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2016 is officially behind us, and it yielded fascinating results.  Public markets started the first six weeks with a massive sell-off, and finished the year strong.  Between early March and early November, markets did little, while we all waited for what seemed to be the most contentious presidential election in history to finally be over.

Looking at select market index returns, the 30 components of the Dow Jones Industrial Average, led primarily by financials and energy, were up 16.47% in 2016.  The S&P 500 was up 11.96%, while the Wilshire 5000 was up 12.6%.  In the small cap space, the Russell 2000 was up 21.31% and the S&P SmallCap 600 was up 26.56%.  Three year average annual returns are 9% and 9.5%, respectively, for the S&P 500, and the S&P SmallCap 600.

credit to: investec.co.uk

 International developed markets, as measured by EFA, were effectively flat for the year, with the 1.6% drop in price offset by the 2% dividend.  Emerging markets, as measured by VWO, were up 10.4%.  Three year returns are negative for both international developed and emerging markets stocks.

Short term bonds, as measured by BSV, were up 1.42%, and long bonds, as measured by BLV, were up 6.65%.  Three year returns are 1.25% for short bonds, and 7% for intermediate/long bonds.

A balanced portfolio, comprised of 32% short bonds, 19% intermediate/long bonds, 31% domestic large cap, 5% domestic small cap, 9% international developed, and 4% emerging markets, would have been up 7.21%.  

As we look at 2017, two questions come to mind.  Those questions are, “What makes for a healthy economy?”, and “What can we expect under the new administration?”.

Last week, we looked at long term population trends.  A healthy society does need people, and it benefits greatly from a prosperous, growing population. 

A healthy society also needs real, personal, and intellectual property rights which can be enforced on an equitable and timely basis by a competent court of law.  A healthy society needs freedom of association, access to capital, a culture conducive to rewarding entrepreneurial drive, and a skilled workforce.  A healthy society needs a tax structure designed to exact taxes from almost all citizens, without the tax burden impairing the desire to be productive. And a healthy society needs to be prepared to engage in a meaningful debate about whether those who live at the edges will be cared for by private funds, public funds, or some combination thereof.  Finally, a healthy society needs governors who will encourage all the above, and will choose to promote good, and thwart evil.

Turning our attention to the upcoming administration, it is obvious that President Trump will bring change.  President-elect Trump has already brought change.  For the half of you who voted for Trump, we encourage you to remember that this is politics, and Trump is human.  For the half of you who didn’t vote for Trump, be encouraged that this too, shall pass, in either four or eight years. 

What could a Trump presidency look like, and what might the economic outcomes be?  A few thoughts.

With Republicans controlling the White House, and both houses of Congress, the first two agenda items will likely be health care reform and tax reform.  There will be some changes to the Affordable Care Act, though we won’t make predictions about what those will look like.  We do expect insurance companies to survive and do well, as they operate on a cost plus basis.

Candidate Trump suggested a 15% corporate tax rate.  We expect something in the 15% to 20% range, possibly with incentives to repatriate what is estimated at close to $1 trillion in corporate cash, parked around the world, due the U.S. tax system’s taxation of all income, regardless of where earned.  Taxing only income earned in the U.S., whether personal or corporate, may be one of the positive changes that come from tax reform.

Trump also suggested a restructuring of personal income tax rates to three brackets, with the highest at 33%.  Along with this though, came some conversation regarding reduced itemized deductions.  It is likely that overall personal income tax rates will drop.  It is unlikely that tax reform will happen without favors built into the tax system, to reward those companies and individuals who write the checks that keep the politicians in office.

Based on the various leadership appointments to date, it appears the emphasis will be on business growth and military strength.  Trump has gone to the business community, rather than lifelong civil servants, for many of his appointments.  This fits his background, though it will be interesting to see how this plays out in effective administration.

In terms of foreign policy, expect Trump to break all traditional protocol.  We expect the Trump administration to be friendly to those who have historically been our friends, which should benefit Britain and Israel.  We also expect the Trump administration to play hard ball with those who harbor or support terrorists, or who don’t support U.S. interests at the U.N., and around the world.

