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Market View

Politics and central bank policy set the pace for 2016, throwing some unexpected curves at the market.

At year-end 2015, amid the backdrop of a low-growth U.S. economy, stagnating corporate earnings, and slowing global demand, we surveyed the investing landscape for the year ahead and contemplated the outlook for key asset classes. The U.S. Federal Reserve (Fed) had just raised (on December 16, 2015) the fed funds rate for the first time in eight years, while the European Central Bank and the Bank of Japan were still engaged in quantitative easing, lending additional support to an already strong U.S. dollar. Our expectations for 2016 were for more of the same “muddle through” recovery we’d seen from 2010–15, namely low rates, low inflation, low growth, and strong returns from just a few places in the markets.

While we generally got those calls correct by and large, it clearly was a year of transition and political shocks that virtually nobody saw coming. What lies ahead in 2017 is perhaps far more uncertainty, as a new U.S. policy regime takes shape and perhaps a new Fed stance as well. We take a reflective look, from both a fixed-income and equity perspective, at the events during what became a very consequential year in the markets—and how they may shape investment opportunity in the year ahead.

The Year in Equities

At the outset of 2016, our view for equities was that a bifurcated market was unfolding. In short, Lord Abbett had become bearish on the broad S&P 500® Index, noting a continued earnings recession, weak overall GDP [gross domestic product] growth, and a volatile reaction to the end of the quantitative-easing tailwind. That said, we saw in this low-growth environment that there were opportunities for investors, notably in some quality dividend-growth stocks, secular-growth industries and companies, and in smaller-cap names that would benefit from investor preference for firms with U.S.-centric revenues. On balance, this theme did unfold between March and October. Book-ending that experience, though, was a sharp sell-off at the start of 2016 and a decisive rally in economically sensitive cyclical stocks following the surprise election of Donald Trump in November, coupled with a Republican sweep of Congress. To gauge the year ahead, first we offer a few observations on an eventful 2016.

The Global Slowdown Scare Deepens and Then Subsides
As noted, 2016 began with a thud, as global equity markets sold off immediately following disappointing manufacturing data out of China, causing the Shanghai Index to plummet 6.9% on the first day of trading in the new year, according to Bloomberg. That prompted the S&P 500 to follow in kind with a 2% decline, which only worsened into February. This market decline was both a continuation, and, in hindsight, the culmination of a macro-driven sell-off that began in August 2015, when fears of a “hard landing” in China’s growth trajectory gripped investors and caused a global sell-off and subsequent volatility into year end. As U.S. investors weighed this international fear with the continued earnings recession across S&P 500 companies, concerns of an economic recession appeared plausible in the case that China’s data continued to worsen and GDP growth continued to disappoint. At their 2016 bottom on February 11, oil prices neared $26 per barrel, reflecting dour expectations for global demand, along with potential recessionary pressures, while the equity markets were down more than 10%.

Fresh economic data in February, including an upward revision to U.S. GDP and improving consumer spending, then caused markets to rebound and they began a steady climb into summer that affirmed that a recession was far less likely than what had been feared. What still loomed ahead, though, were votes on Brexit and the hotly contested U.S. elections.

Political Shocks and Change Jolt the Markets in Ways Not Foreseen
From the February 2016 low into June, the equity markets continued a trend that’s been going on since 2010, and that is the same general direction occurring now in a low-growth global economy, particularly in the developed world. And yet, the historical intervention from central banks had driven equity prices to all-time highs by providing a powerful backstop against recessionary pressures. Both high-growth names up and down the market-cap spectrum and so-called “safety stocks” (i.e., those with low earnings volatility and durable dividends) outperformed. All the while, though, the “Brexit” vote loomed. With most forecasts calling for voters to reject the exit of the United Kingdom from the European Union, albeit by a fairly close margin, the referendum was expected to represent a symbolic protest by voters dissatisfied with the U.K.-EU relationship. However, the fervor of the “Yes” voters won out and—in a shock to global markets—the United Kingdom elected to leave the European Union, beginning the process in 2017. Market reaction was severe for four days, and then stabilized, reflecting, in our minds, two emerging concepts:

  • First, despite calls for dramatic intervention from global central banks at the time, none came. The subsequent stabilization in the markets reflected that while there is not robust GDP growth, we are in a better place today than we were during the European crisis of 2011–12, and therefore better able to weather a shock such as this far more credibly than back then.
  • Second, in hindsight, the vote was evidence of a powerful political force in the Western world—populism. In many nations, sentiment appears to have turned against the two-decade march of globalization, primarily against free trade and the fear of technology (viz., automation) displacing human labor.

