For the investment markets, 2016 was another turbulent year, with several impactful events causing significant swings in the bond and stock markets. This quarter’s commentary addresses seven common questions regarding the investment markets and current strategies of BKD Wealth Advisors, LLC (BKDWA).
1. How’s the U.S. economy doing?
The U.S. economy continues to grow at a slow pace; 2016 growth is expected to be approximately 2% above inflation versus the long run average of 3%. While growth has been slow, the length of this expansion has allowed unemployment to drop below 5% and moved many economic indicators near record levels.
2. How did the stock and bond markets fare in 2016?
A market correction ushered in 2016, followed by more turmoil in June when U.K. voters chose to break from the European Union with the surprise Brexit vote. However, the last quarter had even greater influence on 2016’s performance. A significant postelection rally drove U.S. stocks to near record levels while bonds and international stocks didn’t fare so well. Increased inflation expectations caused interest rates to rise and U.S. bond values to drop. The strength in the U.S. dollar caused international stocks to decline in November and December; indexes finished 2016 with low, single-digit returns for the year.
3. Why did the U.S. stock market rally after the Trump victory?
As election results were tallied and a Trump victory became clear, stock market futures fell by more than 5%. But investor optimism gained traction and U.S. stocks went on to stage a strong finish to the month and year. The gains were sparked by expectations regarding the new administration’s policies, which may include:
- Lower corporate and personal income tax rates
- Less government regulation
- Increased infrastructure spending
- Anticipation these and other policies will increase growth in our economy
4. Has portfolio diversification lost its effectiveness in the current environment?
It’s critical to remember diversification across asset classes is primarily a risk management tool, limiting losses when stocks or other asset classes decline. This benefit was illustrated in early 2016, when U.S. stocks fell more than 11%, while balanced portfolios declined only 5%.1 However, U.S. stocks rallied in the last half of 2016 and outperformed all other major asset classes by more than 7 percentage points. During this period, diversifying among stocks, bonds and alternative investments resulted in a drag on returns versus a portfolio of U.S. stocks alone. Considering we’re seven years into this bull market, diversification and risk management are becoming more important.
5. Considering the rally in U.S. stocks, should investors add to this asset class?
Since the market recovery began in 2009, U.S. stock have gained 15% per year—well above their long run average of 9%. While earnings growth kept pace with the rise in stock prices in the bull market’s early stages, 2016 profits declined. As a result, the market’s price-to-earnings (PE) multiple increased from 19 to 22 on a trailing 12-month basis,2 which is at the high end of the historical range. At current market PE levels, the likelihood of U.S. stocks producing above-average returns going forward is low. Logic argues against increasing U.S. stock exposure at this time.
6. Is the Federal Reserve going to raise rates further in 2017, and will that hurt bond returns going forward?
The Fed is currently expected to raise rates by 0.25% three additional times in 2017. However, BKDWA believes the U.S. bond market already reflects these increases, which means actual Fed action should have less of an effect when it occurs and minimal bond market effect.
7. What is the investment outlook for 2017?
For U.S. stocks to move higher, corporate earnings must grow. U.S. stock returns of 12% in 2016 weren’t supported by underlying growth, and the result was the market’s PE ratio increasing to 22, which is on the upper end of its historical range. If the Trump administration lowers corporate tax rates and passes other pro-growth policies, the market is likely to maintain recent gains; if not, U.S. stocks could be at risk for a decline.
The international stock allocation remains an important component of diversification and should prove productive despite the strengthening dollar. Growth appears to be picking up in many foreign economies, valuations are more attractive than in the U.S. and dividend yields are higher. These are all positive characteristics for investors.
Inflation is on the rise, causing interest rates to climb. Although this caused negative bond returns in the fourth quarter of 2016, it improves the future return potential of bonds and certain alternative investments.
In summary, the prolonged run of outperformance by U.S. stocks may be coming to an end. However, international stocks and alternative investments are poised to produce better returns, which should result in an improved risk and return experience from globally diversified portfolios in 2017.
1 BKDWA Growth & Income Allocation – January 1, 2016, to February 11, 2016
2 S&P Dow Jones Indices: S&P 500 operating earnings through September 30, 2016
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.