It is my expectation that in 2017 the stars finally align and we see a rising interest rate environment that we have been anticipating for over 5 years. It is my expectation that the combination of economics, Fed monetary policy, the new administration’s fiscal policy will lead to create that scenario.

Longer duration bonds are more sensitive to interest-rate changes, and have performed worse in rising rate environments historically. Additionally government bonds tend to be more sensitive to rising interest-rates and have historically underperformed corporate bonds during rising rate environments.

Underweights for 2017 (Fixed Income)

• Long-term to Intermediate Bonds: As interest-rates rise, bond prices fall. This is most true for longer duration bonds.

• Treasuries: Government bonds have the lowest degree of credit risk, and the highest sensitivity to interest-rate risk. If the US and global economies continue the expansion in 2017 and the Fed raises rates as expected, government bond prices will likely be hit the hardest.

Overweights for 2017 (Fixed Income)

• Short-term Corporate Bonds: The low duration reduces price risk associated with interest rates. Also, corporate bonds have higher yield spread vs. government bonds which provides more income to offset losses from declines in bond prices associated with rising interests rates.

• High-yield Bonds: Historically high-yield has outperformed relatively in rising rate environments. Improving fundamentals and rising rates leads to lower defaults. On a basic level, high-yield has less interest rate risk and higher credit risk. Meaning that high-yield is more likely to default, and default risk naturally decreases in rising rate environments.

• Floating Rate: Bank loans do well in environments where corporate credit improves. Bank loans typically adjust coupons every 90 days which makes them very defensive to rising interest-rates.

                                                                                                                          – Wyatt Swartz

Written 1/17/2017

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

                                                                                                                   – Albert Einstein

Before we get too far into 2017 I think that we should look back at how 2016 played out. Studying the past and learning from it is important for all investors.

There were a lot of stories in 2016, some of those stories were even bigger than Dak Prescott and the Dallas Cowboys.

1. China: Early in 2016 Chinese stocks crashed, that coupled with fears of a slowdown in Chinese economic growth weighed on markets pushing markets into correction territory. On 1/21/16 I wrote here that the market downturn had all the indications of a correction and not a bear market. I explained then that a decrease in China GDP growth is natural and that the estimates of +6% growth on the increasing base would be a positive force for continued global economic expansion. No economy can grow GDP in the double digits perpetually. Official numbers are not yet in, but it looks like China GDP growth for 2016 will be ~6-7%. The bear market in Chinese did not spread to global stocks as a whole, once again as predicted.

2. Oil Prices: In addition to the China fears, fears related to low oil prices weighed on markets early in 2016 and contributed to the early market correction. In the same piece (see here) I explained that while the energy sector is hurt from low oil prices, it is really a wash in economic growth terms. Eventually the markets, and the economic data proved me right.

3. Brexit: On June 23 the UK voted to withdraw from the European Union. Prior to the vote most experts predicted that the Brexit vote would fail and that the UK would remain in the European Union. Additionally most experts warned that if by the slightest chance the Brexit did occur, that it would surely lead to recession. In both cases the experts were wrong. UK stocsk dropped -5.6% over the next two days, but they bounced back just as quickly and have been climbing with global stocks since.

4. The Fed: The year of several rate hikes and rising interest rates never really came. Meeting after meeting, the Fed continued to kick the can down the road citing: concerns over interest rates, China, Brexit, etc., only to finally have the first rate hike of the year come in December post the US presidential election.

5. US Presidential Coverage: The major story all year was the US presidential election. During the course of the year US stocks (and world stocks) seemed to move based on perceived shifts in the probabilities of the election results. Pretty much the entire year experts pointed to movements in the markets as an indication that a Trump win was unlikely and that it would be bad for stocks. I wrote here that I believed Clinton would win the election, but that a Trump victory would likely come with some downside volatility and a market correction (not a bear market). The downside push came and went fast, and markets rose steadily after the initial down shock of the election.

Conclusion: The bull market continued in 2016. It was a good year to own stocks, US stocks in particular had a good year. World economic growth continued in 2016 despite the fears it would not.  

                                                                                                                              – Wyatt Swartz

Written 1/12/17