Five themes from 2016 that could influence 2017

There can be no denying 2016 was an eventful year. Thankfully, in marked contrast to 2015, the past year has generally managed to leave investors with holdings in mainstream stocks or bonds, or mainstream stock and bond funds, better off at the end of it than they were at the start, especially if they had capital parked in overseas markets.

The year began with great volatility across a range of asset classes as investors wrestled with the ramifications of the first US interest rate hike for more than a decade. Events then picked up speed with an oil price collapse and a major fiscal stimulus programme in China before the UK’s decision to leave the EU in June, interest rate cuts from the Bank of England further and a plunge in the pound raised the pace.

The second half of 2016 then focussed on oil’s recovery, a surge in metals prices and the race to the White House, which culminated in the election of President Donald Trump and a political shift toward Keynesian stimulus and away from monetarism as politicians fearing their own unemployment responded to the wider electorate’s discontent.

Elections in Italy and Austria and the US Federal Reserve’s second interest rate increase of this cycle then set the scene for 2017 as the year drew to a close, with stocks in the ascendancy over bonds, commodities rallying, the dollar standing tall and emerging markets losing ground after a strong early showing.

The secret now for investors is to see what lessons can be taken from 2016 and applied to 2017, to help them protect wealth and seek positive returns while managing risk most effectively.

The scores on the doors

Just to reaffirm how 2016 panned out, here are a few means of keeping score.

First, by asset class, commodities came out on top followed by high yield debt, with sovereign debt bringing up the rear after a sticky second half.

Commodities did best of the major asset classes in 2016

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

After four years in the doghouse, emerging markets bounced back as they outperformed their developed counterparts.

Emerging markets ended a four-year underperformance streak in 2016

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

This is also reflected in the key regional performance trends, where Eastern Europe and Latin America led the way, helped by oil’s recovery. President-Elect Trump’s protectionist talk came too late in the day to stop them in their tracks. Note these figures are in sterling terms and the pound’s Brexit-inspired collapse meant that holding overseas assets was the way to go.

Oil’s recovery helped Eastern Europe and Latin America in 2016

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

By sector, on a global basis, energy stocks and financials cleaned up. Industrials and technology did well. Defensives and bond-proxies like healthcare, telecoms and utilities found the going a lot tougher.

The Energy and Financials sectors took equities higher as defensives lagged

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

Finally, despite the second-half sell-off, bonds generated positive total returns. Currency movements influence returns as yen and dollar-priced assets stood at the top of the pack and sterling-denominated ones plumb at the bottom, while high yield debt got a boost from higher oil prices and improved growth and inflation expectations.

Bonds saw more volatility as the year wore on but still offered positive returns

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

Key lessons to learn

Looking at that deluge of data, the following five events and trends from last year look to offer the most important lessons for the 12 months ahead.

Brexit and Article 50 took centre stage in the UK

Even though the UK’s headline indices made healthy gains in the wake of the referendum vote sterling-denominated assets generally lagged badly on the world stage in 2015, owing to the pound’s plunge. Within the confines of the UK equity market exporters and dollar-earners generally beat domestic-facing sectors and stocks hands down within the confines of the British equity market.

The pound’s post-Brexit dive went a long way to shaping sentiment in 2016

Source: Thomson Reuters Datastream, Bank of England.

Lesson: The debate over a “hard” or “soft” Brexit is still raging. The former has so far pressured sterling and favoured holding assets priced in currencies other than the pound or domestically-quoted firms that operate mainly overseas. Within the UK, the result is a split market, with overseas plays enjoying all of the momentum, doing well but looking expensive in some cases while domestic plays are unloved and looking cheap but lacking a catalyst to stoke fresh interest in them (at least for now). Any unexpected change in direction for sterling could prompt a reappraisal.

Growth and inflation expectations began to rise, to the benefit of stocks over bonds

Prime Ministers Shinzō Abe of Japan, Justin Trudeau of Canada, Theresa May of the UK and US President-Elect Donald Trump are all championing infrastructure spending and fiscal policy as ways to kick-start their own economies. Markets have latched on to this Keynesian shift and embraced pro-growth, pro-inflation policies with gusto. Bonds have sold off, commodities rallied and stocks moved sharply higher.

