The fourth quarter of 2016 provided a fitting conclusion to a turbulent year for the investment markets. October delivered a painful stock market selloff, which was quickly reversed in early November by the unexpected result of the presidential election. In general US stocks rallied through the end of the year, as investors anticipated the possibility of income tax cuts and increased infrastructure spending … two major themes of the new administration.
This anticipation was starkly reflected in broad market results. On the positive side, the S&P 500 enjoyed a 3.3% advance during the fourth quarter, in a year-end rally that captured the media’s “headline” attention. Foreign markets failed to participate, however, as international stocks dropped almost 3%. Developed overseas economies fretted about the repeated threats of higher tariffs being imposed on goods exported to the US; meanwhile emerging economies face the reality of much higher costs for raw material and corporate debt service, both of which are tied to the soaring US dollar. Unlike domestic stock markets, fixed income markets reacted very negatively to the prospect of reduced revenue and higher spending. The value of virtually every interest rate sensitive investment suffered steady erosion during the last two months of 2016, with broadly-diversified bond indexes selling off 3.8% and Real Estate Investment Trusts (REIT’s) falling 5%.
Much of the volatility in late 2016 simply reflected the uncertainty surrounding the new administration’s fiscal policy. That policy will begin to crystallize shortly, as President Trump and Congress begin to wrestle with the challenge of reconciling campaign promises with the reality of governing. Or put another way, the challenge of managing the trade-off between the allure of faster economic growth (driven by fiscal stimulus and tax reform) versus the threats of economic contraction (fueled by trade protectionism and an ascendant US dollar) and a higher deficit. While US fiscal policy is currently unpredictable, monetary policy is much better defined. As expected, the Federal Reserve raised short-term rates in December … while at the same time explicitly signaling its intention to implement a series of further interest rate hikes over the next two years. This is a clear signal that the Fed views the US economy on a firm footing, no longer requiring the support of an accommodative monetary policy.
Finally, and perhaps most encouraging, the prospect for corporate profits is more positive than it has been in almost two years. The fourth quarter of 2016 saw the first real signs of growth in profits since late-2014. With US stocks currently trading at or near all-time highs, the likelihood that the 8-year bull market in stocks will extend its run relies heavily on corporate profit growth.