Factors ranging from China’s evolving economy to the rise of nationalism combined to make 2016 a year that will not be quickly forgotten.

In this issue:

  • Low rates mean a 70/30 equity/bond blend will face headwinds in keeping up with its solid returns in recent years.
  • The political ground shifted in 2016 and markets reflected the wide ranging implications.
  • Markets may be reaching the end of their tolerance for low inflation.
  • Investors face a diverse set of risks as 2017 begins.


After a lackluster 2015, the S&P 500 returned 12% in 2016, but with no fewer than three drawdowns of at least 5% along the way:

Volatility trended lower as the year wore on, although not without short bursts of higher volatility around the dates of historic political events:


The S&P 500 Managed Risk Index (which has a 0% bond allocation and volatility target of 18%) maintained a 100% equity allocation through all of December, the fifth consecutive calendar month it has done so. Volatility started the month well below the index target and trended down through the end of the year.

The return of S&P 500 Managed Risk Index matched that of the S&P 500, and surpassed the return of a 70/30 blend by 70 bps:

The diversification benefits of bonds: then and now

Over the course of its full history, the S&P 500 Managed Risk Index (dating back to July 2002) has outperformed a 70/30 (S&P 500/US Agg Bond) blend and done so with lower volatility:

One factor, however, behind the solid returns of the 70/30 blend is the performance of the bond market. Over this period, interest rates trended steadily lower and the US aggregate bond market (as measured by the Bloomberg Barclays US Aggregate Bond Index) generated an annualized return of 4.3%. At the beginning of the period in July 2002, the US aggregate bond market yielded 5.0%. 14 years later at the end of 2016 it yields 2.6%. This is noteworthy because the yield of the bond market is generally indicative of its future returns. In figure four, the yield line shows the aggregate bond market yields as of the dates on the x-axis. The return line shows the annualized return, starting with the date on the x-axis, through the index’s weighted average maturity as of the start date:

For example, point A corresponds with October 1997, when the index yield was 6.3%, with a weighted average maturity of 8.7 years. From the end of October 1997 through June 2006 (8.7 years later), the aggregate bond market generated an annualized return of 5.7%. Given the index’s ongoing replacement of bonds and its changing composition, there are naturally times when the end return differs from its starting yield. Generally speaking, however, yields are a reasonably good indicator of future returns.

At the end of 2016, the index yield was 2.6% with a weighted average maturity of 8.2 years. This suggests that investors using bonds as a means of diversification and risk management should expect less return from bonds in the years ahead than they’ve earned in years past.

Rather than relying solely on a fixed allocation to bonds for risk management, a managed risk approach seeks to maintain as much equity exposure as possible, consistent with its respective volatility management and capital protection parameters.

Of course low yields may hint at lower future returns for stocks too. With stocks, however, there is always the potential for earnings growth and price appreciation. With bonds, on the other hand, their fixed coupons act as an anchor, limiting their range of returns. Through their low correlation they still offer a potential way to offset downturns in the stock market, but as a meaningful source of return they’ve lost much of their appeal.


Markets ended a positive year on a positive note. From US equities to global REITs, markets across the board finished December and 2016 higher:


After getting off to its worst new-year start ever, the S&P 500 notched its eighth consecutive year of positive returns amid lower than average volatility. Both its max draw up of 26.5% and max drawdown of -10.3% were smaller than their 15-year average:

After finishing 2015 in the red, mid- and small-cap stocks rebounded sharply, posting returns of 21% and 27%, respectively, half of which were generated in the last six weeks of the year after the US presidential election.

EM stocks hadn’t posted a positive return in four years, but broke the trend in 2016, finishing 11.2% higher in spite of a postelection correction. International developed markets struggled to find footing in 2016 as economic woes in Europe and Asia continued to cast shadows of uncertainty.

Fixed Income

The yield on the 10-yr Treasury finished higher for the second year in a row, albeit not before touching its all-time low of 1.36% in July, shortly after Britain’s vote to leave the EU. Purchased on its July 8 low, the most recently issued 10-yr Treasury bond generated a total return of -8.3% through year end, while the S&P 500 returned 6.2%. Not since 2004/05 has the 10-yr yield finished higher two years in a row.

The increase in rates is attributable entirely to an increase in inflation expectations. Real rates, as measured by TIPS yields, actually finished the year lower.

