause investors to sell. As Congress debates policy proposals and the market evaluates their potential impact, the one certainty investors can count on is market volatility.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but CAPROCK makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.

Copyright 2016 The CAPROCK Group, all rights reserved. The CAPROCK Group is an SEC Registered Investment Adviser. This communication is not a solicitation or offer to sell investment advisory services except in states where we are registered or where an exemption or exclusion from such registration exists. All written content is for informational purposes only and may not constitute a complete description of available investment services. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns. Cappadocia Hot Air Balloon