2016 will be remembered as the year of the “unexpected”. After a strong fourth quarter in 2015, many were surprised when the first 6 weeks of the year were the worst start in market history. The decision by the United Kingdom (UK) to leave the European Union (EU) and the election of Donald Trump were the headlines of a very unexpected year politically. The conflict in Syria, the ongoing migrant crises, volatile oil prices and continued geopolitical uncertainty created plenty of reasons to worry about portfolio returns. Yet all major asset classes finished the year with positive returns despite high volatility along the way. In short, 2016 was a reminder that basing investment decisions on current events or forecasts of future events is a fool’s errand. For disciplined investors, 2016 provided solid, if not spectacular, returns despite significant headwinds.
The US Federal Reserve increased interest rates in December for the second time in 12 months. This pace was much slower than many expected a year ago. Given this, the bond market had plenty of time to price in such a move so the overall impact on prices was muted. The benchmark 10-year US Treasury yield inched up by 0.18% and ended the period at 2.45%. Despite the much anticipated rate increases and headwinds many expected bonds would face in 2016, short and intermediate-term high quality bonds acted as expected by dampening volatility in a tumultuous year and providing low single digit returns. The broad US bond market earned 2.65% while global bonds returned 3.95% due to a more favorable interest rate environment.
US equities took off in the fourth quarter and ended the year at or near record highs. 2016 proved to reverse much of the momentum that US markets lost in 2015. US stocks ended the year up 12.74%, international developed markets squeezed out a positive return of 3.29% and emerging markets earned 11.60%. Much of the underperformance in non-US markets was due to a strengthening dollar. Value companies and smaller companies also reversed course from 2015 and outperformed around the world. This was especially true in the US where small cap value companies, the best performing broad asset class, returned 31.74% for the year and benefited our portfolios. Both US and international real estate investment trusts (REITs) had returns in the mid-single digits, with a return of 8.49% in the US and 3.12% internationally.
The US economy did expand at a modest pace in 2016 but geopolitical events throughout the world and a sluggish global economy caused policymakers to move with caution. The Federal Reserve projected that they would increase interest rates four times throughout 2016. What actually transpired was a single rate increase in December. The employment situation and inflation in the US continued to improve throughout the year, which finally gave the Fed confidence to increase rates despite the global backdrop. The unemployment rate ended the year at 4.7%, which many believe is close to full employment, while wage growth improved to 2.9%. Core inflation in the US increased to 1.7%, the highest rate since 2014 and 2016 was another year of policy experimentation by European and Japanese central banks. Negative interest rates exemplified their bold actions and garnered many headlines throughout the year leaving much of the unprecedented accommodative monetary policy in place. There were signs economic growth was improving in Europe despite the rising political turmoil in the region while the Japanese economy continued to struggle. Inflation in Europe improved to 1.1% while Japan’s inflation barely moved for the year and remains close to 0.5%. The British economy shrugged off any immediate impact from the country’s decision to leave the EU, but many questions still remain. After years of challenges, emerging markets saw many headwinds turn into tailwinds. Rising commodity prices and reform efforts supported growth and stock prices. China, one of the more important emerging market economies, saw steady GDP growth bolstered by government stimulus measures. Overall, 2016 was a year of modestly improving economic data, unexpected events and unpredictable reactions.
History On The Run
When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”
At the end of June last year, UK citizens voted in a referendum for the nation to withdraw from the European Union (EU). In November, Donald Trump was elected president of the United States. These results, which defied the expectations of many, led to market volatility as participants weighed possible consequences.
Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the Brexit vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”1
It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.
But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. Within weeks after the US presidential election, the US S&P 500 and Dow Jones Industrial Average had risen to record highs.
Yes, both events did lead to initial volatility in markets, but it was not exceptional or out of the ordinary.
None of this is intended to downplay the political and economic difficulties of Britain leaving the EU, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.
Now the focus of speculation has turned to how markets might respond to President Trump’s administration.
Given the examples above, would you be willing to make investment decisions based on this sort of speculation? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.
What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.
The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.
Journalism is often described as writing history on the run. Don’t get caught investing the same way.
1. “Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016.
Adapted from “History on the Run,” Outside the Flags column on Dimensional’s website, August 2016. Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission. Diversification does not eliminate the risk of market loss. There is no guarantee investment strategies will be successful. The S&P 500 Index is not available for direct investment and does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.