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Fourth Quarter 2016 Financial Market Review

The surprise election of Donald Trump as the 45th President of the United States had a dramatic impact on the financial markets during the fourth quarter. Despite fears that such an occurrence would lead to a market sell-off, the S&P 500 gained 3.82%, the Dow Jones notched its strongest post-election rally in history, and all three major U.S. stock indexes hit all-time highs multiple times during the quarter. The rally, which is based on optimism that Trump's plans for significant fiscal stimulus will boost economic growth, also drove up the U.S. dollar and high yield bonds. In addition, interest rates moved much higher, as Trump's policies are projected to result in rising inflation and more frequent Federal Reserve interest rate hikes. As the quarter ended, with stocks effectively"priced for perfection" and many believing that markets are expecting too much growth too soon, the key question was "Where do we go from here?"

The Trump agenda calls for an infrastructure spending bill, higher defense spending, corporate and personal income tax reform, and reduced government regulation on the private sector, including the repeal of the Affordable Care Act. However, if all these measures were approved, the likely result would be a larger fiscal deficit and higher government debt, so there will almost certainly be pushback from fiscal conservatives in Congress that will result in a reduced economic impact from these policies. In addition, it may take longer than anticipated for approval and implementation of these polices. As a result, it's very possible that stocks will need to adjust once the reality of the Trump agenda hits home. However, the net result should still be positive for the markets and the economy over the longer term.

Although inflationary pressures remain benign, the bond market has begun to normalize in anticipation of better growth and rising inflation. After hitting an all-time low of 1.36% in July, the yield on the 10-year U.S. Treasury bond rose as high as 2.61% during the fourth quarter. Although this may feel like a lofty rate relative to the recent past, the 10-year yield remains well below the 3.00% level reached just three years ago. The extreme low in rates reached earlier in the year was a reflection of concerns about a potential economic recession and deflation, which no longer appear to be threats. As a result, despite the fact that bond investors have suffered some losses recently, this rise in rates is a positive sign for the economy. We expect interest rates to continue normalizing, i.e., moving gradually higher, over the near term.

As expected, in December the Federal Reserve raised the Fed Funds rate by 0.25%, marking only the second time the Fed has raised rates since 2006. The new target range for Fed Funds is 0.50% to 0.75%. In addition, the Fed signaled a desire to increase the benchmark rate three times in 2017 versus the previous projection of only two rates hikes in 2017. This reflects a more positive projection for economic growth than what was communicated by Fed members prior to the election. Other global central banks, including those in Europe and Japan, continue to deliver monetary stimulus through low rates and Quantitative Easing (QE), but have indicated that a tapering of this stimulus is on the table for 2017. Despite the fact that financial markets have become very dependent on monetary stimulus over the past several years, this tapering, along with the Fed rate hike, signals a belief that global economies are getting strong enough that they can sustain growth without central bank intervention. In addition, many believe that fiscal stimulus, such as that proposed by the Trump administration, can offset any decline in monetary stimulus. Such normalization of monetary policy is a necessary step for the global markets as we move later in the economic cycle, but may produce additional volatility as markets adapt.

U.S. economic growth was solid during the quarter. Employment remained strong, although annualized wage growth continues to trend below 3.0%, which is unusual this late in the cycle, especially with the unemployment rate at a very healthy 4.6%. The manufacturing sector gained strength, as the ISM measure hit a five-month high, while consumer spending, specifically holiday sales, beat expectations. One of the most important economic measures to improve was confidence, as both business and consumer confidence rose to high levels following the election. This is an excellent sign for the economy, as it is generally a precursor to higher spending.

Despite improving economic data overseas, foreign equity markets fell during the quarter, largely as the result of the U.S. dollar rally. The dollar reached its highest level since 2003 as optimism about the U.S. economy and the Fed's rate hike created demand for dollar-based assets. However, a strengthening dollar is not necessarily a good thing as it makes U.S. companies less competitive in global trade markets, which has a negative impact on U.S. corporate earnings. In addition, it creates relative weakness in foreign currencies, especially in the emerging markets where capital inflows are needed to drive economic growth, and weighs down commodity prices. This means the best-case scenario near term would be for the dollar to weaken somewhat.

Crude oil prices fell early in the quarter, but then rebounded sharply following an agreement by OPEC and certain non-OPEC nations to cut production of almost 2 million barrels per day, which is roughly 2% of global production. There remains much skepticism about whether participating countries will comply with the agreement, but there should be support for oil prices at the current level in 2017. Gold was very weak during the quarter, falling 12% as interest rates and economic optimism rose. Gold performs best in periods of financial distress, so it has not been a good asset to own post-election. Other commodities, including copper and natural gas, generally rose during the quarter.

The improvement in sentiment and the potential for fiscal stimulus is a good sign as we move into 2017. In addition, the stock market is much healthier now than a year ago as measured by its improved breadth, i.e., a much larger percentage of stocks have participated in the rally this year. In addition, economically sensitive stocks led the market in the second half of the year, which was in sharp contrast to the first half when safe haven and high dividend yielding stocks were the leaders. However, the sharp move up in risk assets following the election seems to indicate that investors are ignoring the many potential headwinds that remain. Specifically, Trump's plan to restrict trade, China's continued economic challenges and a worsening geopolitical landscape all pose risks, especially for markets that have climbed to an all-time high. Earnings expectations, while more reasonable if economic growth improves, remain somewhat elevated, while the rise in interest rates and the U.S. dollar could reverberate through global markets. As a result, we expect volatility to be a factor for investors in 2017.

We don't want to spoil the excitement following the surprise Trump election, but we do believe prudence is particularly important following any significant move higher in stocks and other risky assets. Notably, the current bull market and economic expansion are now eight years old, which is long by historic standards and creates additional risk for the financial markets. Long-term investors should stay the course, while those nearing retirement may want to re-evaluate their asset allocation to make sure it remains appropriate. As always, we do not recommend trying to time the market.

Thank you for your confidence in GuideStone. Please feel free to contact us if you have any comments or questions.

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