4Q16

March 1, 2017ConsultivaQuarterly Commentary 2016

Donald Trump is inheriting one of the strongest economies that has been handed to a new President in recent history (based on 3Q GDP). Since the 1970’s, only George H.W. Bush and Jimmy Carter assumed the office with higher GDP growth rates. Further, investors have been cheered by Trump’s anticipated business-friendly ambitions on taxes, trade and regulations and have driven U.S. stocks to record highs. The S&P 500 Index gained 3.8% for the fourth quarter of 2016 and 12.0% for the year. Small stocks, as measured by the Russell 2000, rose 8.8% for the quarter and surged 21.3% for the year. 

Donald Trump is inheriting one of the strongest economies that has been handed to a new President in recent history (based on 3Q GDP). Since the 1970’s, only George H.W. Bush and Jimmy Carter assumed the office with higher GDP growth rates. Further, investors have been cheered by Trump’s anticipated business-friendly ambitions on taxes, trade and regulations and have driven U.S. stocks to record highs. The S&P 500 Index gained 3.8% for the fourth quarter of 2016 and 12.0% for the year. Small stocks, as measured by the Russell 2000, rose 8.8% for the quarter and surged 21.3% for the year.

Conversely, the bond market did not fare as well, especially post-election. The prospect of increased fiscal spending sparked concerns over higher inflation and tighter monetary policy, leading to a sharp sell-off in U.S. Treasuries. The 10-year Treasury yield climbed 85 bps, the largest quarterly increase since 1994. The year was a volatile one for bonds; the 10-year Treasury yield started the year at 2.27%, hit an all-time low of 1.37% in July (post-Brexit) and ended the year sharply higher at 2.45%.

The U.S. economic picture continued to improve during the final quarters of 2016. Third quarter GDP was revised up to 3.5% (1.7% year-over-year), the sharpest quarterly increase in two years. Unemployment reached a nine-year low of 4.6% in November and jobless claims remained relatively muted. Initial jobless claims fell to less than 300,000 in early 2015 and remained below this key level for more than 90 weeks, the longest streak since 1970. The Atlanta Fed’s Wage Growth Tracker Index showed that wages advanced 3.9% in October and November, the fastest since November of 2008. Home prices hit a record high in October; the S&P CoreLogic Case-Shiller U.S. National Home Price Index rose 5.6% in October for the trailing 12-month period. The average price for an existing single family home was $282,341 in November, the highest ever. New and existing home sales also posted strong gains, perhaps fueled by buyers rushing to lock in mortgage rates. Consumer confidence, as measured by the Conference Board Consumer Confidence Index, hit its highest level in 15 years in December (113.7). Auto sales are on pace to beat last year’s record of 17.5 million light vehicles. Even the manufacturing sector showed signs of improvement with the ISM Composite Index of factory sector activity showing consistent gains through the quarter.

Inflation, while still benign, continues to rise. For the trailing 12-month period, the CPI rose 2.1% in December, the most since 2014. Core CPI (excluding food and energy) was slightly higher at 2.2%. This also represented a larger increase than the 1.8% average annual increase over the past 10 years. The Fed’s preferred metric, the Personal Consumption Expenditures Index, rose 1.4% over the 12-month time period ending in November but remains short of the 2% target. Oil prices surged to their highest level in 17 months to close the year at $54 per barrel. The U.S. dollar soared for the quarter, hitting a multi-year high versus the euro and the yen and appreciating roughly 7% versus a basket of currencies.

The Fed, in a widely anticipated move, raised the Fed Funds rate 25 bps to a range of 0.50% – 0.75% in December. This turned out to be the Fed’s only move for the year, although at the end of 2015 it had projected four hikes in 2016. As communicated in its “dot plot,” the Fed expects three additional hikes in 2017, though the markets expect fewer. Interest rates began to creep up early in the fourth quarter as investors gained confidence that the Fed would make a move in response to encouraging U.S. economic data. Trump’s win propelled rates sharply higher fueled by expectations for escalating inflation in tandem with more debt. The 10-year U.S. Treasury closed the year at 2.45% but hit an intra-quarter high of 2.60%, the highest since September 2014.

