Market & Economic Review - First Quarter 2017
2016 was a year full of surprises from Brexit to the U.S. election, and the continued rise in equity prices. At the beginning of the year it didn’t look like equity markets would get close to an all time high. The S&P 500 fell about 10.5% by the middle of February managing to end the quarter slightly higher. The first half of the year was all about China and the drop in oil prices. Oil dropped below $30 a barrel and China was experiencing de-acceleration in GDP growth and lending. The 10 year Treasury dropped from 2.3% at the end of 2015 to 1.65% in February. In the second quarter, the focus was on Brexit, or the low probability of a yes vote. Odds that it would pass were between 10%-25% prior to the referendum. Markets priced in a remain vote and quickly shifted after the results came in. The Dow fell over 900 points in the next two days, while the Pound fell to its lowest level since 1985. Prior to Brexit, the odds were favorable that the Fed would raise rates in the third quarter. The selloff in markets and the uncertainty of how Britain would exit the EU pushed off that decision. The fourth quarter was about the election and the Fed raising rates. As we saw in the Brexit polling the expectations were that the Democrats would control the White House while the Republicans would barely hold congress. Markets priced in a continuation in policies, such as financial and healthcare regulation and low growth. Once again the odds were over 70% that Clinton would be the next President, and once again markets and polls were wrong. After a knee jerk reaction decline the S&P 500 proceeded to have its’ best week in over two years, with Financials leading the way higher. The pundits and market strategists began to cipher what President Trump’s policies were and how they would affect markets. The overwhelming reaction was that they would lead to less regulation, higher growth, and higher inflation. With the run up in sentiment, the Fed felt like it was the right time to increase rates again.
For 2016, we experienced a higher than expected move in equities, as small caps led the way rising over 21%. The S&P 500 was up 12% and Emerging markets beat out Developed International markets. Coming out of 2015, we had seen Growth continue to outperform Value, and Emerging Markets continued to be pulled down by lower commodity prices. The first two weeks of the year saw the worst opening for U.S. stocks in history as we quickly were down 9%, bottoming out at a 10.5% drawdown in mid February. We began to see some shifts in market leaders, as Value began to outperform and Small cap stocks began to beat Large Cap stocks. This trend proceeded for the remainder of the year, and accelerated after the election. Financials benefited from the likelihood of less regulation and higher interest rates. Small cap stocks benefited from less international exposure and Small cap value from financial and energy exposure.
Coming into 2017, there seems to be an air of confidence and the belief that economic policy will get moving forward. In several surveys we see that confidence has indeed risen. The question is whether this confidence can be maintained once policy is actually revealed and implemented. The Philadelphia Fed Business Outlook survey was the strongest since 2000 and The Michigan Consumer Sentiment Index was the highest since 2005. Unfortunately neither survey is accurate at predicting growth in the economy or market direction. In fact, the highest readings tend to come right before the beginning of a slowdown and market correction. We do expect the trend in, value relative to growth, to continue to outperform going forward as cyclical and financials play a bit of catch up with some of the other sectors. With a continued strong dollar, we would expect small caps to offer better opportunities than U.S. large cap stocks. On the International front we see slightly better valuations, but a great deal of uncertainty as Europe will hold a couple of key elections that could see the populist wave continue. In addition, the details of Brexit will need to become more concrete. We do see opportunity in the export oriented economies of Germany and Japan, but again the administrations rhetoric on tariffs causes some uncertainty. After several years of diversification not being rewarded, we believe this year it will pay to be more diversified across many different strategies.
We saw a fairly large round trip move in the U.S. 10 year Treasury in 2016, as the yield started the year at 2.3%, dropped to 1.34%, and then ran back up to around 2.4% by year end. The U.S. is in the beginning stage of normalizing monetary policy after seven years of being very accomodative. We also see the rest of the world struggling with keeping policy loose or starting to normalize. In this type of environment we are bound to see volatility. Major bond indices were unchanged to up slightly. The Barclay Aggregate Bond Index was up about 2.3% while Municipal bonds were flat with High Yield up over 15%. High yield was mostly affected by energy companies who make up a larger percentage of below investment grade bonds rallying off of the bottom. Municipal bonds got hurt after the election due to the likelihood of personal tax rates going lower. Post election many of President Trump’s proposals were examined and investors keyed off of the possibility of more fiscal spending, more debt, and higher inflation. We tend to believe that U.S. rates will be somewhat compressed due to the rate differential with the rest of the world. One area of concern is that Municipal Bonds will be affected by lower taxes. The market has likely priced in President Trumps plan which would lower the top rate to 33% and get rid of the 3.8% Obama care tax. What is not priced in is the House version of the plan which would tax interest income at 16.5%. This would likely cause a selloff in Muni’s as they would be less attractive on a tax equivalent basis compared to Treasuries and Corporate bonds, which are more liquid. We think the likelihood of this plan passing is low, but we are looking to mitigate by staying shorter in maturities using individual securities. We are continuing to monitor and will adjust as needed. Other opportunities include floating rate senior loans, and structured credit (CLO’s, MBS, and CMBS). Currently we are in the camp of two rate hikes in 2017, as the Fed continues to weigh the affects of reversing the massive easing they put in place.
Once again we saw hedge fund strategies lag significantly behind equity markets, and once again we saw a large wave of redemptions. It looks like over $100bn was redeemed from hedge funds during 2016. Our results were significantly better in our Absolute Return strategy, but weak in dedicated Long/Short equity. Within the Absolute Return strategy, we did manage to outperform bonds significantly and started to see improvements toward the end of the year. Long/Short strategies were hampered from being long in areas like healthcare, and being underweight financials and materials. Within the Private space, we saw good performance from existing managers as a couple have had some early success with their underlying companies. As we mentioned in last quarter’s update, private equity valuations had risen to historical highs and we were being very selective and looking more at Mezzanine and Secondary funds. Within Mezzanine we can invest in funds that are getting 11%-13% interest with 10%-15% equity warrants in underlying companies, while being higher in the cap structure than private equity. In the Secondary market, we are able to take advantage of the redemption wave in hedge funds, by investing with managers who can purchase the illiquid side pocket investments (direct investments) at 50% to 70% discounts to current value. The discount is high due to the low amount of capital investing and the large wave of investors looking for liquidity. As we have done in the past, we are happy to be a provider of liquidity at a steep discount as we have the patience and dry powder to wait it out.
The new administration will bring with it some optimism of less regulation and growth oriented policies. It will also bring a high degree of uncertainty, as President Trump seems to proclaim bold ideas while having to shift based on the reality of actually passing them through congress. While many of his ideas will increase growth in the future, the drawback is that they will tend to be inflationary in the short term. We are prepared to see a more volatile market not only in equities, but in fixed income and currencies. In our opinion, being diversified will help to mitigate the higher volatility.
Synovus Family Asset Management Investment Team
Michael S. Sluder, Chief Investment Officer & Sr. Portfolio Manger
Andrea R. Parker, Senior Portfolio Manager
Zachary D. Farmer, Senior Portfolio Manager
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