4th Quarter 2016
The stock market continued to rally in the fourth quarter. The Russell 1000 gained 3.8%, the Russell Mid Cap rose 3.2%, the Russell 2500 6.1% and the Russell 2000 8.8%. After many indexes were down double digits in February, the markets rose strongly in the second half: the Russell 1000 ended 2016 up 12.1%, the Russell Mid Cap 13.8%, the Russell 2500 17.6% and the Russell 2000 21.3%. The first half was dominated by fears of economic slowdown and macro events culminating in Brexit. The final quarter of 2015 and the first half of 2016 were “risk off” markets, dominated by the chase for yield. The second half saw a steady improvement in economic metrics and confidence, leading to a reversal in market leadership with cyclical and financial stocks rebounding sharply and defensive stocks underperforming. US GDP growth is likely to end the year at around 2% for 2016. Inflation remained low, but the Fed raised interest rates in December as expected. Employment numbers remained robust.
Looking forward, we expect US GDP growth to be around 2.5% in 2017. Inflation expectations are increasing but we believe it will take some time for inflation to move higher. Although labor markets have tightened, capacity utilization rates are still low (75% in November) meaning there is still slack in the rest of the economy. Oil prices, which fell to almost $26 early last year, have doubled from those levels. Weak energy prices had been a depressant on overall corporate earnings. Consumer and business confidence have both risen sharply and Purchasing Manager Indexes are up around the globe. This bodes well for corporate profit growth in 2017, which we estimate could grow in the high single digits. The Fed may raise rates up to three times in the coming year if economic improvement warrants.
A new Administration in Washington portends changes. We expect some fiscal stimulus from tax reform which will benefit companies and individuals. The legislation is likely to take time and may not become effective until 2018. Negative overhang could come, however, from uncertainty over trade agreements. While economic theory suggests that “border adjustability” will be neutral due to an adjustment in the dollar (as happened in the pound’s reaction to Brexit), practice may prove different. In that event, importers and companies with large overseas operations will be at a relative disadvantage. Geo-political tensions also remain high, and global terrorism is a persistent concern.
The first half of 2016 was challenging for us but we stuck to our discipline and saw some vindication in the second half. We believe the current environment will be favorable for our time-tested style. We continue to stick to our investment discipline: looking for stocks with better than average growth and profitability selling at low multiples. Our portfolios continue to have solid fundamentals and multiples at a sizeable discount to the market.