If there’s one word that characterizes 2016, it’s drama. That goes for last year’s politics, sports and even investments—last year, almost every corner of the global financial market experienced some kind of dramatic reversal, from U.S. stock markets to global bond markets, from crude oil prices to gold prices. You couldn’t have found wilder plot twists in a soap opera. 2016 was the year to expect the unexpected—and some of the changes may well have far-reaching effects on 2017, and for years to come.
In fact, expecting the unexpected is a rule to remember for every investor. A quick review of 2016 will show you why.
A ROLLER-COASTER YEAR
The year started with a brutal sell-off in global equity markets, driven by economic concerns. From January 1 to February 11, the S&P 500 Index plunged 12%—eliminating all the gains accumulated in 2014 and 2015. With the economic expansion and bull market entering a 7th year, it felt awfully like the end of the bull and the beginning of a recession. Then, without any triggering events (such as government stimulus or a Fed rescue), the global equity markets began a breathtaking rally. By the end of March, the S&P 500 Index recouped all its losses from earlier in the year and ended the quarter almost exactly where it started. Although the equity markets had experienced similar short-term, technically-driven V-shape turnarounds in 2014 and 2015, this one was the most extreme in terms of magnitude. In addition, during those earlier corrections, there was little doubt that the bull market was still intact. The only question then was when the market would resume its ascent. This time around, there was plenty of panic and capitulation, as the question became whether the end had finally arrived.
The financial sector had been in a secular decline since the financial crisis of 2007 – 2008, plagued by tough regulations, scandals, etc., with no end in sight. Tumbling interest rates did not help either. Trump’s win may have fundamentally reversed the operating environment for the financial sector.
Small companies can be victims of excessive regulation, as many lack the resources to contend with them and the high cost of compliance has a disproportionately negative impact on their profitability and growth. Trump’s win is expected to bring deregulation relief—and small-cap stocks surged, after struggling in 2014 and 2015. Even after their significant outperformance in 2016 (+21.3% for the Russell 2000 Index vs. +11.9% for the S&P 500 Index), they still trail quite significantly for the three-year period of 2014 – 2016 ( +21.6% of the Russell 2000 Index vs. +29.0% of the S&P 500 Index).
In the bond world, the 2016 U-turn of global interest rates—from negative back to positive—has the most potential to affect global financial markets over the long term. Negative interest rates were all the rage across developed economies outside the U.S. until July – not only short-term interest rates, including policy rates, but also long-term rates. At the nadir in July, Swiss 10-Year government bond yields sank as low as -0.64%, Japan’s 10-Year government bond yielded -0.30% and Germany’s dipped to -0.21%. While U.S. interest rates managed to stay positive throughout this madness, they were pulled down as well, with the 10-Year Treasury yield hitting a record low of 1.32%, nearly a full percentage-point drop from the beginning of the year.
The ensuing reversal, ignited by Japan’s adoption of a 0% target for its 10-year bond yield and accelerated by Trump’s victory, was so powerful that the 10-Year Treasury yield ended the year at 2.45%. This was 28 basis points higher than the 2.27% close of 2015. On the international side, the 10-year government bond yield of Japan and Germany returned to positive, ending the year at 0.05% and 0.21%, respectively. Even the most deep-in-the-negative Swiss 10-year government bond yield closed in on the positive territory, ended the year at -0.19%.