January 2017

2016 In Review & Outlook

2016 Review

The final quarter of the year saw the S&P 500 rise from 2168 to 2239, for a gain of 71 points and a 3.3% increase in value. This gain was very much in line with the gain we saw in the third quarter of 2016, which was 3.2%. Overall, the S&P 500 began the year at 2044, ended at 2239, for a total gain of 195 points and a 9.5% increase in the index. Small stocks emerged with a gain of 8% in the fourth quarter, using the S&P 600 as our measurement, and an unbridled 24.7% for the year.

While U.S. stocks did well, their international counterparts did not do so well. The Stoxx Europe 600 index was down 1.2% for the year. (This may be an opportunity to allocate more assets to international investments.) Total returns on U.S. bonds were: Investment Grade Bonds up 5.8%; 10 year Treasury Bonds down 0.02%; and municipal bonds up 0.2%. The dollar increased in value against most foreign currencies, while crude oil rebounded from the end of 2015.

Corporate Picture

Corporate earnings finally grew in the third quarter of 2016, as reported during the fourth quarter. This was very important because we had not seen any earnings growth for the prior five quarters. With unemployment numbers below 5% and earnings up, the economy appears to finally be moving.

Stocks were boosted after the election with investors’ belief that changes to burdensome corporate regulations would be lifted, creating a business-friendly environment. These changes may lead to greater investment on the part of U.S. corporations in the U.S. Since the beginning of this economic recovery in 2009, we have not seen the significant increases in corporate capital investment or profits that have led recoveries in the past.

Whether or not corporate profits become robust remains to be seen, yet a number of companies have already indicated a willingness to make significant capital expenditures. Such expenditures could ripple through the economy and compound the growth of earnings and jobs creation. Bear in mind that the increasing value of the dollar will make exported goods and services more expensive in foreign countries and thereby reduce exports.

Consumer

Since the downturn in 2008-2009, the U.S. consumer has taken a very cautious attitude toward spending, resulting in reduced debt and increased savings. Over the same period, we have witnessed the unemployment level go from above 12% to below 5%. It should also be noted that at the height of the downturn, many people simply left the job market. Some of those have now returned and found jobs.  We still have a situation where many individuals are “underemployed”, meaning that their earnings are not commensurate with their abilities and education.

If corporate growth occurs in a meaningful way, many employees may find that their talents are once again in demand. In such an environment, we are likely to see wage growth. Generally, wages tend to grow when the supply of employees looking for jobs is less than the demand for new workers. In such cases, businesses looking for workers use benefits and increased wages to pry employees from current jobs.

In the fourth quarter, we saw increased consumer purchasing of goods and services, other than vehicles. One quarter is not a good indicator of consumer sentiment, but it does appear that consumers are becoming much more confident about the economy. Add to this picture increasing wages and a stable economy, and we could see a healthy pickup in consumer spending. Increased consumer spending could propel the economy forward at an accelerated rate.

The FED

I don’t want to be a spoilsport, but we do have to understand that the FED would like to see the economy grow in an orderly fashion. The FED also needs to get the discount interest rate to a point where they have some leverage if the economy begins to falter again.

The FED uses the discount rate to control the short-term aspects of the economy. These changes also tend to spill over into the longer-term direction of the economy. For example, in December 2015 and again in December 2016, the FED raised the discount rate by 0.25%. The discount rate is now at a targeted level of between 0.50% and 0.75%. The FED has indicated that they want to raise the rate at least three more times by the end of 2017. If these increases occur, then the discount rate could be 1.5% by the end of 2017.

The FRB increase has increased mortgage interest rates, which seems to be slowing the sales of homes, both new and existing.  The downturn in the housing market also impacts consumer spending on appliances and related home goods and services. In addition to increasing mortgage interest rates, other types of loans, such as small business loans, automobile loans and others are also rising. Higher interest rates tend to dampen the growth of the economy.

Inflation

Part of the concern that the FED has with growth is a rise in the rate of inflation.  While the FED seems accepting of an inflation rate of 2% to 2.5%, they don’t want it higher than this range. Rapid wage increases can mean an increase in inflation. Demand for more goods and services, from current levels, can cause a rise in inflation. Finally, the new President has expressed an interest in heavy spending on the infrastructure of the country. Such spending would also likely be inflationary, with more demand for laborers, materials and services to complete such projects.

A jump in inflation will also result in higher interest costs for U.S. Government debt. This increase in cost could exacerbate the growth of the National Debt and lead to further increases in the inflation rate. If the inflation rate begins to exceed the rate acceptable to the FRB, then we may see accelerated increases in the discount rate to slow things down. If that were to happen, the even higher rates might further slow corporate growth and consumer spending.

Conclusion

The final quarter of 2016 ended on a positive note, with corporate earnings increasing and consumer spending trending up. This may be a time of increasing volatility, with uncertainty about the above in the markets. In this environment a well-diversified portfolio will be important.

Ed Mallon

posted Tuesday, January 24, 2017 at 11:43AM