Quarterly Market Commentary – Fourth Quarter 2016

Gabriela Santos, Global Market Strategist at JP Morgan Asset Management, joined us for a webcast to recap the fourth quarter of 2016 and share thoughts on the outlook for financial markets in 2017.   

The current economic expansion is 91 months long. It began in July 2009, making it the third longest expansion since 1900. It can be said that we are in the late innings of this expansion. While it has been a historically long expansion, it has not been without some bumps in the road. Investors have seen market pullbacks and extreme volatility over the last seven and a half years from macroeconomic events like the BP oil spill, a global slowdown in China and Brexit.

During this economic expansion, the U.S. economy has experienced muted gross domestic product (GDP) growth compared to historical averages, with a current pace of roughly 2% annualized GDP growth. We are seeing signs of improved growth in 2017 from three main sources.

The first factor that could (and should) lead GDP growth in 2017 is the consumer. A tight labor market, higher wage growth and lower overall gasoline prices has helped fuel (no pun intended) consumer spending.  The second component of GDP growth in 2017 is government spending, which should pick up under the Trump administration; all signs point to increased infrastructure and defense spending. The third and perhaps most crucial component of GDP growth for 2017 will be investment spending from small and large U.S. corporations. While many companies have shied away from spending because they still remember the effects of 2007 and 2008, the new administration could encourage companies to increase spending in areas such as building new factories or buying new computers for their workforce.  

The U.S. labor market is near full employment. The current unemployment rate is 4.7%, which is well below the high of 10% we experienced in October 2009.  Wage growth is finally moving in the right direction, with an uptick to 2.5% at the end of 2016 and expectations of a continued rise in 2017 (but still below the historical average of 4.2%). With a tightening labor market, improving wage growth and business spending picking up, the expectation is for inflation to increase as well. We have started to see inflation rise since 2015 with the headline consumer price index (a measure of inflation that excludes food and energy) ending the year at just under 2%. This number is expected to gradually increase above 2% in 2017, but it is not expected to increase dramatically into hyperinflation territory.

The Federal Reserve and interest rate increases were a hot topic in 2016. They will continue to be a point of interest in 2017.  U.S. interest rates are likely to continue moving upward at a gradual, but faster pace compared to the past two years. Market expectations are for the Federal Reserve to raise interest rates three times in 2017, three more times in 2018 and then another three or four times in 2019. As we know from past experience, we will have to see if these expectations become reality as macroeconomic shocks can play a major factor in the Federal Reserve’s decision to make interest rate changes.  

Along with the economic expansion the United States has experienced over the last seven and a half years, we have also seen an increase in the U.S. equity market (up 230% since the market low in 2009). Valuations of U.S. stocks, as measured by forward price to earnings, are now slightly above their 25-year average (current valuations of 16.9x versus average of 15.9x). However, we are still nowhere near the levels that markets experienced in the late 1990s with valuations in the 24x to 26x range. U.S. earnings have seen a rebound the last several quarters as the dollar and energy drags from 2015 fade. We should continue to see increased earnings growth in 2017 because of the potential for corporate tax rate cuts mandated by the new administration.  

Meanwhile, overall growth in international markets (both developed and emerging) have lagged behind the United States the last several years. With lower growth, however, the current valuations of international markets look cheap compared to their U.S. counterparts. Overall, there is still money to be made in both U.S. and international equities, but investors will need to be selective in what they are purchasing.

Fixed Income Summary  

Interest rates across the yield curve increased during the fourth quarter, with a sudden jump after the November 8 election. The yield on the 10-year U.S. Treasury bond ended the fourth quarter at 2.45%, up 0.85% (i.e., 85 basis points) from where it started the quarter (1.60% as of September 30).  

With the rapid increase interest rates, we saw negative returns in the investment grade bond space of the U.S. bond market (remember, there is an inverse relationship between interest rates and bond prices). The Barclays U.S. Aggregate Bond Index returned –2.98% for the quarter. Treasury Inflation-Protected Securities also struggled for the quarter, losing nearly 2.5%. U.S. high-yield debt fared better, with a positive 1.8% return for the quarter.

Equity Market Summary

The fourth quarter equity markets were led by small cap value, which returned 14.1% for the quarter.  Value outperformed growth across every category (large-cap, mid-cap, small-cap). The same holds true for the 12 months ending December 31, with value outperforming growth across all categories. Small cap value led the year, with returns of 31.7%.

The financial sector significantly outperformed all other S&P 500 sectors for the fourth quarter, with returns of over 21%, much of which came in the last two months of the year after the presidential election. The energy sector also saw a nice increase for the quarter, with positive returns of 7.3%. Meanwhile, the health care and real estate sectors saw negative returns for the quarter, with –4.0% and –4.4% respectively.

Emerging markets (as measured by the MSCI Emerging Markets Index) were down 4.1% for the quarter, but still saw returns of 11% for the year. International developed markets (as measured by the MSCI EAFE Index) posted much more muted returns, with only 1% for calendar year 2016.


As always, diversification is a topic that we stress to retirement plan participants through communication and education meetings. A diversified asset allocation portfolio is meant to smooth out returns over the long term without having huge positive or negative swings. The following chart shows an example of the long-term results of diversification.

1 Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management