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Q4 2016 Review & Outlook: An Early Take



Below we show the pre-tax year to date total returns (includes changes in price  & dividends) of three broad based index funds representing the total US market (VTI) , all foreign equities (VEU), and emerging markets (VWO). The total returns are impressive in the main. If we convert them to compound annual basis, they get bigger: 11.9% for US equities, 2.7% for foreign equities, and 14.2% for emerging markets stocks.  We note, although do not show it in the graph, Developed Foreign Markets are down -.2% on a total return basis for the same time period. We see a strong argument for diversification.


US Equities by Growth/Value and Large/Small Capitalization

Small cap stocks were up +16.4% leading all other sectors, followed by Value at +13.7% with Growth stocks in last place with +5.6%. Not bad numbers at all, far exceeding our expectations. Whether they are sustainable remains to be seen.


Fixed Income

Fixed income is of particular interest because this is where it all starts globally, where the linkages intersect the global markets instantaneously in terms of economic expectations, currencies, liquidity, credibility and confidence. Below we display Long Term Government Bonds, the Total Bond Market, Short Term Investment Grade Bonds, junk, and Emerging Markets bonds, and we see a significant point of inflection.

Reviewing the total returns year to date one is tempted to say, ‘well, not too bad,’ and indeed it is not. But there is something in the works. Look at the drawdowns, the declines from highs in the period for long bonds and emerging markets (green and red lines below, respectively). These are significant declines. A drawdown of ~11% in long bonds over a short time frame might make one question if the fixed income party is over. It certainly evidences the risk of duration, and much more to come, one suspects.



All this was driven by relative large moves across the curve with no formal action by the Fed. See the 10 and 30 year rates below. Seems to us a Fed move on short rates is a foregone conclusion but moot with regard to markets.


Probability of a rate hike & inflation expectations

Rate hikes and expectations are linked, and the Fed is following, not leading. Below we see courtesy of the Chicago Mercantile Exchange a translation of actual interest rate futures prices to the probability of a Fed hike. This is what the market thinks or rather what expectations market prices reflect.


We can also get a view of the longer term expectations by looking at the 5 year, 5 year forward inflation curve which reflects the market view of future inflation. More specifically, it is a measure of expected inflation (on average) over the five-year period that begins five years from today. And again, we see a significant trend.


Labor markets

Labor markets have reached what the Fed defines as full employment, that is unemployment at 5% or less. In their documented policy view, it’s game over, time to hike.


Of course, we do not agree with the metric of their primary benchmark, the Unemployment Rate, which ignores persons who are not looking for work (evidently people who could work but have stopped looking for work do not exist). So we included the Labor Participation Rate just to be contrary. It does raise a question: is there hidden slack in labor force? If so, it might be positive for economic growth in face of potential welfare reform. If not, we retain the same embedded costs and move on with the rate hike.

In any case the market expectations of higher nominal interest rates and higher inflation in connection with full employment seems to indicate higher rates are on the way. The questions, of course, are when and how much? Our view is that a .50% move by the Fed is a bit aggressive given their pattern of  passive/aggressive behavior, and a .25% hike... an action sufficient to have no impact... is much more likely. Nothing may be the best outcome. We’ll see. Only the Janet knows... which, in and of itself, seems to beg for reform of the Fed.

Credit spreads

Credit spreads are the premia that bond buyers pay over the US Treasury rate to compensate them for credit risk. Spreads indicate risk appetite of investors and represent a cost of credit that incorporates an acceptable return after expected losses. Spreads are a major component of the cost of money, and the trend for most of 2016 has been down. If rates go up, one might expect spreads to go up. It’s nature’s own way of tightening, and it can happen even absent explicit Fed actions. Spread widening based on an expectation of increasing demand for money to fund real, productive transactions can be a sign of economic growth and beneficial for equity markets. Alternatively, spread compression can also indicate a reduction of perceived credit risk. We’re not sure which phenomena we face.  We still retain a bias to investment grade product in favor of treasuries which in our view represent return free risk.


Yield curve offers some comfort

An upwardly sloping yield curve is generally a good thing, while a flat or negative curve can be a leading indicator of recession. The data below is the difference between the 2 and 10 year Treasury rates. Note the recovery of a more positive slope was mostly driven by a significant move in the 10 year rate. We view this as a positive indication. Adios, Mr. Obama.