The tricky bit for bulls is these infrastructure projects and spending plans will take time to arrange and so they may not start to come to pass until 2018 at the earliest. The tricky bit for sceptics who don’t believe this is a re-run of the 1980s Reagan revolution in the US is they won’t have any counter-factual (evidence that the Trumpflation plan doesn’t work) until 2019 at the earliest as a result.

Global equities looked to have broken out relative to bonds in late 2016

Source: Thomson Reuters Datastream. Total returns in sterling terms, to 8 December.

Lesson: As the year came to a close it looked like equities had make a decisive break, relative to fixed income, judging by the performance of two broad-brush trackers, namely the iShares MSCI All World ETF (for stocks) and the iShares Global Government Bond ETF (for bonds). At some stage the Trumpflation trade needs to deliver growth and inflation but for the moment the market seems prepared to believe.

All hail to the mighty dollar

The dollar began the year strongly in the wake of December 2015’s Fed interest rate rise, lost momentum as the US central bank failed to follow through on its target of delivering four further hikes this year and then rallied as 2016 drew to a close, encouraged by the second Fed rate rise on 14 December, as well as hopes for improved US growth under Trump.

Dollar strength meant US assets were a great place for investors to have parked their cash, although it did pressure emerging market assets late in the year. Regular readers will know this column’s predilection for the chart which shows how the buck and emerging market equities have historically had a clear inverse correlation and this trend held firm in 2016.

The dollar and emerging markets maintained their historic inverse relationship in 2016

Source: Thomson Reuters Datastream

Lesson: The dollar and commodities look set to once more dictate how emerging market assets do in 2017, while too much strength in the greenback could start become a problem for the US economy later in the year, especially if coupled with rising bond yields.

The darkest hour (as usual) came before the dawn.

In 2015, oil was a disaster, emerging markets underperformed their developed equity counterparts for the fourth year in a row and in the UK, the industrial engineering, mining and industrial metals sectors were ranked in the bottom five of the FTSE All-Share’s 39 sectors by performance.

In 2016, oil rallied substantially, EM beat DM as Eastern Europe and Latin America led the way, while industrial engineering, mining and industrial metals sectors were ranked in the top five of the FTSE All-Share’s 39 sectors by performance. Bonds hit the buffers in the second half.

Contrarian policies won the day as in some cases the news became so negative and the valuations so cheap any minor shift in sentiment proved enough to generate fresh interest and upside momentum. In addition, the market narrative shifted, as hopes for growth and inflation trumped fears of recession and deflation.

This also explains the dash from bonds to stocks and within equities from expensive defensives to cyclicals and financials – just look at the UK market to see which sectors ended 2016 with momentum and which ended it without it. These charts look at the weekly performance of the 39 FTSE All-Share sectors and then rank them 1 to 39 on each occasion.

Banks and insurers stormed back into favour in the UK post-Brexit ….

Source: Thomson Reuters Datastream.

… while expensive defensives fell from grace after a long reign at the top

Source: Thomson Reuters Datastream.

Lesson: There is always value to be found somewhere and contrarians can have their day. By continent the most persistent laggards of the last three years have been the UK, Western Europe and Asia-Pacific ex-Japan, so it will be interesting to see if this trend persists or breaks in 2017.

Active managers had their chance to shine in 2016

The inexorable rise of passive funds is understandable. Trackers and Exchange-Traded Funds (ETFs) are cheap and transparent in that investors know exactly what you own in the portfolio. They are also ideal for periods when market momentum is strong and asset correlations are high. Yet if ever fund managers were going to justify their fees and fend off the attentions of both the regulator and any unhappy clients it was in 2016. Monetary policy began to diverge as the US followed a different path from the UK, Japan and Europe and bond markets began to rebel against central banks’ interest-rate crushing tools. Equities diverged from bonds, giving multi-asset funds and managers a chance to shine. In an equity context, there was a wide range of returns between regions and sectors (as noted above), as finally all boats stopped rising with the tide. And the gap between winners and losers on a stock-by-stock basis was massive, as evidenced by the results from the FTSE 100 and FTSE 350 indices.

Good fund managers will have cashed in on a huge range of stock performance in 2016 within the FTSE 100 and FTSE 350

Source: Thomson Reuters Datastream, covers period to 12 December

Lesson: If 2016 was a first real chance for active managers to add value for some time then 2017 could easily be a sequel, especially if the trend towards value continues to run.

Russ Mould, Investment Director