Overseas, the European Central Bank announced that it would extend its asset purchase program beyond March, 2017 when it was set to expire, but purchases will be lower (€60 billion per month down from €80 billion per month). Italians voted “no” to reforms and a rescue fund was created for troubled banks in response to acute challenges at Monte dei Paschi di Siena. Deutsche Bank settled with the U.S. Department of Justice for its role in selling mortgages during the crisis, agreeing to a $7.2 billion payment (roughly half of what was originally suggested).

The unemployment rate in the euro zone declined to 9.8% in October, the lowest since July, 2009; it has been falling since reaching a record high of 12.1% in April, 2013. The range in unemployment rates is highly divergent among euro zone countries, with Spain’s at 19% and Germany’s at a 35-year low of 4%. Consumer prices in the euro zone increased 0.6% year-over-year in November, the highest since April 2014, but well below the 2% target. GDP is expected to have picked up in the final months of the year from the 0.3% (1.6% year-over-year) pace registered in the third quarter to 0.4% – 0.5%.

In Asia, the Japanese economy advanced 0.3% (1.0% year-over-year) in the third quarter, below the preliminary estimate of 0.5%. The economy continues to struggle in spite of aggressive stimulus measures. The Bank of Japan made no changes to its monetary policy but upgraded the outlook for 2017 given the yen’s weakness versus the U.S. dollar, which should provide a boost to exports. The dollar reached a 14-year high versus the yen. Despite worries at the start of 2016, China ended the year with growth expected to be in line with its target of 6.5%. Its stock market stabilized and is up 19% since its low in late January, 2016. Its currency has depreciated, but in an orderly fashion. However, challenges remain in the form of a high debt load and an overheated property sector.

The misfortunes of 2016 have been well-documented in the media. But, for the most part, Wall Street emerged from the tumultuous 12 months better than where it started. A terrible beginning to the year for stocks gave way to a spring bounce. A summer calm settled in that lasted until the run up to the 2016 U.S. presidential election, which in turn inspired a comprehensive rally in risk assets. Two key flashpoints for market volatility in 2016 were surprise results in the U.S. election and the United Kingdom’s “Brexit” from the European Union. Interestingly, both events were widely predicted by analysts to negatively affect the equity markets, but instead they preceded robust gains for U.S. stocks. In fixed income, a first-half rally for U.S. Treasuries gave way to a late-year sell-off as improving economic data in the U.S. inspired the Federal Reserve (Fed) to raise interest rates in December for only the second time in a decade. Commodities also had a disordered run in 2016, with the Commodity indexes shaking off early jitters for its first annual advance since 2010.

Source: Callan Associates Inc.

U.S. Equity

Equities posted strong returns in the fourth quarter, cheered by relatively good economic data, a rebound in corporate earnings, and speculation that Trump’s presidency will bring lower taxes, lighter regulation and increased spending. The S&P 500 climbed to an all-time high of 2,239 on December 30 and closed up 3.8% for the quarter. Small capitalization stocks outperformed large by a wide margin; the Russell 2000 rose 8.8% in the quarter and was up 21.3% for the year while the Russell 1000 gained 3.8% and 12.1% for the same periods.

Source: Callan Associates Inc.

Value gained favor after prolonged underperformance. While this trend was in place before the election, Trump’s win boosted Financials and Energy stocks, which make up a significant portion of the value indices. The largest difference between growth and value was in small caps. The Russell 2000 Value outperformed its Growth counterpart by 10.5% (+14.1% versus +3.6%) in the quarter and by double that amount, 20.4%, over the year (+31.7% versus +11.3%).

Quality Sectors[1]

During the quarter, low quality outperformed higher quality stocks in the large cap value, mid cap core and value sectors.

Low quality outperformed higher quality stocks in the large cap value and core sectors in 2016.

Economic Sectors

Within the S&P 500 Index (+3.8%), there were stark differences in sector returns. Financials (+21.1%) were beneficiaries of “Trumponomics”, riding expectations for a more lenient regulatory environment and higher interest rates, while Health Care (-4.0%) was one of the worst performing sectors. While smaller cap bio tech stocks performed well, uncertainty over the future of Obamacare hurt hospitals. The newly established REIT sector (-4.4%)[2] was punished by rising interest rates.

Source: S&P Dow Jones Indices LLC; Callan Associates Inc.

