2016 Year-End Markets Review
By Guy C. Holbrook, IV, CFA
General Market Thoughts
2016 followed in 2015’s path as a year of significant volatility in the financial markets, with a healthy dose of craziness thrown in for good measure.
Driving much of the volatility early in the year was Brexit: Few predicted the significance of the populist revolt focused on job retention and cultural identity in the face of widespread immigration in the European Union. While the citizenry were voting to keep jobs, another significant underlying issue according to many studies was the fear of a loss of self in the community. Too much change, too fast, was being fostered on a large segment of the population, and so they fought back in the voting booth. The same can be said with the election of Trump in the US, and for all the political pollsters who were wrong (almost every single one), Brexit should have been a sobering indication that the status quo would be anything but, come election night.
We would be remiss if we didn’t mention: dirty politics and dirty water in Flint Michigan, Supreme Court Justice Scalia’s death—with no replacement, and the Cubs winning the World Series for the first time in 108 years. Zika fears persisted in Florida and at the Olympics, self-driving cars became reality, and, lastly, who could have predicted the fascination that Pokemon Go would become? While the direct impact to financial markets in 2017 is arguably weak, Pokemon Go exemplifies the absurd year that was 2016.
Post election, the economy and markets ended the year strong. Though we would argue that unemployment as reported, while below long-term averages at 4.7%, does not truly reflect the significant number of discouraged workers who have either given up looking for work or are only working part time due to the lack of full-time positions available.
By capturing discouraged workers, underemployed workers, and other folks who exist on the margins, the U-6 rate paints a broad picture of the underutilization of labor in this country. In this sense, the U-6 rate is often called the true unemployment rate—which currently stands at 9.3%, and is at its long-term average. With the potential for additional workers to enter the labor force, wage pressures may remain muted, giving the Fed some breathing room when it comes time to raise rates.
Student Loan Debt Crisis
A specific area of concern we have at Tidegate Capital is the rapidly growing student-loan debt and the resulting negative impact it will have on the Millennials. A significant unintended consequence of more freely available student loans, is the college administration’s mindset of increasing tuition 3X inflation to provide the best housing, athletic facilities, activities, and dining halls possible to lure prospective students. When it comes to higher education, keeping up with the Jones’ evidently has its price.
The red line indicates Consumer Price Inflation felt by the average American. College Tuition and Fees, in yellow, have been 3X CPI, while Student Loans have sky-rocketed over 8X CPI. Time will tell if this heavy debt burden will curtail Millenials major life purchases like homes and autos. Renting apartments, using Uber and ordering from Blue Apron are becoming the norm as we believe that what we are seeing a major secular trend underway and not a temporary, cyclical fad.
Tidegate Capital focuses on real estate, the fourth asset class and, in particular, multifamily apartments. Multifamily is an often overlooked investment choice for a number of reasons: 1) it incorporates a long lead time and exhaustive due diligence process 2) it requires feet-on-the-street oversight, which makes it challenging for the average investor to manage on his/her own and 3) it may be less liquid than many of the other investment vehicles available.
In the multifamily space, we expect 2017 to reflect positive, though more muted, rent improvements than we have seen recently. There remains the potential for appreciation primarily in the value-add Class B and C space as most new construction has been in the Class A space, putting pressure on rents and valuations there.
The long-term structural shift towards lower vacancy rates with the millennials beginning to move out on their own has begun.
The demographic shift towards more renters and fewer homebuyers will still be a net positive in all rental classes. We believe that many of the primary markets and tier-one cities do not represent attractive offerings at current valuations, in fact the real value lies in the secondary and tertiary metros where Cap Rates remain more attractive.
The Home Ownership Rate remains low; higher mortgage rates and large amounts of student debt will not help Millennials acquire the American Dream.
Sector and Asset Class Commentary
There's no doubt that many aspects of Trump's agenda are good for stocks and bad for bonds, near term: tax cuts, deregulation, and fiscal stimulus. However, the result can be a stronger dollar, which will weigh heavily on multinationals. Global economic growth has been lackluster as almost all central banks have either remained on hold or eased further. One exception to the rule was the US, where 2016 expected GDP growth of close to 2.5% allayed Fed concerns enough to warrant a rate hike of 25 bp’s in December. Should the US experience acceptable GDP growth in 2017, along with continued low (reported) unemployment, we expect the Fed to gradually raise rates throughout the year. This strategy, if effected too quickly, however, poses its own set of risks since a higher dollar vs. other global basket currencies would result in a negative impact to US manufacturing. In other words, our goods become too expensive on the world markets.
For much of 2016, the stock market continued on its Mr. Toads Wild Ride of ups and downs similar to what we saw in 2015. The S&P was nearly 8% underwater by early February, though 9 months later on the Friday before the election the year-to-date return had made a positive run and was up nearly 5.50% YTD. Since election day, through year-end the S&P was up close to another 5%.
The stock-market rally since the US election reflects a victory of expectations for enhanced corporate profits as Republican control of the White House and Congress often results in less regulation, lower taxes and the potential for a stronger economy. Whether or not reality matches expectations will be seen, though hopes and dreams are often left in the rear view mirror during the political process.
The Bond Markets are sailing on the edge as the Fed made it clear after their most recent rate hike in mid-December that they plan to normalize interest rates. After an extended period of artificially low interest rates, at the expense of household savers, the Fed will continue to keep as steep a yield curve as possible to help financial institutions with their long-term liabilities, and to enhance profitability: they are all too big to fail.
For those looking for income in the bond markets, the average junk-bond yield is approximately 5.90% and is close to its two-year low but well above the sub-5% levels it reached in 2014. Despite the low yields and potential for significant volatility, many investors still view junk bonds as attractive at a time when the 10-year Treasury note yield is below 2.5% and stock valuations are widely seen as unsustainable.
Though there are few signs of an impending slowdown on the horizon, we believe that there are still risks in traditional asset classes, particularly with stock prices at current levels that may be unsustainable. We believe a prudently structured, well-diversified portfolio with the inclusion of real estate can continue to provide the best return-to-risk profile.
In closing, we at Tidegate Capital hope all our readers have a very healthy and prosperous 2017. We look forward to providing you with quarterly updates and market commentary, and, as always, we welcome your feedback.