The US$

The trade weighted US$ has strengthened to levels not seen since November, 2002. This will make US$ based exports more expensive to foreign buyers but imports less expensive for US$ based buyers. Most US based multinationals have a diversified portfolio of currencies, across both costs and revenues, so the impact will be negative, but manageable. It’s not like they haven’t seen a strengthening dollar for the last decade. Small to midsize companies face the same phenomena but typically have less international diversification.

Now is not a bad time to travel because your pommes frites avec vin rouge along with foreign stocks just got a lot cheaper.




We still face significant unknowns, but on balance the downside bleed of destructive policies of President Obama will soon cease. This alone is the basis for some optimism as the relief rally in equities has shown.

Where we go from here is the question that will be clarified. We do have concern about the aging bull markets in equities and fixed income. They are long in tooth and both fueled by money printing or “quantitative easing” in newspeak. Consider that from March of 2009 to date the total return of  the broad US market ( VTI )  was 290% (or 19.3% CAGR). That’s a very long & large run. See below:

Interest rates may well be a catalyst for correction... or geopolitical events or liquidity events abroad.  If the Fed does move, count on a retrenchment in stocks, but also realize that rising rates do not always mean a falling stock market, but there are many moving parts, including some that may be beneficial, some that may explode.


From a short term perspective domestic equities are at an all time high. Anticipate a correction. It may only take a little bad news, and we have so many opportunities to get it. Longer term we sense there significant upside as the move by the equity markets post election seems to validate, but we’re not sure the risk is diminished. We’re going to be moving some big, powerful things around, and we’re working pretty much without a net.

We anticipate rising rates but expect them to be modest. We do think we have reached a signal point of inflection for the bond market, that fixed income investors might wish to avoid an undiversified fixed income strategy that relies upon duration or junk spreads for yield. It could get a little chippy out there in fixed income.

Europe and Asia are not in good shape.  Europe has no choice but to monetize its debt by further devaluation, and that will spur capital inflows to the US Treasuries and equities.  Europe will essentially lower their standard of living and decapitalize their citizens by a long, slow bleed. Brexit fever may well spread to France and others. It could get a little more messy.

Mr. Trump

And all this brings us to Mr. Trump. We still face significant unknowns and will have to parse out the difference between what Mr. Trump says, what he means, what he wants to get done, and what he can get done.

We think much of the initial & ongoing hysteria was manufactured and overdone. Recall how all the hedge funds & talking heads were certain that if Trump won the equity market would instantly collapse? Wrong. Not only wrong in magnitude, but direction. Dead wrong, and remember that the next time you’re feeling frisky.

We think the manufactured hysteria about “he’ll do something crazy” is also overdone. We have this thing called the separation of powers, or at least before Obama we did. As a practical matter Trump will face severe opposition from incumbent Congressional Democrats. One suspects the Supreme and Federal courts will not accord him the same unlawful leeway accorded Obama, and we hope for sake of rule of law that they do not. Lastly, support by the Republican Congress, many of whom dislike the man for having disrupted their sandbox, should not be taken for granted. It will be necessary. Our sober view is that significant safety rails are built in.

As to policy matters, Mr. Trump’s  stated tax policy is a material improvement over our current (and imbecilic) tax regime and will likely generate higher levels of economic growth. His energy policy will create significant changes to domestic energy production and impact global petro$ flows. More petro$ will flow to US producers which in turn helps domestic capital formation & employment while simultaneously de-capitalizing many state sponsors of terror and other bad actors. Small changes in the long term expected cost of energy and the geopolitical risk associated with the energy supply chain can have a significant impact on the US and global economies, investment and employment... not to mention consumer spending. It might very well happen in the intermediate term.

Trade policy is our main concern. Wilbur Ross, David Malpass, Stephen Moore, and Peter Navarro are members of his Economic Advisory Council, and they have their work cut out for them on trade. But again, we suspect and hope Trump’s rhetoric may be a bit different than the results he may generate. We don’t need a trade war or another Smoot-Hawley.

From our perspective, though, and it may strike some as odd, education policy is the real touchstone.  Look at the waste of generations of human capital impaired by the serial failure & corruption of our public school systems and higher education. It spans generations and borders on gross neglect.

By that standard America may be seen as one of the underdeveloped countries in the world. It is not our resources that make our country great but our people, our human capital. The long term fix is to break the educational monopoly that has come to exist. Improve the schools, improve the quality of education, and greatly expand access to it by adding parental freedom of choice. If he can deliver educational freedom to the inner cities, to the entire country... look out. America just may be great again.  


we can all remind ourselves that the richness of this country was not born in the resources of the earth, though they be plentiful, but in the men that took its measure.” - And the Fair Land


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