Dividend Payments

S&P Dow Jones Indices^® reported that net dividend increases (increases less decreases) for U.S. domestic common stocks increased $8.9 billion during Q4 2016. This is a 50% increase from Q3 2016, which netted a $6.0 billion gain, and 148% higher than the $3.6 billion gain of Q4 2015. For Q4 2016, aggregate increases amounted to $11.3 billion, up from $10.3 billion in Q4 2015. Dividend decreases declined to $2.3 billion, from $6.7 billion, in Q4 2015. For the full year ending in December 2016, net dividend increases fell 38.9% to $23.6 billion, compared to a $38.7 billion increase for full-year 2015. Dividend increases fell to $43.9 billion, from $54.7 billion; dividend decreases rose to $20.2 billion, from $15.9 billion during 2015.

Additional findings from S&P Dow Jones Indices’ quarterly analysis of the dividend activity of the approximately 10,000 U.S. traded common issues include:

• 784 dividend increases were reported during Q4 2016, compared to 755 increases in Q4 2015, a 3.8% year-over-year increase.
• For 2016, 2,634 issues increased their payments, compared to 2,810 issues in 2015, a 6.3% decrease.
• 134 issues decreased dividends in Q4 2016, compared to 142 in Q4 2015, a 5.6% year-over-year decrease.
• For 2016, 659 issues decreased their dividend payments, compared to 504 decreases in 2015, a 30.8% increase.
• The percentage of non-S&P 500 domestic common issues paying a dividend rose to 54.7%, up from 52.2% in Q3 2016 and 47.4% in Q4 2015.
• The weighted dividend yield for paying issues was 2.59%, down from 2.67% in Q3 2016 and 2.72% in Q4 2015.

“Large-cap dividend cuts from Energy issues slowed significantly in Q4 2016, as smaller-cap issues struggled the most to increase or maintain its dividend payments,” said Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices, in a quarter end communication. He went on to add that; “Oil’s recent 18-month high and OPEC’s planned production cut could add earnings stability to the sector, which could open a dividend recovery with measured increases.”

418 issues, or 82.8%, within the S&P 500 currently pay a dividend, up from 82.2% at the end of Q3 2016. All 30 members of the Dow Jones Industrial Average^® pay a dividend.

Silverblatt found that 68.5% of S&P MidCap 400^® issues pay a cash dividend, down from 68.8% in Q3 2016. 50.2% of S&P SmallCap 600^® issues pay a dividend, which is a decrease from the 52.4% of small-cap issues paying dividends in Q3 2016.

Yields continued to vary, with large-caps at 2.09% (2.12% in Q3 2016), mid-caps at 1.53% (1.64% in Q3 2016) and small-caps at 1.18% (1.31% in Q3 2016). The yields across dividend-paying market size classifications continue to be compatible, with large-caps at 2.46% (2.52% in Q3 2016), mid-caps at 2.17% (2.34% in Q3 2016) and small-caps at 2.07% (2.27% in Q3 2016).

“For 2016, both the issues’ and aggregate dollars increase slowed, as the payment growth rate has halved since 2015,” added Silverblatt. “While fewer and smaller decreases hurt, it was significant Energy cuts, and some Materials issues, that led to the slowdown. Q4 2016 saw fewer dividend reductions and a rise in the amount and size of dividend increases.

“Within the S&P 500, the average dividend increase for 2016 was 10.51%, down from 13.08% in 2015; however, Q4 2016 was 11.71%, up from 10.14% in Q3 2016. At this point, large-cap Energy issues have stabilized, which should stop the pulldown in payments. Yet, adding them back– once oil and commodity prices have stabilized – will take time.

“Absent a significant negative event, 2017 could be another record year for dividends, as growth in both earnings and cash are expected on the Street. The key question, however, is whether dividend growth returns to a 10% rate from 2016’s 5%. That answer may be more dependent on events coming from Washington than from Wall Street, with repatriation and taxes at center stage.”

U.S. Home Prices

Data through October 2016, released by the S&P Dow Jones Indices^® for its S&P CoreLogic Case-Shiller Home Price Indices^®, shows that home prices continued their rise across the country over the last 12 months.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, covering all nine U.S. census divisions, reported a 5.6% annual gain in October, up from 5.4% last month. The 10-City Composite posted a 4.3% annual increase, up from 4.2% the previous month. The 20-City Composite reported a year-over-year gain of 5.1%, up from 5.0% in September.

