What Caused the 2016 Stock Rally?

The global equity index is up 8% over 12 months in US dollar terms. Will 2017 see similar returns for stocks or will bond markets rally instead?

Dan Kemp 9 January, 2017 | 11:32AM
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2016 capped a truly remarkable year for financial markets. Driving much of this exhilaration were three monumental events: starting with China, hitting the halfway point with Brexit and finishing with Donald Trump. These events created deeply embedded fears about the direction of the politics, however simultaneously sparked a growing story about reflation. Remarkably, this produced formidable performance across most equity markets – the global index is up 8% over 12 months in US dollar terms, and a turn of fate for traditional fixed income markets – the global aggregate index rising 9% in the first half then losing 6% in the second half.

The strong returns in many markets through 2016 are unsustainable in the long term

As a quick recap, it ironically started and ended with concerns about China, albeit for very different reasons. With initial concerns about a Chinese slump and the potential for an emerging market debt crisis, commodity markets were sent into further turmoil. Central banks continued to aggressively act, with stimulus packages from the European Central Bank, Bank of Japan and Bank of England growing in both creativity and size.

This led to an amazing $300 billion plus in fixed income fund inflows through 2016, relative to a net $113 billion outflow in the second half of 2015, and pushed more than a third of the worlds bond yields into negative territory. Meanwhile, as investors realised the China crash was not transpiring, commodity prices continued to improve and emerging markets gained in sentiment.

These developments concealed the swift rise in nationalism, as the public became discontent with the state of politics and increasingly suspicious about the effectiveness of policy. The dissatisfaction erupted when Brexit was voted for, sending the pound sterling plummeting as newfound fears transitioned back towards the sustainability of the European Union. Inflation expectations were also beginning to shift and currency divergence became the major source of volatility.

If currencies risk could tell the story of 2016 alone, we saw both the British pound and Mexican peso fall by 16% each against the US dollar. Then there was the indecisive nature of the Japanese yen, which rallied more than 13% only to lose it all. These fundamental shifts must be considered under a pragmatic risk framework.

The U.S. election was the last major hurdle of the year, and the victory by Donald Trump cemented a dramatic change in political discourse. Unsurprisingly, this also sent markets on a left turn and his tweets increased speculation about a trade war between the U.S. and China. This prompted investors to speculate on the cyclical or structural nature of reflation and sent them on a path of short-termism and sector rotation. Market participants have since been balancing their thoughts on a pendulum between the perception of future change and fundamental change itself.

What is the 2017 Outlook?

By contemplating what was a remarkable year, investors find themselves pondering similar themes as the year before. A European break-up, a Chinese slowdown, an inflation surprise and concerns about overheated valuations in both bond and equity markets. This appears to be the never-ending loop of tail risks that an investor must thoughtfully endure. While 2016 has powerfully demonstrated the folly of making political predictions, and thereby drawing market inferences from political changes, investors should be aware of the potential implications of further political upheaval.

Withstanding this, there are some significant changes underfoot. To pick one such extremity as an example, a U.K. investor returned 35% from emerging market equities in 2016 whilst a South African investor gained nothing at all. Such oddities beg many questions about the relationship between performance potential and the risk of a permanent loss of capital.

Looking ahead with a valuation context, there are many more hurdles to jump. Most critically, valuation pressures continue to mount in many key markets, creating a growing sense of caution that is both prudent and warranted. The strong returns in many markets through 2016 are unsustainable in a long-term context that is predisposed to the gravity of fundamental valuation. This increases our focus on the preservation of capital, whilst thoughtfully allocating assets towards pockets of opportunity that offer compelling valuation advantages and a margin of safety.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA