by Scott Smith, CFA

Note: This post is an excerpt from Gould Asset Management’s Economic and Market Review for the Fourth Quarter of 2016. The excerpt is posted here for the benefit of our blog subscribers.

US Stocks Jump as Markets Digest Trump’s Surprise Presidential Victory 

US stock markets finished 2016 on a strong note, rising 3.8% for the quarter and 12.0% for the year, as measured by the S&P 500 stock index. Donald Trump’s surprise win proved to be the defining event of the quarter. Markets surged on the prospect of increased infrastructure spending, lower personal and corporate tax rates, and relaxed regulatory requirements. Investors are saying that taken together, these measures will accelerate US economic growth.

Financial stocks surged on the quarter, rising 21.1% as measured by the S&P Financial Select Sector index, amid rising interest rates and expectations of a friendlier regulatory environment. Banks’ lending profits stand to benefit should the yield curve continue to normalize.

Mid and small cap stocks capped a remarkable year that saw the Wilshire 4500 index rise 6.5% on the quarter and 18.5% for the year. The strong performance comes on the heels of two consecutive years (2014-2015) in which large-cap stocks soundly outperformed mid and small caps, illustrating the benefits of broad diversification across all sectors and capitalizations of the US stock market.

Market volatility was modestly higher in the fourth quarter, with the VIX volatility index reaching a high of 23 just prior to the November elections, before falling back to more subdued levels (low teens) at year-end.

Strong US Dollar Proves Too Much for International Stocks

International developed markets failed to keep pace with the US, with the MSCI EAFE index falling 0.7% in the fourth quarter, and putting year-to-date returns at a meager 1.5%. The strong US dollar (up 5.4% on the quarter, and 4.3% on the year) contributed to the poor showing, although a number of thorny issues (such as slow economic growth, Brexit, terrorism, a refugee crisis, etc.) also factored into foreign markets’ performance.

Emerging markets stocks performed well in 2016, despite taking a step back in the fourth quarter. They shed 4.1% on the period, but still finished up 11.6% for the year. This will be an interesting segment of the world market to follow as we move further into 2017, given President-Elect Trump’s protectionist leanings and his unconventional approach to foreign relations so far with Russia, Mexico and China, three of the larger emerging economies of the world.

Bonds Retreat as Markets See Economy Heating Up; Fed Bumps Rates Higher

Bonds declined in the fourth quarter, but still posted positive returns in 2016. The Bloomberg Barclays US Aggregate bond index (a broad measure of US taxable fixed income performance), fell 3.0% on the quarter, paring year-to-date returns to 2.7%. 2016’s modest bond returns may become more typical, should interest rates continue to rise or even just stabilize at current levels.

Interest rates rose substantially in the fourth quarter in response to expectations of faster economic growth, with the 10-year US Treasury yield climbing from 1.60% at the start of the quarter to 2.45% by year-end. Higher growth usually translates into greater demand for borrowed money, as well as upward pressure on prices, both of which push interest rates higher. The Fed, also sensing an economy heating up, raised rates by 0.25% at its December meeting and projected multiple rate hikes in 2017.

Municipal bonds posted lackluster quarter and year-to-date returns, with the Bloomberg Barclays Municipal Bond index shedding 3.6% on the period to finish 2016 up 0.3%. Lower personal income tax rates would reduce the relative appeal of munis when compared to taxable bonds. The silver lining is that munis are now far more attractive than they were even just three months ago, and probably now represent a better value for high tax-bracket investors.

Energy Stocks and Commodities Finish Strong, REITs Slide

Energy stocks were among the best performing investments in 2016, rising 7.3% in the fourth quarter and 27.4% for the year. OPEC’s surprise decision to cut production in November pushed oil prices and the sector higher. Commodities rose 2.7% on the quarter and 11.8% on the year, while real estate investment trusts (REITs) succumbed to interest rate pressures, dropping 3.0% in the fourth quarter. Despite the slide, REITs finished 2016 up 8.6% and have a 3-year annualized return of 13.2%, making them one of the best performing asset classes since 2014.

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