Seattle, Portland, and Denver reported the highest year-over-year gains among the 20 cities over each of the last nine months. In October, Seattle led the way with a 10.7% year-over-year price increase, followed by Portland with 10.3%, and Denver with an 8.3% increase. 10 cities reported greater price increases in the year ending October 2016 versus the year ending September 2016.

“Home prices and the economy are both enjoying robust numbers,” said David M. Blitzer, Managing Director & Chairman of the Index Committee at S&P Dow Jones Indices. “However, mortgage interest rates rose in November and are expected to rise further as home prices continue to out-pace gains in wages and personal income. Affordability measures based on median incomes, home prices and mortgage rates show declines of 20-30% since home prices bottomed in 2012. With the current high consumer confidence numbers and low unemployment rate, affordability trends do not suggest an immediate reversal in home price trends. Nevertheless, home prices cannot rise faster than incomes and inflation indefinitely.”

Blitzer added; “After the S&P CoreLogic Case-Shiller National Index bottomed in February 2012, its year-over-year growth accelerated to a peak rate of 10.9% in October 2013 and then gradually fell to its current rate of approximately 5%. During the same period, the highest year-over-year rate from any city was 29% in August and September 2013; currently the highest single city gain declined to approximately 11%. Both national and city growth in home prices slowed but remains above the growth rate of incomes and inflation.”

The chart below depicts the annual returns of the U.S. National, the 10-City Composite, and the 20-City Composite Home Price Indices. The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, which covers all nine U.S. census divisions, recorded a 5.6% annual gain in October 2016. The 10-City and 20-City Composites reported year-over-year increases of 4.3% and 5.1%, respectively.

The following chart shows the index levels for the U.S. National, 10-City and 20-City Composite Indices. As of October 2016, average home prices for the MSAs within the 10-City and 20-City Composites are back to their winter 2007 levels.

The table below shows the housing boom/bust peaks and troughs for the three composites along with the current levels and percentage changes from the peaks and troughs.

Sources: S&P Dow Jones Indices & CoreLogic

Non-U.S. Equity

Foreign developed and emerging market indices trailed the S&P 500. The MSCI ACWI ex-US fell 1.3%, modestly below the MSCI EAFE’s -0.7% result. Dollar strength was broad-based and thus detracted from returns for U.S. investors. The MSCI Emerging Markets Index dropped 4.2% for the quarter.

Source: Callan Associates Inc.

In developed markets, Italy (+11%) was the top performer in the fourth quarter, although it remains at the bottom of the pack for the year (-11%). Among emerging markets, Russia posted the best return (+19%) while Turkey (-14%) sank. Turkey’s economy shrank 1.8% in the third quarter, its first year-over-year decline since 2009. Mexico, hurt by “Trumponomic” concerns, was down 8%.

U.S. Fixed

Interest rates in the U.S. rose sharply in the fourth quarter, driven both by encouraging economic data and worries that the pro-growth agenda put forth by President-elect Donald Trump will have an inflationary effect. The 10-year U.S. Treasury yield rose 85 bps and returned -6.8% for the quarter in the sharpest quarterly selloff in more than two decades. TIPS outperformed nominal Treasuries, bolstered by rising expectations for inflation. The Bloomberg (Blmbg)[3] TIPS Index returned -2.4% for the quarter but ended the year up 4.7%. The 10-year inflation breakeven rate was 1.95% as of December 30th.

Source: US Treasury Department

Source: US Treasury Department, Bloomberg

The Bloomberg U.S. Aggregate Bond Index returned -3.0% for the quarter but was up 2.6% for the year. The Corporate sector returned -2.8% and +6.1% for the same periods. Issuance by U.S. corporations hit another record high in 2016 at roughly $1.3 trillion. Long maturity bonds performed the best, in relative terms, with long corporates outperforming like-duration Treasuries by 436 bps. Mortgages underperformed Treasuries as durations extended with the increase in interest rates. The Bloomberg Barclays High Yield Index gained 1.8% in the quarter and more than 17% for the year.