These themes were confirmed by the far more shocking outcome of the U.S. elections in November. Not only was Hillary Clinton favored in virtually all polls, but also many forecasts showed the potential for a Democratic Senate and a possible sweep of the House as well. Obviously, the exact opposite happened, and the market reaction proved most stock market forecasters wrong as well. Instead of the dramatic sell-off pundits had thought would happen in the face of an outsider becoming president and of a one-party sweep, equities rallied strongly off the result in anticipation of expansionary fiscal policies in the new administration.

Dramatic Shifts Across Asset Classes
As reflected in Chart 1, the first half of 2016 was, from an investment standpoint, dominated by fear. When gold and silver are leading by a wide margin over other asset classes, with a 25% return over six months, the prevailing sentiment clearly is negative. Moreover, the preference within equities for large, low-volatility stocks and aversion to small-cap stocks continued.

 

Chart 1: In the First Half of 2016, Gold and Silver Glittered
Total returns (%) for selected asset classes, January 1–June 30, 2016

Source: Morningstar. Data as of June 30, 2016.
The investment categories listed in this chart are represented by the following indexes: Emerging Market Stocks, MSCI Emerging Market USD Index; Agricultural Commodities, S&P GSCI Agricultural Index; Gold & Silver, S&P GSCI Precious Metals Index; Small Cap Stocks, Russell 2000 Index; High-Yield Bonds, BofA Merrill Lynch U.S. High Yield Master II Constrained Index; Value Stocks, Russell 3000 Value Index; Convertible Bonds, BofA Merrill Lynch All Convertibles, All Qualities Index; International Stocks, MSCI EAFE Index; U.S. TIPS (Treasury Inflation Protected Securities), Bloomberg Barclays Capital U.S. Treasury TIPS Index; Large Cap Stocks, S&P 500 Index; Floating Rate Loans, Credit Suisse Leveraged Loan Index; Short-Term Corporate Bonds, BofA Merrill Lynch 1-3 year ‘BBB’ U.S. Corporate Index; EM Bonds (Emerging Market Corporate Bonds), JPMorgan CEMBI Broad Diversified Index; Barclays Agg. (Core Bonds), Bloomberg Barclays Capital U.S. Aggregate Bond Index; 10-Year Treasuries, BofA Merrill Lynch U.S Treasury Current 10-Year Index; Municipal Bonds, Bloomberg Barclays Capital Municipal Index; Growth Stocks, Russell 3000 Growth Index.
Past performance is not a reliable indicator or a guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.
Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

However, as reflected in Charts 2 and 3, the big political events of 2016 had a powerful “risk-on” reversal of those trends, with small-cap stocks awakening from their slumber, both due to their U.S.-centric revenues, which should benefit investors looking to take advantage of a strengthening dollar, and their higher return potential should economic growth accelerate. 

 

Chart 2: In the Second Half of 2016, Equities Roared Back and Bond Yields Soared
Total returns (%) for selected asset classes, July 1–December 30, 2016

Source: Morningstar. Data as of December 29, 2016.
The investment categories listed in this chart are represented by the following indexes: Emerging Market Stocks, MSCI Emerging Market USD Index; Agricultural Commodities, S&P GSCI Agricultural Index; Gold & Silver, S&P GSCI Precious Metals Index; Small Cap Stocks, Russell 2000 Index; High-Yield Bonds, BofA Merrill Lynch U.S. High Yield Master II Constrained Index; Value Stocks, Russell 3000 Value Index; Convertible Bonds, BofA Merrill Lynch All Convertibles, All Qualities Index; International Stocks, MSCI EAFE Index; U.S. TIPS (Treasury Inflation Protected Securities), Bloomberg Barclays Capital U.S. Treasury TIPS Index; Large Cap Stocks, S&P 500 Index; Floating Rate Loans, Credit Suisse Leveraged Loan Index; Short-Term Corporate Bonds, BofA Merrill Lynch 1-3 year ‘BBB’ U.S. Corporate Index; EM Bonds (Emerging Market Corporate Bonds), JPMorgan CEMBI Broad Diversified Index; Barclays Agg. (Core Bonds), Bloomberg Barclays Capital U.S. Aggregate Bond Index; 10-Year Treasuries, BofA Merrill Lynch U.S Treasury Current 10-Year Index; Municipal Bonds, Bloomberg Barclays Capital Municipal Index; Growth Stocks, Russell 3000 Growth Index.
Past performance is not a reliable indicator or a guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.
Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

Sector Themes
A key outcome of the U.S. election was a dramatic shift in investor sentiment away from the few sectors of the U.S. economy that had been leading for years and into areas that had lagged. Specifically, we had seen technology, staples, utilities, and telecom lead while economically sensitive sectors such as financials, industrials, energy, and materials lag. The summary of this disparity is that in a low-growth world with higher expected volatility, the targeted areas for investment were either in the highly transformative area of technology (e.g., the “FANG”1 [Facebook, Amazon, Netflix, Google] trade of 2013–2015) or in durable income stocks in the staples, utilities, and telecom sectors. At the same time, investors avoided stocks that were economically sensitive simply because by definition their benefit is only realized when economic activity is strong or improving. 

