The calendar turning is an arbitrary metric-point from which to measure and assess the recent past and what it portends for the future. It is a moment when we can take a step back and think about our goals and specific paths to achieving them. At key moments during the year, we contemplate what our year-end commentary would look like were the year to end at that very moment. In 2016, there were four distinct periods in which the narrative forged a decisive break from what preceded it:

  1. The Meltdown: January ended with the S&P down 5%. It was down 10% about halfway through the month. The only worse Januaries were in 1990 and 2009. The infamous “January Barometer” which holds “as January goes, so does the market” had many investors trembling. During this time, markets were trading in lockstep with crude oil.[1]
  2. The Snapback: February was similarly volatile, with the S&P and Russell finishing within spitting distance of UNCH (unchanged), after a 6.52% and 9.05% respective drawdown. The 1st quarter finished up for the S&P after a strong March. Energy, mining and industrials led the way up.
  3. The slow grind: This act lasted from the beginning of April through the day before election day. For the first part, markets slowly churned with an upward bias, only to be interrupted by an interlude dubbed “Brexit.” The second half of this act saw the slow upward grind give way to a slow downward grind. While this downward phase will make history books as the “longest losing streak since 1980,” the market fell just shy of 5% altogether.[2]
  4. The PostElection Frenzy-This was the outcome and reaction that no one predicted. Even the most enthusiastic Trump supporters did not expect a market rally upon a Trump victory. What overnight on Election Day seemed like a market catastrophe turned into a surge led by financial stocks, industrials and energy stocks. This strength persisted through year-end, with the tech sector the notable laggard.

While this summary focuses on equity markets, the action in bond markets was equally noteworthy. Coming into the year, consensus was that we were at the start of a rate hike cycle and that rates would rise as the curve steepened throughout the year. Instead, in the first half, rates collapsed and the yield curve flattened. We felt this was “flat wrong.”[3] By the end of the year, rates ended up higher, though the yield curve only steepened slightly. The path was volatile, to say the least.

RGA Investment Advisor

RGA Investment Advisor

Trading Politics

The year’s political developments deserve further discussion, as they greatly influenced market action throughout 2016. Brexit was the first political landmine for markets during the year. This landmine left little collateral damage on global markets, with the recovery in US indices taking nary more than a few days. It remains to be seen whether the United Kingdom will actually “leave” the European Union, as the political processes were not prepared in advance, and the outcome was hardly popular across all demographic profiles. Notably, the younger voters (under 24) voted in favor of “Remain” by a 75% to 25% margin. [4]

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In a backwards-looking assessment of 2016, it is easy to forget that what looks like a strong year for equity markets, the pockmarks were severe, with serious questions raised at the time.  At the time, prominent news sites and analysts alike dubbed Brexist “a Lehman Moment” implying that the consequences would be as severe for markets and economies as was the failure of Lehman Brothers in September of 2008.[5] We emphatically argued otherwise and were largely met by deaf ears for a few days until markets quickly repaired themselves and traders grasped how unclear the consequences would be. Our most poignant paragraph from the time is worth repeating today:

The invocation of Lehman here strikes us as a case of “recency bias”—a form of post-traumatic stress disorder that the humans who operate markets exhibit in the aftermath of extreme events. The cleanest definition for the recency bias is that it “is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.”[1] Ultimately it is easier to recall recent events, especially when a high level of emotion is involved. Ye the more emotion is involved, the harder it is to cleanly recall a sequence of events with a factual level of detail. This is why every time the markets have had a rough patch since the Great Financial Crisis, some investors wonder whether it will be the next acute phase of troubles. A reality that we often cite in these instances is that it is far safer to fly in an airplane shortly after a crash happens, than just before. This is true because those who are stakeholders in the security of flying are on higher alert for any potential problems in the aftermath of disaster. The same is true in financial markets, with one of the clearest signs today being the very safe capital ratios in the financial sector. If you will recall, the troubles at banks were the transmission mechanism through which problems in markets became a real economic calamity, and while we are never immune from problems in markets, they are far less likely to spread and become really deep when in such good shape.

The U.S. Election has some similarities to Brexit. Ultimately we had what can be called a “populist” vote led by backlash against “elites” with a mandate to protect national interests in an increasingly complex and global economy. The market recovery post-U.S. election was even quicker than following Brexit. While it looks like markets have uniformly surged, the moves have been far more nuanced. The most cyclical sectors have seen the biggest boost, while the most yield sensitive have declined. Technology (in the middle) has done little, if anything. Importantly, most of the forces that have driven this “Trump Trade” were in place well before the election itself.

The cyclical sectors like energy, materials and mining, and industrials had led the way since the market’s strong March. Some of the narrative attribution, suggesting that a major tax reform, a $1 trillion stimulus and a more lax regulatory environment seem overbuilt excuses for an extension of what has been a multi-month rally. There is little evidence that such a stimulus can and will be passed anytime soon. Tax reform might happen sooner, though the consequences are uncertain when considered alongside potential trade tariffs.

The most real rally in any sector since the election is in the financials. We say “real” in this case, because the shift in the yield curve will be consequential for earnings. Bank net interest margins bottomed in Q1 of 2015 and had been trending up, albeit modestly so through 2016.

RGA Investment Advisor

Simply based on the yield curve action, this bottoming in the bank net interest margin will accelerate in 2017. Moreover, while in other areas, the rollback of regulation will be a more complex

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