The municipal bond sector faced headwinds in the fourth quarter with robust supply, concerns over Trump’s desire for lower taxes, and rising interest rates contributing to outflows from the sector. Supply in 2016 was $445 billion, breaking its record from 2010 ($443 billion). The Bloomberg Barclays Municipal Bond Index fell 3.6% for the quarter and was essentially flat (+0.2%) for the year.

Source: Callan Associates Inc.

Other US Fixed Income

Source: Callan Associates Inc.

Non-U.S. Fixed

Overseas, yields were also higher, though dollar strength was the primary driver of sharply negative returns for unhedged indices. The Bloomberg Barclays Global Aggregate ex-US Index fell 10.3% for the quarter (-1.9% on a hedged basis). The U.S. dollar benefited from higher interest rates as well as prospects for growth. The yen lost more than 13% versus the dollar over the course of the quarter and the euro depreciated by more than 6%. Emerging markets debt underperformed developed markets. The JP Morgan EMBI Global Diversified Index dropped 4.0% for the quarter and the local currency GBI-EM Global Diversified lost 6.1%.

Source: Callan Associates Inc.

Currencies

The US dollar rose sharply versus most currencies over the quarter. The Japanese yen (-13.2%) was one of the largest decliners, as yield differentials between the US and Japan continued to widen; the BOJ’s new yield-targeting policy helped anchor 10-year JGB rates at 0% even as US Treasury yields climbed.

Emerging markets currencies (Mexican peso, -6.1%; Chinese renminbi, -4.0%; Indian rupee, -1.9%) also depreciated significantly against the US dollar following Trump’s election victory, over concerns about potential US trade protectionism. European currencies (euro, -6.1%; British pound, -4.9%; Swiss franc, -4.6%) also fell versus the greenback. The dollar gained further momentum after the market priced a more aggressive hiking path by the Fed after its December meeting.

Source: Wellington Management

Commodities benefitted from OPEC (Organization of the Petroleum Exporting Countries) announced cuts as well as the prospect of increased infrastructure spending. In November, OPEC agreed to production cuts to reduce output by 1.2 million barrels per day or roughly 1% of global output. Several non-OPEC nations also agreed to cut output by around half a million barrels per day. Oil closed the year at $54 per barrel, the highest level since July, 2015. The S&P GSCI Commodity Index rose 5.8% for the quarter and 11.4% for the year. MLPs were up modestly during the quarter (Alerian MLP Index +2.0%) with stronger results for the year (+18.3%).

Source: Callan Associates Inc.

US Real Estate

The U.S. REIT market (as measured by the FTSE NAREIT Equity REITs Index) posted a return of -2.9% for the quarter, in line with the Bloomberg Aggregate Bond Index (-3.0%) but lagging the S&P 500 (+3.8%) by 670 basis points. The average U.S. REIT dividend yield at quarter-end stood at 4.0%, as compared to 2.1% and 1.5% for the S&P 500 and Russell 2000 indices, respectively.

Source: FTSE™, NAREIT®.

During the quarter, Lodging/Resorts (+20.4%), Specialty (+2.1%) and Residential-Apartments (+1.7%) posted the strongest returns while Retail-Free Standing (-13.0%), Retail-Regional Malls (-11.6%) and Health Care (-10.8%) were the weakest sectors.

Source: FTSE™, NAREIT®.

Other Real Estate

Source: Callan Associates Inc. EPRA: European Public Real Estate Association (Non-US Real Estate)

Commodities

Source: Callan Associates Inc.

S&P Goldman Sachs Commodity Index (“GSCI”)

Commodities (+5.8%) strengthened over the quarter, with three out of the four sectors posting gains for the period. The energy (+8.7%) sector rallied following OPEC’s November 2016 meeting, where it was announced that the organization’s members would lower oil production by 1.2 million barrels per day (b/d) to 32.5 million b/d starting on 1 January 2017 — the first cut in eight years. Non-OPEC producers subsequently agreed to trim a further 600,000 b/d. Gasoline (+14.0%), gas oil (+10.6%), heating oil (+8.9%), and crude oil (+7.3%) all strengthened on the news. Natural gas (+13.7%) also rallied as forecasts for cooler temperatures helped boost the outlook for demand, while the US became a net exporter of the commodity for the first time in more than 60 years.

