2016 Q4 Investment Report Commentary
Market Update: Recalculating…
When heading to a destination, many turn to Google Maps or other GPS apps for turn-by-turn directions. You have advance notice of turns, left-hand exits, and even accidents or road construction. Should you miss a turn, they recalculate your journey without judgment. No such reliable guide exists for investors, as the future of markets is impossible to map.
Prudent investing therefore becomes an exercise in “recalculating” without a map, and building portfolios must take this reality into account. Confounding expectations are a regular feature of the markets and the fourth quarter was no exception. Clearly, the most surprising event was the election of Donald Trump, defying most experts’ predictions. This surprise poses many implications going forward, but the biggest impact on markets to date has been the rapid rise in interest rates. The move actually began before the election, as the 10-year Treasury moved from 1.6% on September 30 to 1.9% on Election Day. To be sure, the subsequent move to 2.5% by year-end was more impressive as investors fully embraced an expected pick-up in growth and inflation (see chart below). This recognition coincided with the increased likelihood of a Fed rate hike, which happened in December.
These altered expectations and the Fed’s rate increase led the market to cast aside its preoccupation with the economic stagnation thesis and embrace higher rates, a shift repeatedly postponed over the last three years. The move in interest rates led to strong relative returns for Daintree clients’ fixed income portfolios, performance that resulted from sound positioning and resolute patience.
Daintree’s process considers the various expectations built into asset prices, but long-term valuation is a key component that drives occasional tactical changes in client portfolios. Valuation typically gives us a better fix on whether markets are priced for perfection or imply a dire view. Currently, the optimism in stocks does have a basis in economic reality, but stocks are not altogether cheap. Rather, the U.S. appears a bit rich while Europe and Emerging Markets seem somewhat attractively priced. For bonds, the move in rates certainly pushed them closer to our long-term expectations, but this move may be just the beginning of a series of rate increases.
Overall, Daintree recognizes these solid underlying economic trends, but today’s valuations constrain our enthusiasm. We continue to believe our well-diversified portfolios offer the best approach: clients can participate in the upside while still maintaining sufficient protection in the event economic conditions and markets take a wrong turn.