Anyone looking at the yield curve from just the first and last day of 2016 could be forgiven for thinking it had been an uneventful year. The level and shape of the curve at year end was nearly identical to where it began the year. In reality, 2016 experienced some of the biggest relative rate moves in the post-crisis era:

Rates outside the US also traded in a relatively wide range, as yields in Germany, Japan and Switzerland tested the most fundamental of investment tenets, spending much of the year in negative territory.

In Germany the 10-yr bund finished the year yielding 0.21%, while in Japan, the BOJ was achieving its policy target of 0%. The yield on the 10-yr Swiss bond first went sub-zero in January 2015 and since then has spent 8x more days in negative territory than in positive. The central banks for all three countries continue to maintain negative short-term rates in an ongoing effort to stimulate growth and inflation that remain stubbornly low.

Commodities and Currencies

In this year of seismic adjustments, commodities and currencies were not to be left out. After being down nearly 6% ytd in August, the green back went on a tear, rising 8.6% through the end of the year, with the bulk occurring after the election. The dollar now sits at its highest level in 14 years, as divergent central bank policies strengthen the prospects of it pushing even higher.

After declining a cumulative 60% over the last two years, commodities, as measured by the S&P GSCI Index, rose 28% in 2016. Arguably the most influential commodity, the price of oil saw its largest calendar year increase since its 80% rise in 2009. A year-end OPEC agreement to cut production generated upward pressure; whether or not they uphold the production levels they’ve agreed to remains to be seen. Given the broader supply and demand dynamics, the likelihood of prices going much higher from here seems low.


Since the financial crisis market bottom on March 9, 2009 through the end of 2016, the S&P 500 has netted an annualized total return of 19.1%, nearly double what it was during the 50 years prior to the financial crisis. Combined with the relatively low volatility and exceptionally low risk free rates, the Sharpe ratio over the period is the best since 1999, right before the bursting of the tech bubble:

This period is marked by unprecedented amounts of central bank accommodation, dispensed increasingly in response to financial market circumstances, rather than solely to the dollar’s integrity. It’s also marked by historically low inflation. It is often claimed that this type of activism can’t go on forever, but why shouldn’t it? What stands in the way of never-ending accommodation and ever-climbing stock markets?

The answer to that question is arguably linked to the idea of moral hazard. Based on the assumption that the downside will be incurred by someone (or something) else, moral hazard arises from the distortion of risk and manifests itself by reducing the incentive to guard against it. Central banks have arguably been manufacturing protection against market risk.

In such an environment, taken to the extreme, it becomes morally irresponsible not to lever up with cheap money and pour it into a stock market, on which the Fed is perceived to have written the mother of all put options.

In free economies, however, where interest rates and currency values act as moderating influences, something has to give. The value of a thing cannot remain detached from the thing itself indefinitely. In the case of hyper-accommodative policy, all roads lead back to the currency.

As a growing number of loans increases the amount of currency in circulation, the currency will become less valuable if there is not a corresponding increase in the amount of available goods and services. This process may already be picking up speed.

A look at loan growth relative to GDP reveals that it currently sits above its pre-crisis level at the top of its 20-year range:

Inflation in 2015 was 0.7%. In 2016 it was 1.7%. At a 0.75% fed funds rate and $2 trillion in excess reserves, monetary policy by just about any standard remains extremely accommodative.

So why can’t this go on indefinitely? Ultimately, it comes down to the simple truth that free markets won’t allow it.


Beyond rising inflation, other significant risks and uncertainties loom on the horizon. China’s ongoing transition from an exportbased to a consumer economy, aging demographics in the developed world, ongoing turmoil in the Middle East and the threat of terrorism, the removal of unprecedented monetary accommodation, the rise of nationalism and its effect on global trade, and ongoing technological innovation.

Closing the book on one year doesn’t eliminate the risks heading into the next. Investors could hardly be blamed for wanting to pull out of equity markets altogether; in such a low rate environment, however, they can hardly afford to. Accordingly, actively monitoring market risk will remain a critical component of portfolio management, particularly for investors who rely on their investments for income and are sensitive to the market’s sequence of returns.

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Milliman Financial Risk Management LLC is a global leader in financial risk management to the retirement savings industry. Milliman FRM provides investment advisory, hedging, and consulting services on over $166 billion in global assets (as of June 30, 2016).

Established in 1998, the practice includes professionals operating from three trading platforms around the world (Chicago, London, and Sydney).

Milliman is among the world's largest providers of actuarial and related products and services. The firm has consulting practices in healthcare, property & casualty insurance, life insurance and financial services, and employee benefits. Founded in 1947, Milliman is an independent firm with offices in major cities around the globe.

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