Source: S&P

Industrial metals (+5.7%) benefitted from continued Chinese manufacturing growth, declines in stockpiles, and speculation that Trump will increase infrastructure spending, leading to rallies in copper (+13.6%) and zinc (+7.5%). Nickel (-5.7%) pulled back on a stronger US dollar and fears that Indonesia would relax its export ban on low-grade nickel pig iron ore.

Agriculture & livestock (+2.4%) was driven by robust performance across lean hogs (+30.3%), live cattle (+14.8%), and feeder cattle (+11.0%). Cattle prices rallied due to high beef live-to-cutout spreads and seasonal trends, while supply for both feeder and live cattle declined. Hogs benefitted from lower weights and healthy export sales, which helped reduce supplies. On the other hand, soft commodities retreated in part from surging US bond yields, a stronger dollar, and Trump’s election win adding pressure on emerging markets. Corn (+2.1%) posted a strong quarter as farmers have been restricting supply by holding onto the grain, which provided pricing opportunities despite record crops. Soybeans (+3.4%) advanced on export prospects and increased concerns over South American growing conditions.

Precious metals (-13.2%) pulled back over the quarter on increased expectations of interest rate hikes, a stronger US dollar, and improving growth prospects for the US following Trump’s election. Both gold (-12.7%) and silver (-17.2%) ended the quarter lower.

Hedging Strategies and Hedge Funds

Hedge funds posted gains across all strategies in December to conclude 2016, with the HFRI Fund Weighted Composite Index® (FWC) rising to a record Index Value level as oil prices surged, equities gained and U.S. interest rates increased into year end, according to data released by Hedge Fund Research (HFR®). The HFRI Fund Weighted Composite (FWC) advanced +1.1% in the month, bringing the annual return to +5.6% and the Index Value to 12,966, surpassing the prior record from May 2015 and the highest value since inception in January 1990; the HFRI Asset Weighted Composite Index also gained +1.1% in December. In a year dominated by the dual political financial market dislocations of Brexit and the U.S. Presidential election, the HFRI FWC gain topped the gain of global equities, as represented by the MSCI World Index.

Source: Callan Associates Inc.

Equity and credit-sensitive Event Driven (ED) strategies – including M&A, Special Situations and Distressed – led industry performance for December and 2016. The HFRI Event Driven (Total) Index gained +1.5% in the month and +10.2% for the year, the strongest annual gain since 2013. All ED sub-strategies climbed in December, led by the HFRI Activist and ED: Multi-Strategy Indices, which each gained +2.5%. For 2016, the HFRI Distressed and Special Situations Indices led sub-strategy performance with gains of +13.4% and +11.6%, respectively, both posting their strongest calendar year gains since 2013. The HFRI Activist and HFRI Credit Arbitrage Indices each gained +10.5% for 2016.

Fixed income-based Relative Value Arbitrage (RVA) strategies also advanced for December and 2016, with the HFRI Relative Value (Total) Index gaining +1.2% for the month, bringing the YTD return to +7.8%. RVA sub-strategy performance was led by Yield Alternative strategies, which includes Energy Infrastructure, MLP and Real Estate exposures; the HFRI RV: Yield Alternatives Index advanced +2.6% in December and +17.6% for 2016. Hedge funds investing in corporate bonds also posted strong performance, with the HFRI RV: Fixed Income-Corporate Index gaining +1.9% December and +11.7% for the year.

Long short Equity Hedge (EH) strategies advanced in both December and 2016, with the HFRI Equity Hedge (Total) Index gaining +0.9% for the month and +5.5% for the year, as global equities rallied to conclude a strong 4Q. EH sub-strategy performance for December was led by quant strategies, with the HFRI EH: Quantitative Directional Index up +1.7%. The HFRI EH: Energy/Basic Materials Index added +0.5% in December, concluding the year up +18.7%, leading not only EH sub-strategy performance, but all sub-strategy performance.

Macro hedge funds gained in December as interest rates rose and energy commodities surged, though Macro produced only a small gain for 2016. The HFRI Macro (Total) Index climbed +1.2% in December, led by Energy exposures and CTA strategies, bringing its 2016 gain to +1.5%. The HFRI Macro (Asset Weighted) Index produced a slightly higher gain of +1.3% in December. Despite strong performance early in the year and through the Brexit turmoil, quantitative, trend following CTA strategies posted a disappointing decline in 2016; the HFRI Macro: Systematic Diversified Index gained +1.2% for December, paring the decline for the year to -1.0%. Out of 27 HFRI sub-strategy indices calculated by HFR, HFRI Macro: Systematic Diversified was the only index to decline for 2016. Macro sub-strategy performance in 2016 was led by commodity exposures, with the HFRI Macro: Commodity Index advancing +5.2%.

