2016: A Year of Surprises  

Brexit and the Trump victory were at the top of the surprise list, as pollsters got both predictions wrong up to and including the day of the voting. Markets acted very negatively after the British vote but European indices recovered most losses by year end.

In the U.S. election, initial negativity from the surprise Republican sweep was wiped out the next day as stock markets rallied led by industrials and banks. Government bonds had the opposite reaction as higher growth and inflation are expected with Trump's policies. Small Cap U.S. stocks, measured by the Russell 2000 index dropped 27% from June 2015 to February 2016 then soared 44% into year end. The 10 year U.S. Treasury yield went to 1.336% in July, 2016 and ended the year at 2.446%. This was in fact a multiple year double bottom in yield terms and likely marked the cyclical low. This jump and yields caused a principal loss of about 10% in the 10-year note and dragged down other fixed income investments and many yield oriented stocks.

Gold rallied 30% from Jan. – July, 2015 then dropped about 16% into year end. The U.S. dollar index- $DXY dropped almost 7% from Jan. – May, 2016 then rose 11% into the close of 2016 marking a 14-year high. Domestic stocks outperformed most asset classes.

If one stayed the course and weathered early year volatility, fears of China and European slowdown, combined with political uncertainty you prospered. Defensive investments did not pay off in 2016.

Key asset classes had mixed annualized returns as measured by various Vanguard funds listed below:

VGIT-- Intermediate Government Bond Fund +1.12 %

BND-Total Bond Fund +2.57%

VTEB-Tax Exempt Bond Fund +0.17 %

VGK- FTSE European Stock Fund -0.59 %

VOO- S&P 500 +11.96%

VWO- Emerging Markets Stock Fund +11.75%

We enter 2017 with the U.S. economic expansion closing in on its eighth anniversary, the third longest on record.  The longevity of this business cycle may portend a coming slowdown, potentially culminating in a mild recession and bear market in stocks in 2018. With that said, we support the view that business cycles do not die of old age. Energy-related capital spending is recovering. Business and consumer confidence are up. Animal spirts are rising with more pro-business policies expected from Republicans who have majorities in both houses.  

The financial system shows few signs of stress. The federal funds rate has a negative, real yield. The yield curve is upward sloping and credit is flowing.    

Fiscal policy is expected to turn simulative, with lower taxes, less regulation, and more infrastructure spending. 

Probable outcomes include:

Lower corporate taxes.

Repatriation of $2-4 trillion in cash held by U.S. corporations overseas.

Increased defense spending.

Deregulation with respect to banking and energy.

Support for Mr. Trump's agenda will not be unanimous. However, we are confident legislation and regulatory roll back will come about in the first 100 days of the new administration. For the stock market, earnings for the S&P 500 Index in 2017 may increase to around $131. This places the price/earnings ratio at about 17.3 times, forward earnings before any corporate tax cut. 

Every 1% decline in the corporate tax rate is said to generate an additional $1.30 in earnings. If the Trump Administration were to achieve its goal of a 15% corporate tax rate, this would imply as much as an additional $26 in earnings. 

Economists and the Fed expect no recession in 2017.

Real GDP growth and inflation of about 2% over the next 3 years is the base line forecast. I would not be surprised by higher growth along with higher interest rates as full employment is likely to raise wage levels.

The risks of course are there as well, if Mr. Trump starts a trade war with China, Mexico, or Japan. Adversaries will try to test his Presidential metal in the foreign affairs.

We see a positive return on stocks for the year ahead. Bond returns will be more difficult given rising short term rates as forecast by most experts.

We look forward to discussing with you, your account positioning,  and your investment goals as soon as possible. 

We wish you all a very happy, healthy, and prosperous New Year!

Doug Coppola

John Coppola

January 6, 2017

Communication is for informational purposes only & doesn't constitute offer to sell or a solicitation of an offer to purchase any interest in any investment vehicles managed by CFA or an associated person or entity. CFA does not accept any responsibility or liability arising from the use of this communication. No representation is being made that the information presented is accurate, current, or complete, and such information is always subject to change without notice. We do not provide legal, accounting or tax advice. Any statement regarding legal, accounting or tax matters was written about the explanation of the matters described herein & not intended or written to be relied upon by any person as definitive advice. Any discussion of U.S. tax matters contained within this communication is not intended to be used and cannot be used for avoiding penalties that may be imposed under applicable Federal, state or local tax law or recommending to another party any transaction or matter addressed.

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