Sun, 01/01/2017 - 20:06

John Davidson

The final two weeks of 2016 was quiet. The few economic releases did little to affect the expectations on the economy or move the markets. As typical, the last couple of weeks of the year are less liquid and, therefore, experience less active trading activity. Equity markets gave back a little of its post-election gains and interest rates gave back some of its post election increases. In the US, consumers and industries alike spent the time getting ready for the holidays, the new year, and the new political direction while licking some of the wounds from the brutal Presidential campaign in the US. The US dollar was mixed; energy and gold commodity prices gained on the week. With little news to move the markets in the past two weeks, this report will focus on longer time frames.

Perspective:

The tables below have been modified to include not only data for the past two weeks, for the period since the election, and for the calendar year 2016, but also data for the last 8 years. That longer time period has interest because 1) it is a period of recovery from the worst contraction in the US economy since the Depression, 2) it starts just before the trough in equities experienced in March of 2009, 3) it covers most of the period of the Obama administration. The results of that time period are striking and worthy of reflection. See the comments associated with the tables below:

On a personal note, also worthy of reflection for the Davidson family was the time spent with our children and grandchildren during the holidays. Being with each other, sharing meals and stories, experiencing the excitement of new additions to our family, and seeing the holidays through our grandchildren's eyes were moments of pride and joy that will endure into the new year and beyond.

Economic Releases: Home Sales

US Home Sales increased in November. Existing Home Sales (green in the chart below) rose 0.7% to 5.61 million (SAAR), an increase of 15.4% from a year ago. New Home Sales (blue in the chart below) increased 593,000. In other housing news, MBA Mortgage applications increased 2.5% the week of December 16th. Pending Home Sales fell -2.5% in November. The Case/Shiller Home Price Index rose +0.6% (SA) in October; the not seasonally adjusted increase was just +0.1%; the increase was +0.1% from a year ago.

Source: St Louis Federal Reserve, FRED, Econoday via WSJ.com

Other US Releases:

US 3rd quarter GDP was revised up 3.5% (SAAR), the best increase in 2 years and above the range of expectations. New Orders for Durable Goods fell -4,6% in November; ex-transportation, New Orders rose +0.5%. November Personal Income was flat, but Consumer Spending rose +0.2%. The University of Michigan's Consumer Sentiment Index f rose 2 ticks to 98.2 in December. The Conference Board's Consumer Confidence Index rose, more decidedly, over 4 points to 113.7 in December. The Chicago Purchasing Manager's Index (PMI) fell 3 points to 54.6 in December, a possible forecast for what next week's PMI's might show.

Source: Econoday and the Wall Street Journal

Economic Releases outside the US

European Union Consumer Confidence became less negative in December. UK 3rd quarter GDP increased +0.6% from the previous quarter, 2.2% above the 3rd quarter of the previous year. UK Home Prices increased +0.8% in December, well above expectations.

The Bank of Japan left monetary policies unchanged after its December 19th meeting. In November Household Spending fell -0.6%, Retail Sales increased 1.7%, Industrial Production increased 1.5%, and the Unemployment Rate ticked up to 3.1% in Japan. In China, the CFLP PMI for Manufacturing fell 3 ticks to 51.4 in December. The Bank of China met and indicated that it plans to "emphasize a monetary policy that is prudent and appropriately neutral...in 2017."

Source: Econoday and the Wall Street Journal

Equity and Bond Index Returns:

For the last two weeks of the year US and Asian equity markets were down, but Canadian and European markets rose. S&P 500 valuations remained rich at 16.9 times forward earnings estimates, as compared to the 10-year average P/E of 14.4 or 5-year average P/E of 15.0 times forward earnings. Falling interest rates caused bond markets to recover a portion of what was lost since the election.

This indices below do not include the impact of dividend payments. For the year or even a quarter that impact is small. But, for a year, that could add 1%-3% to the changes reported in the table. The 8-year period, the compound impact could be a significant understatement of the total return. Unlike the equity indices in the table, the Bloomberg Bond indices include the impact of interest payments.

Since the election, equity markets outside China provided strong high-single digit and low double-digit gains. Narrowing credit spreads generated a positive returns for the High Yield Index; Investment Grade Bond Indices fell since the election. The capital markets reflected expectations for higher inflation and higher interest rates than those incorporated in those markets prior to the election.

