U.S. financial markets have reacted swiftly to the results of the Presidential election. Equities have reacted positively as campaign promises of fiscal stimulus and tax cuts should provide a backdrop for stronger economic growth – at least domestically. The S&P 500 ended the year up 12.6%. These views have also led to a stronger U.S. dollar.
Fixed income markets have responded quite differently with lower prices and correspondingly higher yields. Those same campaign promises are likely to be inflationary and potentially will make the Federal Reserve (Fed) move to hike interest rates more than it would have otherwise. Despite highs and lows for bonds in 2016, we’re mostly back to where we started the year with long-term investors having essentially earned their coupon rate this year. The yield on 10-year Treasuries bottomed around 1.40% amid concerns over weaker global growth, deflation, and the impacts of Brexit. Treasury bond yields now appear to be closer to a fair reflection of economic fundamentals. Given the pace of the adjustment, however, we wouldn’t be surprised to see some retracement and further repricing as the market digests new information and reassesses the impact of the incoming President’s policies.
Economic data was already quite strong prior to the election. The U.S. is at full employment (defined as an unemployment rate at or below 5%). Third quarter gross domestic product (GDP) growth was recently revised upward to 3.2%. The inflation trend has been gradually moving higher. This in and of itself would imply that yields and interest rates should be moving higher. Proposed fiscal stimulus should be net expansionary, perhaps adding 0.5% to 1.5% to GDP over the next several years, and likely inflationary, which has led to sharply higher yields.
With the election over, markets turn their focus to the Fed. Even before the election, markets were expecting a 0.25% interest rate hike from the Fed in December, followed by a gradual hiking cycle that would likely include two hikes in 2017. Expectations for December remain intact; however, if the current market view of fiscal policy reflationary impact proves correct, the Fed will likely be forced to speed up its hiking cycle or risk falling behind the curve on inflation. Speculation about promised fiscal stimulus and tax cuts should continue to bolster markets. We continue to believe increased volatility should be expected and corrections of five and ten percent to stocks will not be uncommon as aforementioned policy actions take shape.
We have and will continue trimming stocks in more seasoned accounts on market strength, though we still think stocks provide the best long-term opportunities and continue to maintain an overweight position. We still favor domestic equities over international, and maintain our tactical overweight to small and mid-cap stocks. We believe that establishing the appropriate portfolio with a long-term, strategic perspective sets the foundation for achieving investors’ goals and objectives. We also believe there are shorter-term opportunities to improve risk-adjusted returns, but it’s important to clearly distinguish between these two perspectives. Diversification helps reduce volatility, but that also means holding asset classes that may not be in favor at a given time. Fixed income is an important component of volatility reduction and loss mitigation in times of financial market distress. By definition, a truly diversified portfolio will underperform the best performing asset class over short periods (current best performer: stocks which are near all-time highs), but investors will generally reap the benefits of diversification over longer periods.
As always, if it has been a while since you’ve visited with us about your financial goals, please feel free to contact your account administrator. They will find a mutually convenient time to review your account and determine if the current allocation is still appropriate for your circumstances.Some trust products and IRA contributions/balances are not a deposit, not FDIC insured by any federal government agency, not guaranteed by the bank and may go down in value.