Look for countries around the world, and especially across Europe, to shift right.  Look for leaders of these countries to work to gain favor with the new administration.

credit to: clker.com

Domestically, expect an emphasis on law and order, and substantial moral support for law enforcement.  Expect Trump to use his position to encourage companies to keep jobs stateside, and to promote business formation and growth.  Also, look for a repeal of all Obama executive orders.

There will be no wall.  Talk of building a wall between the U.S. and Mexico was red meat for the campaign trail.  There will be increased border security.  However, we believe that immigration will actually be easier for those from around the world going forward, especially if they have marketable skills, or bring money with them.  Trump is well aware of the need for ongoing immigration in order to support a robust economy.

However, in going along with the law and order theme, those from outside the U.S. with a criminal background won’t be allowed in, and those who develop one while here will be shipped out quickly.  Sanctuary cities will lose funding.  Places such as San Francisco, Berkeley, and Boulder will face continuing protests against the Trump administration, and will be the home to any number of lawsuits against domestic and foreign policy.  None of this will make a difference. 

The U.S. military will be told to go win wars and restore law and order in those places around the world which matter to U.S. interests.  The military will cease being a playground for social experimentation.

There is talk of infrastructure spending.  From a tax outcomes standpoint, this could be a repeat of the ‘80’s, when tax rates declined, and the federal deficit jumped, though Trump is certainly no Reagan.

Looking around the world, the EU is coming apart, as many nationals in the respective EU countries express their desire for local control and self-direction.  The surprise is that the EU has lasted this long.  Russia will stand down.  Putin knows that he now has a peer, and will mind his behavior.  Putin knows the U.S. has the strength, and with the Trump administration, the will, to return Russia to the dark ages, if Putin doesn’t mind his manners.

It appears that China may be making a recovery.  The plus for China is simply the massive number of people who live there.  The downside is the ongoing Communist mindset, and it’s negative impact on the country and its citizens.

In terms of economic outcomes, a Trump presidency should bode well for both those prepared to work, and those prepared to hire.  Those able bodied persons prepared for neither could have a tough few years.

The possibility of lower personal and corporate income tax rates, repatriation of hundreds of billions of dollars, the carrot and stick approach to keeping jobs stateside, a relaxed regulatory environment, and the possibility of substantial infrastructure spending should be a boon to the U.S. economy.

So, how to invest in light of these potential outcomes?  The following is how we are positioning.  Note that these aren’t recommendations for you, simply thoughts from us, based on our observations of the world and the markets.  Also be advised that, while there is optimism in some quarters regarding potential economic outcomes, we are also eight years into the current bull market.

The S&P 500 has three and five year returns above its long term mean return.  We are reducing exposure slightly to the S&P 500.

Small cap stocks are below mean return over three years, and above mean return over five years.  While this isn’t a clean call, we are increasing our small cap exposure slightly.  Industrials, energy and financials should perform above the mean. 

Short bonds are at their mean, and intermediate/long bonds are above their mean return, over both three and five years.  We are reducing exposure to intermediate/long bonds.

The economic and political climate in Europe is messy, and will remain so.  This can make for a challenging investment environment, though there isn’t the correlation one would think between economic outcomes, and short-term market performance.  International developed markets returns are below the mean over both three and five years.  We will maintain our current weighting.

Emerging markets have underperformed over the last three to five years.  We are increasing our exposure to these markets slightly.

We always enjoy hearing from you, and look forward to any observations you may have about what might be next for us, as a country, an economy, or in the markets.

Quote of the week:

“If we become increasingly humble about how little we know, we may be more eager to search.”

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”

                                                                                                                                       Sir John Templeton

 “The only thing we have to fear is fear itself”.

                                                                                                          Franklin Delano Roosevelt

P.S.  This quote is from FDR’s first inaugural speech, given March 4, 1933.  You can read the entire address at http://historymatters.gmu.edu/d/5057/.