For the year, with the exception of the CSI 300 and Swiss markets, equities generated positive gains, with the TSX leading the pack. The Dow was the best of the US. Even with BREXIT, the FTSE generated the second best gain in the pack. On the bond side, the narrowing credit spread in the high yield sector gave the HY Index a higher return than any of the US equity indices. The last two weeks saved the Treasury Index from having no gain at all.

For the 8-year period, the recovery from the financial crisis was significant. Risk assets recovered brilliantly, as shown in the equity and high yield sectors. US equity Indices more than doubled; the Nasdaq more than tripled. The Nikkei and DAX also more than doubled. The fact that credit spreads were so wide from the financial crisis generated equity-like returns in the high yield sector. Bond markets benefited both from falling interest rates and narrowing spreads during that period. Note that the Bloomberg Indices started at the end of 2009; the calculation below incorporates comparable indices for 2009 to match the full period.

Equity Indices % Change	Price	% Chg since:	ETD % Chg	Calendar	Past 8 Years
	12 /30/ 16	12 /16/ 16	11 /04/ 16	2016	12/31/08
Dow Jones Industrials	19,763	-0.4%	10.5%	13.4%	125.2%
S&P 500 Index	2,239	-0.9%	7.4%	9.5%	147.9%
Nasdaq	5,383	-1.0%	6.7%	7.5%	241.3%
S&P/TSX Composite	15,288	0.2%	5.4%	17.5%	70.1%
FTSE 100 Index	7,143	1.9%	6.7%	14.4%	61.1%
CAC 40 Index	4,862	0.6%	11.1%	4.9%	51.1%
DAX Index	11,481	0.7%	11.9%	6.9%	138.7%
Swiss Market Index	8,220	-0.1%	8.3%	-6.8%	48.5%
Nikkei 225 Index	19,114	-1.5%	13.1%	0.4%	115.7%
HK Hang Seng Index	22,001	-0.1%	-2.8%	0.4%	52.9%
Shanghai CSI 300	3310	-1.1%	-1.3%	-11.3%	82.1%
Bond Indices % Total Return
Bloomberg Treasury Index 6.0	124.1	0.9%	-3.3%	1.0%	19.5%
Bloomberg Corporate Index 7.0	143.7	1.4%	-2.1%	5.9%	72.1%
Bloomberg High Yield Index 4.2	169.8	0.6%	2.0%	17.4%	167.4%
S&P 500 Valuation
Factset fwd 12-month Earnings	$132.79		$130.69	$127.11
% Change in Earnings			1.6%	4.5%	10-Year Ave
Price/Earnings Ratio	16.9		16.0	16.1	14.4

Data Source: Bloomberg app for the Iphone; Earning Estimates from Factset

Bond Yields and Spreads:

In the last two weeks of the year, interest rates fell but credit spreads were little changed. The TIPS spread widened.

Since the election, interest rates were higher, credit spreads are narrower, and the TIPS spread is wider by about a quarter of a point. This reflects expectations for higher interest rates and higher inflation.

For the calendar year, interest rate changes were mixed. TIPS performed better than Treasuries as investors sought more protection from inflation. Credit spreads narrowed as investors reached for yield and were willing to accept a lower premium for the credit risks.

The 8-year period had an unusual beginning. In the midst of crisis, investors reached for safety and liquidity in US Treasuries. The demand for Treasuries drove yields lower. Trading and price-discovery were in scarce supply. Even TIPS, backed by the US Government were out of favor; the TIPS spread was just 12 basis points, meaning inflation only had to be +0.12% or more to generate a higher yield than 10-year Treasuries! The high yield indices were priced at a spread of 1800 basis points, or 18%, over Treasuries. Investment grade credit spreads were over a point higher than the current spreads for high yield. From that unusual beginning, non-US bonds, TIPS, and credit product had the most declines in yield and best relative performance.