“Like US equities, the HFRI reached a record high in December, benefitting from post-election optimism, surging commodities and despite increases in US fixed income yields. This record level of HFRI performance also coincides with record hedge fund assets reached in 3Q16,” stated Kenneth J. Heinz, President of HFR. “Following a disappointing decline in 2015, hedge fund performance in 2016 was the highest since 2013 and not only tops indices of global equities, but also the annualized HFRI performance over the last 5 and 10 years. The recent (post-election) increase in investor risk tolerance is likely to drive continued performance and capital gains into mid-2017.”

Private Equity

During the fourth quarter, 2,470 investors deployed $12.7 billion in capital to 1,736 venture-backed companies, according to the PitchBook-NVCA Venture Monitor. The report found that throughout 2016 more than $69.1 billion was invested across 7,751 companies in the entrepreneurial ecosystem, representing the second highest annual investment total in the past 11 years. Given the high levels of venture investment activity recorded in 2014 and 2015, 2016 represented less of a decline and more of a return to normal for the venture capital industry.

“Fourth quarter activity reinforces what we saw and heard all year, which is that the venture investment levels are readjusting after peaking in 2015. We view this recalibration as a healthy normalization and a return to a much steadier pace of investment,” said Bobby Franklin, President and CEO of NVCA. “The large amount of capital raised for deployment to the ecosystem as well as optimism surrounding the IPO pipeline are all positive signs as we look ahead. Given the 2016 election results and the venture industry’s return to normal, 2017 will prove a pivotal year for venture investors and the startups they support.”

“As companies stay private for longer than ever, the venture capital markets are maturing accordingly,” said PitchBook founder and CEO John Gabbert. “After a couple years of frenzied investments and lofty company valuations, the venture capital ecosystem is moving away from a financing peak and returning to a normal, healthy investment climate.”

Fundraising activity

Despite a decline in investment activity, 2016 recorded the highest amount of capital raised by venture funds in the last ten years. Each quarter posted historically high fundraising figures; however, the second quarter stood out with venture capital firms raising $13.6 billion. The fourth quarter recorded $7.3 billion raised, bringing the total amount of capital raised in 2016 to $41.6 billion across 253 funds.

Investment activity

The $12.7 billion deployed to 1,736 venture-backed companies in the fourth quarter brought annual investment to $69.1 billion across 7,751 companies. Despite recording the second-highest amount of capital invested (second only to 2015’s tally of $78.9 billion) in the last 11 years, 2016 saw a sharp decline in terms of completed financings. More than 8,000 deals were completed in 2016, representing a 22% year-over-year decline and the lowest count since 2012, a clear indication that venture investors are being much more critical of their investment opportunities.

Exit activity

The pace of exit activity for venture-backed companies continued to slow in the fourth quarter of 2016, with only 142 exits completed valued at $6.8 billion. Despite a slowdown in exit activity, the median exit size in 2016 reached $84.5 million, a decade high and a 30% increase from the year prior. Corporate acquisitions proved to be the most popular exit route for venture-backed companies in 2016, while the IPO window remained narrow. In the fourth quarter, seven companies went public bringing the total number of completed IPOs to 39 in 2016, the fewest since 2009, which had ten venture-backed companies debut on the U.S. exchange.

Puerto Rico[4]: (excerpts from X Square Capital’s Q4-2016 Commentary)

It was an eventful quarter in Puerto Rico. In tandem with the electoral process, the Fiscal Oversight and Management Board (the “Board”) began addressing some of the most pressing issues surrounding Puerto Rico’s fiscal crisis. The need for structural reforms regarding labor laws, the department of education, healthcare, and higher education were highlighted in a letter sent by José Carrión, Chairman of the Board, to the incoming Governor, Ricardo Roselló. Furthermore, in a bid to further reiterate the need for immediate action, the Board published an ambitious timetable that seeks to have a certified Fiscal and Economic Growth Plan (the “FEGP”) by January 31^st.