Following the U.S. elections, the narrative shifted dramatically. Financial stocks, in particular, took off because for years they have been shedding unprofitable activities, lowering costs, and increasing their operating leverage. With expectations now that interest rates likely will rise and benefit their net interest margins, the markets are viewing their outlook as suddenly robust given that just a small improvement in revenues could dramatically affect their bottom lines. Similarly, for industrial commodity stocks that could benefit from increased infrastructure investment or energy and materials stocks that could benefit from a revival in the energy space, investors have pulled back their allocations to the “financial repression”2 trade and reallocated to cyclicals. We will see how far this shift can run in 2017 once the new government takes office, but clearly the equity markets have undergone a psychological recalibration of where growth acceleration will be coming from in the U.S. economy going forward.

Equity Outlook
Interestingly, while the economic landscape has changed due to political change, our outlook for 2017 is not significantly different than 2016 from an equity perspective. We still think exposure to high-growth stocks will be important in the coming years for investors needing to meet long-term portfolio objectives.  While we believe economic growth could accelerate with infrastructure and tax policies, it likely will still remain below trend for some time to come. As a result, broad equity market returns could disappoint investors. Finding big growth themes such as financials rallying off a near-decade of financial repression or information security stocks rallying in an increasingly insecure world will be key, and investors should look to allocate to these types of big themes. We also believe investors who want to insulate their portfolios from foreign risks, whether they be currency, economic, or political, will want to continue to focus on smaller-capitalization U.S. stocks. 

Finally, we continue to believe that a focus on durability through dividends will be an appealing way to navigate uncertainty for investors who are looking for a smoother ride to the same destination over time.  For more detail on our 2017 equity outlook, see two pieces we’ve written recently on dividends in a rising-rate environment and trends to watch in the broader equity market

The Year in Fixed Income

Coming into 2016, the bond market faced multiple challenges. Not only did the market have to deal with uncertainty regarding central bank policy, credit markets were under stress from concerns of slowing global growth. Falling commodity prices led to sharp declines in the energy and metals and mining sectors of the high-yield market, eventually spilling over to other corporate credit sectors. This volatility created attractive valuations in the high-yield bond and floating-rate loan markets. While this environment also led to wider spreads among investment-grade corporate bonds, short-duration corporates held up reasonably well. We had suggested that short-term corporates may offer an alternative for investors who were looking for income with limited interest-rate risk, and less volatility than other segments of the market. Municipal bonds, as a domestic asset class, also had performed well during the market volatility that had been sparked by global issues at the end of 2015. The 2016 outlook for municipals appeared positive as credit fundamentals continued to improve, retail demand was robust, and the asset class offered attractive aftertax income in a yield-starved world. What follows is how the year evolved in various segments of the market.

Credit Market Recovery
The year 2016 started in “risk-off” mode in the credit markets. Concerns over commodity-related credits led to continued spread widening, with high-yield bond spreads increasing by nearly 200 basis points (bps) in just the first six weeks of the year. In early February, spreads approached 900 bps over U.S. Treasuries, and the average yield in the high-yield market exceeded 10%, according to Bloomberg. But the market staged a dramatic turnaround: After bottoming out on February 11, the high-yield market rallied throughout the rest of 2016, with spreads tightening by nearly 475 bps from their peak. After posting sharp losses to start the year, the high-yield market ended the year up more than 17%. Those segments that were most out of favor to begin the year led the way, with energy up nearly 40% and the metals and mining sector soaring more than 50% in 2016, Bloomberg reported.

Treasury Yields Hit Historical Lows, and Then Bounce Back
In a similar fashion, Treasury yields experienced a roller-coaster ride in 2016. As spreads widened in the first six weeks of the year, the yield on the 10-year Treasury bond fell, according to Bloomberg. Concerns over slow growth kept rates low through the first half of the year, with the 10-year Treasury reaching a low of 1.36% on July 8, after the Brexit vote. But rates started to tick higher in the second half of the year on signs of stronger economic growth and increasing inflation pressures. The move to higher rates accelerated after the election of Donald Trump to the presidency on November 8. By year-end, the yield on the 10- year bond had increased by more than 100 bps off its low, ending the year about 25 bps from where it began the year, Bloomberg reported. This move to higher rates led to losses in Treasury securities, as well as losses in the representative Bloomberg Barclays Aggregate Bond Index, which largely is comprised of government-related securities, in the second half of the year. Credit-sensitive sectors of the market, such as high-yield bonds, floating-rate loans, and short-duration corporate bonds, were able to generate positive returns in spite of rising Treasury yields, as they have historically during periods of rising rates.

