January 09, 2017
Monthly Market Summary – December 2016
Central bank decisions were a main focus for market participants during December. As was widely expected, the U.S. Federal Reserve Open Market Committee (Fed) raised the federal funds rate by 0.25% with a unanimous vote. This was the first rate increase since December 2015. The federal funds rate target range is now 0.50% – 0.75%. The Fed also raised the discount rate and the rate paid on required and excess reserves. In a move that was unexpected, the Fed increased the number of projected rate increases in 2017 to three from two. The rate hike projection was increased because, as the Fed commented, inflation expectations have risen considerably and labor conditions have tightened. However, the Fed repeated that they expect the pace of rate increases to be gradual as economic conditions warrant. In another much anticipated announcement, the European Central Bank (ECB) left interest rates unchanged but announced that the monthly asset purchases (quantitative easing or QE) will be extended from the original expiration date of March 2017 through December 2017. However, unexpectedly, the amount of the monthly purchases will be reduced by €20 billion, which was interpreted by some analysts as a tapering of monetary stimulus. Financial markets initially sold off after both the Fed and ECB announcements but mostly rebounded on signs of improving economic conditions.
Market Indices – December 2016
Similar to the prior month, much of the economic news reported during December showed improving conditions and added to market participants’ expectations for stronger economic growth, higher inflation, and higher interest rates. For example, the third quarter U.S. gross domestic product (GDP) growth estimate was revised up to 3.5% from the prior estimate of 3.2%. Both the Institute for Supply Management manufacturing and non-manufacturing indices were higher than in the previous month with the manufacturing index coming in better than expected. The housing market continues its uptrend with existing and new home sales rising. The latest U.S. jobs report was solid with unemployment dropping to 4.6%. Other economies continue to see improvements also. The unemployment rate for the eurozone declined to 9.8% and the latest eurozone composite purchasing managers’ index (PMI) report remained in expansion territory at 53.9. In China the PMI is back to the July 2014 high of 51.7 and industrial production beat analyst expectations with a 6.2% gain. In Japan, retail sales rose a better than expected 1.7% and industrial production was up 1.5%.
Major U.S. equity indices continued to march higher in early December reaching several new record highs before pulling back a bit late in the month. Small-capitalization (cap) stocks continued to be the performance leaders. The Russell 2000® index had a return of 2.8% compared to returns of 2.0% for the S&P 500 and 1.1% for the Russell MidCap® index. Small-cap stocks in general were seen as benefiting the most from Trump administration policies because they tend to have more domestically focused businesses. On a style basis, value outperformed growth in the equity indices because telecom, utilities, financials, and consumer staples had the best returns while healthcare, consumer discretionary, and technology stocks had lower returns. After a pause in November, investors’ focus returned to high dividend sectors, such as consumer staples and utilities leading interest rate sensitive sectors to post the highest returns for the month. Sectors that had the largest gains in November on expectations for faster economic growth, such as industrials, energy, and materials cooled and were among the weakest performing sectors in December. Healthcare also was weak as drug pricing concerns and uncertainty about the impact of potential changes to the Affordable Care Act continue to pressure the sector.
The MSCI EAFE index of developed international market equities and the MSCI Emerging Markets (EM) index had returns for December of 3.4% and 0.2% respectively on a U.S. dollar basis. Currency moves had a negative impact on the EAFE index return for U.S. investors as the dollar strengthened. On a local currency basis the EAFE index return was 4.5%. Currency movements had little impact on the EM index return for U.S. investors. Among developed international markets, eurozone country equity indices had the highest returns boosted by some better than expected economic data as a weaker currency has been a benefit to the region’s manufacturers and exporters. Among the emerging market countries, Russia was the top performer as that country’s economy is benefiting from higher oil prices which is expected to continue since Russia agreed to cut its oil production along with the Organization of Petroleum Exporting Countries (OPEC). China was a laggard with a negative return for the month hurt by significant capital outflows as the Chinese yuan weakened. In addition, the India index had a small negative return as the demonetization policy recently enacted continues to be a drag on that economy.
