Asset Class Summary: Fourth Quarter 2016

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Adding to the excitement created by elevated volatility in the markets, a year-long variation in asset class returns made investors’ heads spin. It was not the time to be asleep at the wheel when allocating funds across your portfolio. While returns may be unpredictable, what investors can rely on is that the best performing asset class tends to be different every year. This underscores the impetus behind our philosophy of diversified asset allocation.

In 2016, U.S. Small Cap stocks were the winner with a 21% return outpacing the healthy 12% return of U.S. Large Cap stocks. Considering the low expectations we started with in early 2016, these are impressive gains.  2016 also marked the eighth straight year the large-cap S&P 500 Index posted a positive return.  While an eight-year positive winning streak has occurred twice before, it’s interesting to note that the market has never had a nine-year winning streak.

In contrast with the U.S. reported strong equity returns, the international developed equity benchmark (MSCI EAFE) continued its struggle and ended the year up only 1%.  While the pick-up in manufacturing data in international developed countries noted in our Economic Overview is encouraging, the level of uncertainty remains high.  Political risk is a major factor, with 2017 elections scheduled in European heavyweights, France and Germany.  A populist turn in France or Germany could have a serious impact on the future of the EU.  Growth in the Euro Zone has surprised to the upside in light of a recessionary outlook; however, the 1.7% rate projected for 2017 is still lower than the U.S.  Japan’s major stock index, the Nikkei, was a bright spot for international developed stocks with a 5% return in 2016.  Japan’s expansion has been tepid at 0.8% in 2016 and up slightly to 1.0% in 2017 with equity returns dependent on the strength or weakness of the Yen along with exports.

The strong dollar is another potential headwind weighing on international returns; it especially hurt European returns in 2016.  European stocks were flat for the year in dollar terms, although they gained 7% in local currency terms.  The major currency decliner was the British pound - it dropped 16% versus the U.S. dollar, triggered by June’s Brexit vote. The Euro fell by 3% on the year.

The risk factors mentioned above along with the lack of meaningful price appreciation have resulted in the attractive valuation of international stocks – which means at SHWM we still like to own these stocks as we believe the potential for growth is greater as compared to domestic equities.  A little good news for international stocks could go a long way.

Emerging markets, which can be highly volatile, are also an important part of a diversified portfolio. In our view, the potential for growth is greatest in this region with China being a main driver.  Emerging markets stocks ended a three-year losing streak to post an 11% return in 2016.  The International Monetary Fund expects economic growth in emerging markets to accelerate to 4.6% in 2017 from 4.2% in 2016.  Stronger growth in the U.S. could help boost emerging countries’ exports, while the dollar again will play an important part in returns.

Bonds

While U.S. stocks and emerging markets stocks enjoyed a nice ride, traditional bonds struggled to end the year in positive territory after a sharp fourth-quarter sell-off.  Core bonds got off to a strong start with the 10-year Treasury yield dropping to an all-time low of 1.37% in early July.  Then yields reversed course rising to 2.5% by year-end as riskier assets gained favor and bond prices dropped.  Short-term and intermediate municipal bonds were basically flat for the year and the Barclays Aggregate Index gained a little over 2%. 

The big winner in the fixed income space were high-yield (or “junk”) bonds which in some cases can trade similar to equities.  High yield bonds earned 17% while interest rate spreads compressed and fundamentals appeared to improve for corporate balance sheets. It might be safer to say the expectation for improved fundamentals drove the outperformance for high-yield bonds.

Alternatives

Alternative investments were a mixed bag which is somewhat expected given the wide range of strategies in this asset class.  Master Limited Partnerships (MLPs) tied to lease payments on energy pipelines was the leader, gaining 18% as measured by the Alerian MLP Index. This represented a partial recovery from the sell-off in 2015.  MLPs continue to be an attractive holding with a stable dividend yield close to 7%, much higher than current fixed income yields. 

Managed Futures represented by Credit Suisse Managed Futures Index lost 7%.  The managed futures funds which attempt to take advantage of trends (up or down) across a wide range of investments, often found themselves on the wrong side of the trade as the trends reversed quickly during the year.  However, we continue to like this strategy considering the attractive long-term returns and the diversification benefits due to the lack of correlation to equity and bond markets. 

The option trading strategies held in our client portfolios typically perform well in a sideways market.  Our two managers were able to hold on to their relatively strong positive performance as the equity market finished the year. With rich valuations in most equity and fixed income sectors, alternative investments continue to be an area for potential outperformance and risk reduction with returns unrelated to changes in the stock market or interest rates.

In summary, we are maintaining our U.S. equity bias versus foreign exposure while keeping an eye on diverging valuations for any potential opportunities.  We think traditional fixed income offers limited upside in the current rate environment and have been reducing holdings in favor of unconstrained bond funds and alternative investments.  We will continue to make asset allocation changes based on our outlook for the markets and the investment objective established for each portfolio. 

Read more perspective on the quarter just ended with our Economic Overview and Market Overview. Thank you for your continued confidence in our ability to manage your investment assets. Please call me or anyone on our team at 404-874-6244 or email me here.

Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.