2016 was the year of surprises. There were a number of unexpected political outcomes throughout the year, namely the “Brexit” vote, Donald Trump winning the U.S. presidential election and OPEC members reaching a deal to reduce oil production.
But perhaps the biggest surprise was stock markets themselves. After the worst 10-day start in history and a January that saw 93% of investors lose money, both Canadian and U.S. markets finished the year with healthy double digit returns. The Canadian index, represented by the TSX finished up 17.62%. The Dow Jones Industrial Index (DOW) in the U.S. set new highs and almost reached the 20,000 point mark. It finished the year up 13.42%. The Global Index, represented by the MSCI world, finished the year up 5.41%
What happened in 2016 serves as a reminder to investors to ignore the “noise”, take a long-term approach, and remember the importance of investing in a high quality and diversified portfolio.
Key Themes for 2017
We expect two key themes to emerge in 2017: Improved U.S. Growth and Bond/Equity Divergence.
Economic indicators in the U.S. strengthened in the second half of 2016, confirmed by a Gross Domestic Product (GDP) number of 3.5% and a projected 2.0% pace in the 4th quarter, which comfortably exceeds the ceiling for U.S. economic growth. The Republican administration’s planned policies are also expected to accelerate economic growth in the U.S. Overall there is renewed faith in the longevity of the U.S. recovery.
The second key theme for 2017 is likely to be a continued divergence between equity and bond returns. For thirty years equity and bond returns have been positively correlated in that falling interest rates have benefitted equities and bonds. That has changed since the U.S. election on November 8th. Since the election, U.S. equities have rallied sharply in anticipation of stronger economic growth and its causal linkage to stronger corporate earnings while U.S. bond returns have been very soft. Bond returns have been weak because investors fear that fiscal stimulus will cause inflation to move upward.
As mentioned above, the Republican administration’s planned fiscal stimulus is expected to accelerate economic growth in the U.S. Stronger economic growth and higher inflation should be beneficial for revenue growth, and proposed corporate tax cuts would provide a meaningful boost to corporate earnings. Because of all these possible measures, we continue to be biased towards U.S. equities.
Several Canadian companies should benefit from the strengthening of the U.S. economy in 2017. However, with weak commodity prices and Canadian economic growth and inflation expected to remain modest, Canadian equities are likely to underperform their U.S. counterparts in 2017.
Equities in some European countries are attractively valued but because of persistently low growth, inflation, high unemployment, and growing uncertainty about the future of the euro, we recommend an underweight position in international and emerging market equities.
During the first part of 2016, bond prices increased due to weak economic growth and inflation. However, as central banks’ monetary policies appeared to have peaked and it seemed that governments would have to begin implementing their own fiscal stimulus, bond prices decreased in the second half of the year.
While domestic and global government bonds can offer stability and diversification benefits, overall returns are expected to be low. Thus, most bond managers are underweight government bonds. They may simply decide to hold cash instead and maintain a neutral weighting in investment grade bonds based on the slightly higher yields they offer over governments.
The consensus is that the Bank of Canada will hold its key interest rate steady for some time to come and that the U.S. Federal Reserve Board will modestly increase the federal funds rate over 2017. This will likely keep short-term rates low, but U.S. fiscal stimulus may push longer yields modestly higher.
This will help keep the Canadian dollar remain low for an extended period. The U.S. dollar is expected to drive higher due to higher growth and inflation in the U.S.
Although 2016’s surprises created volatility and uncertainty in the capital markets, they also created opportunities for experienced investors, and will continue to do so in the coming year.
We continue to recommend a diversified portfolio that is tailored to your individual investment objectives to take advantage of opportunities as they arise, while protecting your investments from further volatility.
On behalf of the entire You First team, we would like to wish you and your family all the best for the year ahead, and to remind you that my team and I are just an e-mail or phone call away should you wish to discuss your investment portfolio in greater detail.