Municipals
Although municipals generated strong returns in the first half of 2016, the end of the year was not as kind. The asset class began to face the headwinds of rising Treasury yields and an increase in supply in the fall. Problems were exacerbated post-election, as sharply higher Treasury yields, combined with additional policy concerns, led to price declines for tax-free bonds. Mutual fund investors reacted by selling, resulting in large fund outflows, which put additional technical pressure on the asset class. This was not a great year for municipals, but as we have seen in the past, lower prices and more attractive valuations eventually bring buyers back to the asset class. With yields much higher now, according to Bloomberg, we think it is likely that after the current volatility, investors will recognize that the asset class appears relatively attractive and that the uncertainly over the policy issues that are causing concern might not be so negative after all. 

Outlook
Despite the strong rally in high yield in 2017, our leveraged credit team remains positive on the U.S. economy, and believes that credit conditions in the high-yield market are improving. There are, however, certain segments that are, we believe, better positioned than others to potentially perform well in this environment. Within our investment-grade mandates, it seems that while the market has been pricing expectations for stronger U.S economic growth, several factors could lead to increased volatility. This suggests taking a diversified approach to fixed income—and being prepared to take advantage of periods of spread-widening during those bouts of volatility that will eventually come to pass.  

(For more information, please see our recent Fixed-Income Outlook for 2017.)

In Brief, Did 2016 Meet Our Expectations?

Certainly, the S&P 500 exceeded our expectations, with a total return of 13% for 2016, since, like much of the rest of the world, we did not anticipate the global political shocks and their consequences. Notably, the bulk of the S&P 500’s returns came after November 8.  

On the fixed-income side, our 2016 outlook for high-yield bonds, floating-rate loans, and short corporates turned out to be correct, at least in terms of direction. But few expected high yield to end the year up a substantial 17.5%. The 40–50% gain in commodity-related names would have been difficult to predict.  Finally, the negative year experienced in the municipal market was not in line with our expectations.

 

Chart 3: Political Events in 2016 Had a Powerful “Risk-On” Effect, Especially for U.S.-Focused Assets
Total returns (%) for selected asset classes, December 31, 2015–December 29, 2016

Source: Morningstar. Data as of December 29, 2015.
The investment categories listed in this chart are represented by the following indexes: Emerging Market Stocks, MSCI Emerging Market USD Index; Agricultural Commodities, S&P GSCI Agricultural Index; Gold & Silver, S&P GSCI Precious Metals Index; Small Cap Stocks, Russell 2000 Index; High-Yield Bonds, BofA Merrill Lynch U.S. High Yield Master II Constrained Index; Value Stocks, Russell 3000 Value Index; Convertible Bonds, BofA Merrill Lynch All Convertibles, All Qualities Index; International Stocks, MSCI EAFE Index; U.S. TIPS (Treasury Inflation Protected Securities), Bloomberg Barclays Capital U.S. Treasury TIPS Index; Large Cap Stocks, S&P 500 Index; Floating Rate Loans, Credit Suisse Leveraged Loan Index; Short-Term Corporate Bonds, BofA Merrill Lynch 1-3 year ‘BBB’ U.S. Corporate Index; EM Bonds (Emerging Market Corporate Bonds), JPMorgan CEMBI Broad Diversified Index; Barclays Agg. (Core Bonds), Bloomberg Barclays Capital U.S. Aggregate Bond Index; 10-Year Treasuries, BofA Merrill Lynch U.S Treasury Current 10-Year Index; Municipal Bonds, Bloomberg Barclays Capital Municipal Index; Growth Stocks, Russell 3000 Growth Index.
Past performance is not a reliable indicator or a guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.
Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

1 FANG trade references the dramatic returns of four dominant market leaders – Facebook, Amazon, Netflix, and Google (now Alphabet). The performance of the four stocks reflected the narrowness of the equity markets, especially in 2015 where, if not for those four stocks, the S&P 500 would have been negative. The peak of their performance suggested that the market would only reward massive companies consolidating market share at the expense of most others.

2 Financial repression is a broad term that can have a number of meanings. With reference to the 2010-2015 period, it refers to a period of ultra-low rates both on the long end and the fed funds rate on the short end. On the short end, the low rates are designed to fight recession and deflation, which is effectively a penalty on saving. It also has come to include heavy regulation on banks both in terms of tight lending and reducing their scope and size. Many believe that some of these policies saved the United States and the global economy from falling into a depression after 2008, but the consequences have been low growth. The financial repression “trade” references investor preferences for low-volatility assets in this environment as well as a handful of big secular winners that don’t rely on broad economic growth for success. Lastly, the term has become connected to financial engineering  In an era with no economic growth, companies have sought to generate growth through restructurings, leverage, and buybacks.

 

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