The FEGP is based on the assumptions of the latest fiscal plan presented by the outgoing administration, which the Board emphasized should not consider federal transfers that have not been legislated or that do not currently count with the support of a bill or similar consideration in Congress. The numbers provided by the FEGP will serve as the starting point for negotiations with bondholders.

The Board’s timetable appears more symbolic than practical since it will be very difficult, almost close to impossible, to conclude a broad based fiscal plan full of underlying assumptions and economic projections for the next 10 years within 30 days of transfer of power to the new administration. Governor Rosselló has already signaled to the Board his intention of rolling back the deadline by at least 45 days in order to have a detailed plan regarding fiscal expenditures, cost control and revenue measures (at the state and general fund level). As a consequence of these delays, it can be estimated that the legal stay will be extended until May 1 at which point more serious, voluntary negotiations will begin. In the meantime, the Board will run parallel analyses with its advisors and complete the hiring process of its executive advisor and its working group.

The timeline set by the Board is an open invitation for interested parties to work together in formalizing all the necessary actions, reforms and bills that need to be put forth, both stateside and at the federal level, in order to arrive at more realistic projections in the 10-year FEGP. As the Report to the House and Senate by the Congressional Task Force on Economic Growth for Puerto Rico highlighted, Puerto Rico needs an equitable treatment for both Medicaid and Medicare funding programs, a revamping of its statistical collections and reporting services, a modernization of its energy infrastructure, tax reform and, among other things, to devise a mechanism that will incentivize labor force participation.

During the first 24 hours of his tenure, Governor Rosselló issued several executive orders that will apparently set the tone of his administration. Most notably, the new administration intends to reduce by 20% the head count related to political appointees, and budget expenditures by 10% overall (10% operational expense reduction as well as a 10% reduction in government contracts). These cost reductions are estimated to yield between $70-$100MM in savings during the first six months (the second half of FY2017), and up to $500MM in savings for the FY2018 general fund budget.

If the same guidelines are applied to the consolidated budget, which is expected to be the case for FY2018, then as much as a $2B total reduction in spending may be possible. Moreover, in a bid to depoliticize the tourism agency, the marketing of the island as a destination will be carried out by an independent body, intended to be kept at arm’s length from political parties and the electoral cycle. This measure in particular, signals a relevant philosophical change that, if applied to other government entities and corporations, could remove significant obstacles to the development and economic growth of the island.

Finally, the declaration of a state emergency, as applied to infrastructure and fiscal matters, will likely pave the way for a faster permitting process and the closing of all open or vacant employment positions until further notice, another executive order of interest to stakeholders.

Meanwhile, the economy continues to show resiliency in the face of the fiscal crisis. Tourism, manufacturing, and auto sales were a bright spot in 2016. Also, general fund revenues beat estimates by $46MM during the first half of FY2017, which is already trending at a record pace. This represents an improvement of approximately $120MM over FY2016. Anecdotal evidence portends a confidence rebound in the economy, as well as a general investment appetite for infrastructure projects. Notably, the high-end real estate market has been showing signs of increased strength in terms of pricing and inventory draws, as well as mid-price range residential in coastal metro areas, where a scarcity of inventory has become the rule of the day. Real estate remains very fragile in the suburbs and another year of record repossessions is expected.

We enter 2017 with U.S. stock markets at new highs, rising interest rates and historically low volatility. The U.S. economy continues to gain traction and there are glimmers of hope that a bottom has been reached overseas. However, a whole host of geopolitical challenges continue to cause angst. Further, the election of Donald Trump has resulted in widespread speculation as to the impact his policies will have on markets, but much uncertainty remains with respect to the scope, implementation and timing of these policies.

We continue to recommend prudent asset allocation and risk assessment, based on future capital needs for plan sponsors, institutions and individual investors. We believe that higher quality, medium duration yield producing assets are favored. In addition, rebalancing is fundamental to a well-executed long-term investment strategy. Hence, we shall continue to explore opportunities for rebalancing as assets shift in weight relative to overall strategies.

Finally, we believe that due diligence reviews and an adherence to a well-developed investment policy remains the most prudent course for long-term investors. Continued fiduciary education is paramount.

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