The Bloomberg Barclays U.S. Aggregate Bond index had a return of 0.1% in December. During the month, government bonds sold-off as higher oil prices spurred expectations for a pick-up in inflation, the Fed raised the fed funds rate by 0.25%, and the Fed unexpectedly increased the number of projected rate hikes in 2017. Bond prices decline as yields rise. The 10-year Treasury bond yield rose in December to over 2.5% for the first time since 2014 and ended the month at 2.45% which is up from 2.37% at the end of November. All but the shortest maturity Treasury bond indices posted a small negative return for the month. Non-U.S government bonds sold-off as well. Prices for China’s five and 10-year treasury bonds dropped so sharply that trading was temporarily suspended. U.S. corporate and municipal bonds fared better and ended the month with positive returns. U.S. corporate high yield bonds posted the highest returns for the month helped by improving conditions in the energy sector.
The Bloomberg Commodity index had a return for December of 1.8%. Gains of 10% for the livestock sub-index and 9% for the energy sub-index drove the broad commodity index higher offsetting negative returns for the industrial metals, precious metals, and grains sub-indices. The price of crude oil rose during the month on news that 11 countries joined OPEC in agreeing to production cuts. West Texas Intermediate crude oil was priced at $53.72 per barrel at the end of December, which is the highest price in 17 months. The price of gold declined during December to reach $1,154 per ounce at month-end as the dollar strengthened.
Vogel Consulting, LLC (Vogel) Tactical Recommendations
No changes were made to our tactical asset allocation recommendations during December. Economic data is showing improvement. Also, expectations are high that business-friendly economic policies such as tax cuts and infrastructure spending proposed by President-elect Trump will lead to higher economic growth in the U.S., but the details and timing of any policy changes are uncertain. Due to that uncertainty, it is likely financial markets will experience bouts of volatility as more details emerge about any fiscal or monetary policy changes. Therefore, we are maintaining our neutral position in U.S. equities. We continue to underweight developed international stocks even though there are some signs of improving economic conditions because uncertainty remains high in Europe due to several upcoming elections. Also, the U.S. dollar is likely to strengthen due to better economic growth and higher interest rates relative to other developed countries. A stronger dollar could dampen international equity returns for U.S. investors. We continue to expect interest rates to move gradually higher and therefore continue to underweight fixed income.
Our tactical asset class recommendations include an equal weight position in U.S. large-cap, mid-cap, and small-cap stocks as well as emerging market equities with an underweight to developed international equities. We continue to recommend an equal weight to hedge fund strategies and an underweight to fixed income. We favor hedge fund strategies over fixed income for the lower expected volatility portion of portfolios since bond yields are near historically low levels and are likely to rise and bond prices fall as central bank polices are adjusted. Within fixed income we continue to recommend a focus on short to intermediate term bonds. We also continue to favor non-Treasury bonds for the yield advantage they provide compared to Treasury bonds. Since our expectation is for a moderate rate of inflation to continue, we recommend an equal weight to real assets. Finally, we expect that financial markets will experience periods of wide swings up and down due to changes in expectations about Federal Reserve interest rate policy, oil prices, economic data reports, political news particularly in Europe and as more details become known about any actual or expected changes to government policy and regulations as the Trump administration begins work. Therefore, we continue to recommend using periods of market strength to raise any cash needed to support spending needs over the coming 12-24 months.
The statistical information contained in this commentary has been compiled from publicly available sources and is presented to you for your review and for discussion purposes only. The information contained in this commentary represents the opinion of the author(s) as of its date and is subject to change at any time due to market or economic conditions. These comments do not constitute a recommendation to purchase, sell or hold any security, and should not be construed as investment advice or to predict future performance. Past performance does not guarantee future results.
The statistical information contained in this commentary was derived from sources that Vogel Consulting, LLC believes are reliable, and such information has not been independently verified by Vogel. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Russell Investment Group. An index is not managed and is unavailable for direct investment.