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    A Change in Leadership

    Baseball enthusiasts were entertained by the run-up and outcome of the 2016 World Series Championship playoffs between the Cleveland Indians and national favorite Chicago Cubs.  The Cubs, who led the majors with 103 wins this past season, had not won a World Series title since 1908. Meanwhile, the Indians had not won the World Series since 1948, and hoped to match the success of their hometown Cavaliers who had just won the NBA crown earlier in the year, ending the city’s 52-year span without a major professional sports title.  The Cubs, down three games to one in the best of seven series and their back against the ivy-covered brick wall, evened the series to force a final game, eventually winning game seven in an extra inning, rain delayed battle. Cubs fans celebrated their well-deserved victory, dancing in the streets into the early morning hours, liberated from the “Billy goat curse,” and having ended the longest championship drought in American sports history.

    The Cubs’ victory was not only celebrated on the field, but also in the team’s back office. After a miserable 2011 season when the Cubs finished last in their division, and recognizing the need for a general manager with a deep analytical background to select players rather than relying on scouts’ judgments, Cubs owner Tom Ricketts brought in Theo Epstein as president of baseball operations.  Epstein came from the Boston Red Sox, where he had helped the Sox win two World Series titles over a five-year period, ending a similar 86-year “Curse of the Bambino” championship drought.

    Epstein is a follower of “Sabermetrics,” made better known in the book and movie titled “Moneyball” and Oakland A’s manager Billy Bean, which focuses on nontraditional statistics over more traditional metrics, examining a player’s worth based on his ability to help his team score more runs than the opposing team.  Leveraging the Cubs’ deeper resources, Epstein revamped his scouting department and coaching staff with those who understood this data dependent process, while simultaneously replenishing and cultivating their minor-league system. After season losing records in years 2012-2014, the Cubs made the playoffs in 2015 with the third-best record in major league baseball, before their 2016 World Series feat.

    Market and political events of the fourth quarter and most of 2016 were similar to the Cubs’ recent baseball success.  In the aftermath of the great recession, U.S. economic growth was anemic, averaging less than 2.0% over the last eight years. This was well below the longer-term average of 3%, an annual level never reached under the outgoing administration. As a result of this slow growth, low inflationary economic setting, combined with aggressive Central Bank bond purchases, investors played “small ball,” showing preference for those asset classes benefitting from zero interest rate Fed policy and declining yields. In this environment, defensive stable growth companies and equity sectors outperformed, including consumer staples, utilities and telecommunications. These were desired due to their high degree of earnings predictability and attractive dividend yields. Companies pursuing financial engineering (issuing low yield debt and using proceeds for aggressive share repurchases) also benefitted.  Although driving up the value of financial assets, these easy money policies did little for the real economy, disappointing fundamental investors by continuing to languish below potential.  While U.S. employment trends improved, for the average American, the standard of living and discretionary income declined.

    President Donald Trump’s message resonated with these primarily disenfranchised suburban, blue collar workers who were seeking change, similar with the Brexit vote outcome. Like the Cub’s back office, President Trump’s campaign success was accomplished by utilizing unconventional techniques including turning to social media (Twitter mostly) rather than reliance on the mainstream media, distancing himself from traditional political methodologies, leveraging his personal resources, and an active ground building effort.  His come from behind victory challenged the credibility of the nation’s leading pollsters, calling into question their mathematical models, assumptions, and survey methods. While a surprise to the general public, his victory was consistent with his inner circle’s views on how the campaign was progressing, and the shifts needed to improve the probabilities of success and driving more electoral college runs across the plate.

    While the markets were already starting to transition towards beneficiaries of the later innings of the U.S. economic business cycle, the equity and bond markets responded quickly to the unexpected election outcome. President Trump’s proposed economic policies including the reduction of corporate and personal tax rates, higher fiscal spending, and the repatriation of cash held overseas, were viewed as highly favorable to the domestic equity markets, while unfavorable to the bond markets. All else being equal, lower tax rates improve after tax earnings and discretionary spending, while repatriation of overseas cash holdings would be expected to result in higher dividends, share repurchases and capital spending.  For fixed income investors, a move away from aggressive monetary policy (low Fed funds rate) and towards higher fiscal spending for an infrastructure build out, and trade protectionism, at the margin would be cause for a faster pace of Fed funds rate hikes and a higher rate of inflation. During the quarter, 10-year Treasury yields rose from 1.6% to 2.45% in response to these potential initiatives.

    A strong third quarter GDP report, the first Fed funds rate hike in a year, and potential for a faster normalization of the benchmark funds rate caused the dollar to rally, investors to shift aggressively into domestic equities, while putting downward pressure on returns from both international and emerging market equities due to concerns over trade policies.  On an absolute basis, the broad Stoxx Europe 600 Index was up 5.8% in Euro terms, but down 0.6% for U.S. based investors, as the dollar rallied 6.4% against the Euro. As global investors must increasingly recognize, currency adjustments will continue to influence overseas net returns when diversifying and investing in foreign markets, both unfavorably when the dollar rises and favorably when the dollar falls.

    The election outcome heavily influenced domestic markets, with investors also focusing on the proposed policies of reducing banking regulations and developing energy infrastructure.  Rising yields, wider interest rate spreads between short and intermediate bond maturities, combined with the prospect of reduced banking regulations caused the financial sector to soar, up by 21.1% in the quarter.  For the energy sector, helped by an agreement by OPEC members and other major suppliers to curtail production, crude oil prices continued their recovery, up 11.4% in the quarter.  This news helped the energy sector rally by 7.3% in the period, generating a gain of 27.4% for the year, after a miserable 2015 performance with a losing record of -21.1%.

    With heavy weighting in both the financial and energy sectors, the value style of investing, having been large underperformers in 2015, put in a late inning rally to dominate the competition.  For the quarter, the Russell 3000 Value Index beat the Russell 3000 Growth Index by a final score of 7.2% to 1.2%, and for the year by the score of 18.4% to 7.4%.  Similarly, the market’s minor league farm team recruits, as represented by the small-cap. Russell 2000 Index, helped drive runs across the plate by producing a fourth quarter return of 8.8%, and 21.3% for the year.  The election outcome and market’s response caused CEOs, small business owners and consumer confidence to soar, optimistic the removal of the regulatory curse might favorably change the trajectory of the economy and reinvigorate their profitability.

    If these trends are indeed changing, the rotation away from defensive, low volatility asset classes towards economically sensitive asset classes would still be in early stage. If so, adjusting portfolios to reflect these new dynamics would prove worthwhile, rather than simply relying on what has worked in the past. Inflation sensitive industries and sectors, small cap stocks, commodities, and floating rate bonds are examples of potential beneficiaries, while long term Treasuries would be a tired portfolio favorite to trade for a younger and more agile draft choice.

    Implementing profound change, including new back office personnel and coaching staff, the trading away of well-known brand name players, and a message and style that does not resonate with a broad subset of the population has been met with resistance. Similar to the early months of most new Presidents, there are likely to be errors and setbacks along the way.  However, if comparable to the Cubs’ progression and while uncertain in the short run, for the long term good of the American franchise, we should all root for these unconventional approaches to eventually prove effective.