2016 - Quarter 4

The high yield fixed income sector, which is highly correlated to equities, outperformed all other fixed income markets in 2016 by returning 13.22%.

Fixed Income Return Summary

Longer municipals, as well as intermediate corporates, government, and treasury indexes all ended the year in positive territory. Shorter municipal bonds underperformed the market with a slightly negative return for 2016.

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Yield Curve Shift: Since the Election

After the election on 11/08/2016, yields in the municipal bond market have risen dramatically. The chart below demonstrates the shift in yield for AAA rated general obligation municipal bonds.

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The red dotted line represents the yield curve as of 11/08/2016, and the blue line represents the yield curve as of 12/30/2016. The yellow bars represent the yield curve shift during that time, with the change in yield shown in basis points on the right axis. Maturities greater than fifteen years saw increases of one hundred basis points or more.

Yield Curve Shift: For the Year 2016

The yield curve shift for the year was much less than the move since November. The five‐year part of the curve experienced the greatest yield increase, rising over fifty basis points, while bonds in the 10‐15 year range and the long end outperformed the rest of the curve.

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We have been using barbell strategies for many of our clients for the last few years to take advantage of a bear flattening of the yield curve. The barbell typically is weighted with some maturities in the 10‐14 year part of the curve. To offset the duration risk of these longer maturities we have a heavy weighting in the 1 year part of the curve. We have generally underweighted or avoided the 5 year part of the Muni curve. This strategy has worked well for us as bonds in the 3‐5‐year area have seen their yields rise the most this year.

Uncertainty Has Increased Since the Election

During this period of transition from the Obama administration to the Trump administration, markets are reacting to this change in leadership and anticipating possible changes in policies and their impact on the economy. This is evidenced by the recent rise in interest rates, and in the rise in the price of equities. The markets are likely predicting changes that will not materialize after Trump takes office. There may also be changes which take place after January 20th that markets are not currently foreseeing. We believe the new administration is still in the formulation stage of the policies they would like to implement. The prudent course for investors is to focus on the current state of the economy, and watch as policy develops and see how the economy reacts to these changes which are likely to take place.

We know the economy, like the economies of all the developed nations, suffers from very high levels of debt. When Reagan took office the ratio of debt to GDP was 30%. This ratio increased to 60% by the time Obama took office. Since then the ratio has risen to about 105% during the Obama administration. High levels of debt act as a deterrent to economic growth. We also know the economies of other developed nations have not responded positively to massive doses of monetary easing by the world’s central banks. The U.S. has had the fed funds rate at or near zero
for over 8 years. The Fed has also engaged in quantitative easing programs to stimulate the economy. Economic growth during this time since the financial crisis has been lackluster. The economy has been in a liquidity trap and the Fed has been “pushing on a string.” During this same time, we have also had massive amounts of fiscal stimulation by the Federal government. The federal debt has risen by more than 100% in the last 8 years. During the most recent budget year deficit spending accounted for about 16% of our budget. Both fiscal and monetary policies have been accommodating, however, we have still been stuck in a low growth environment.

Trump has voiced several policy positions, and many of them are not consistent in a coherent economic policy package. His stated goal is to achieve economic growth in GDP of at least 4% a year. This is to be accomplished by cutting taxes, increasing spending on infrastructure and the military, and reducing the deficit. It will not be possible to reduce the deficit if we increase spending and cut taxes. It should be clear to all that we cannot achieve enough growth in the economy by cutting taxes to balance the budget. We also don’t know which of these policies will become enacted, and if they are enacted, how the economy will respond.

The new administration is also struggling with creating a cohesive concept of what the proper role for the federal government should be about the economy. There seems to be some tension between a government that has more of a hands‐off approach to business in the areas of regulation, and a government that has more of a hands on approach in telling businesses where they can have their factories.

Uncertainty has increased with Trump’s election, not decreased. Investors should not assume the economy will grow faster and interest rates must rise. These are not known events. We are still over indebted and likely to be in a low rate environment for a long period.