Government Bonds	Bond Yields (%)	bp chg since	ETD bp Chg	Calendar	Past 8 Years
	12 /30/ 16	12 /16/ 16	11 /04/ 16	2016	12/31/08
UST 2-Year	1.19	-6	41	14	42
UST 10-Year	2.44	-15	66	17	23
US TIP 10-Year	0.47	-24	38	-23	-163
UST 30-Year	3.07	-10	51	5	39
Canadian 10-Year	1.71	-12	56	32	-97
UK 10-Year	1.23	-20	10	-73	-179
French 10-Year	0.68	-8	22	-30	-273
German 10-Year	0.20	-11	7	-43	-275
Swiss 10-Year	-0.26	-33	15	-14	-236
Japan 10-Year	0.04	-1	11	-22	-113
Credit Spreads		bp chg	bp chg	bp chg	bp chg
Bloomberg Corp OAS BUSC	128	-2	-15	-43	-445
Bloomberg HY OAS BUHY	429	1	-83	-304	-1374
Rates		bp chg	bp chg	bp chg	bp chg
US Mort 30-yr %	4.09	-12	60	16	-117
10-Year TIPS Spread	1.97	9	28	40	185

Data Source: Bloomberg app for the Iphone

Currency and Commodity Markets:

In the last two weeks of the year, the US dollar was mixed, energy and gold commodity prices gained, but silver and corn commodity prices declined.

Since the Election, the US dollar gained against all of the other currencies in the table. Energy commodity prices gained, but metals commodity prices fell. As you know, the strong US dollar makes imports more attractive and challenges exports.

For the year, the Yen and Loonie gained on the US dollar; the Pound was the weakest currency following BREXIT.

Over the past 8-years, the US dollar gained against all 5 currencies in the table. Again, the strong US dollar is good for political chest thumping, but challenging for US export growth. Oil and metals commodity prices were higher, but natural gas and corn commodity prices were lower over the last 8 years.

Currencies vs $	Closing	% Chg since	ETD % Chg	Calendar	Past 8 Years
	12 /30/ 16	12 /16/ 16	11 /04/ 16	2016	12 /31/ 08
Yen	85.50	0.8%	-11.8%	2.8%	-22.5%
British Pound	1.23	-1.3%	-1.6%	-16.4%	-15.5%
Euro	1.05	0.6%	-5.6%	-3.2%	-24.7%
Canadian Dollar	74.45	-0.7%	-0.2%	2.9%	-9.5%
China Renminbi	14.40	-0.4%	-2.7%	-6.5%	-1.6%
Commodities
West Texas Intermediate	$53.84	3.7%	22.2%	45.4%	20.7%
Brent Crude	$56.82	2.9%	24.7%	52.4%	58.6%
Natural Gas	$3.74	9.5%	35.0%	60.5%	-35.6%
Spot Gold	$1151	1.5%	-11.8%	8.5%	32.4%
Spot Silver	$15.94	-1.0%	-13.5%	15.2%	40.7%
CBOT Corn	$352.00	-1.2%	0.9%	-1.9%	-2.1%
Spreads
Brent-WTI	$2.98	$3.31	$1.51	$0.24	-$8.78

Data Source: Bloomberg app for the Iphone

Equity Index Gains in US dollar terms:

The equity table above shows the percent change of different stock indices in terms of its local currency. To calculate the return to the US dollar investor one must combine the change of each index with the change in the applicable currency. The following table shows the 5-day, quarter-to-date and year-to-date results of investments made in each index in US dollar terms:

Return to USD Investor	Currency	% Chg	% Chg	Calendar	8 years
12 /30/ 16	since:	12 /16/ 16	11 /04/ 16	2016	12/31/08
S&P 500 Index:	USD	-0.9%	7.4%	9.5%	147.9%
Nikkei 225 Index:	Yen	-0.7%	-0.3%	3.2%	67.3%
FTSE 100 Index:	Pound	0.5%	5.1%	-4.4%	36.0%
DAX Index:	Euro	1.3%	5.6%	3.4%	79.7%
CAC 40 Index:	Euro	1.2%	4.9%	1.5%	13.7%
S&P/TSX Composite:	CAD	-0.5%	5.1%	21.0%	54.0%
Shanghai CSI 300:	Yuan	-1.5%	-4.0%	-17.0%	82.1%

For the last two weeks of the year, the DAX and CAC were the best markets for US dollar investors. Since the election, the S&P 500 generated the highest return. For the year the Canadian TSX generated the highest return for a US dollar investor. Over the 8-years, the S&P 500 was the best place to have been invested for a US dollar investor.

One caveat: These comparisons only look at absolute, not risk-adjusted total returns. The lower correlation of non-US markets to US market may cause the overall risk of the international portfolio to be less than that of a US-only market portfolio; therefore a risk-adjusted analysis could provide a different result.