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Aon Retirement and Investment Blog

First Quarter 2016 Market Review and Outlook

Regional equity returns were notably varied over the quarter, with North American equities performing strongly relative to other developed regions.
The quarter saw a loosening of monetary policy from central banks in Europe and Japan, and a more dovish tone from the US Federal Reserve. The MSCI All Countries World returned -1.3% in local currency terms, but dollar weakness pushed the return up to 0.4% for unhedged US investors. US equities (Dow Jones Total Stock Market) returned 0.9% over the quarter. In US dollar terms Canada* (12.1%), Emerging Markets* (5.1%) and Australia* (2.8%) were the strongest performers as commodity prices began to stabilize and the currencies of commodity exporting nations strengthened versus the dollar. Japan* (-5.5%) was the weakest performing region despite significant yen strength, with the UK* (-2.6%) and Europe ex-UK* (-2.0%) also returning negatively in dollar terms. 12 month global equity returns (MSCI AC World) were -4.4% in local currency terms, and -3.8% in US dollar terms. US equities (Dow Jones Total Stock Market) returned -0.4% over the 12 months to 31 March 2016.
 
*MSCI Investible Market Regional Indices
 
Core inflation picks up in the US, but manufacturing remains weak
Economic data indicated that the US manufacturing sector was still struggling, although the picture improved marginally compared to the previous quarter. The ISM Purchasing Managers' Manufacturing Index reached its lowest reading since 2009 in the fourth quarter of 2015, but has seen a slight upturn in the first two months of 2016. However, the index remains below the crucial level of 50, above which indicates the sector is growing. The improvement in the sector is correlated with a slight weakening in the US dollar, whose strength had been impacting US manufacturers' competitiveness.
 
Despite recent upward revisions, US GDP growth has been clearly slowing for six months. Notwithstanding this, the US labor market remained strong, with the unemployment rate remaining low at 5.0%, despite more people looking for jobs again. This was coupled with stronger than expected non-farm payrolls in both January and February.
 
We have started to see inflation pick up in the US, with the core measure (which excludes energy and food prices) reaching 2.3% over the 12 months to February. Although the headline inflation figure to February was kept lower by energy prices falling in January, we have seen crude oil prices increase by circa 50% over February and March, so we would expect to see an uptick in the headline inflation figure. As we saw in the third quarter, average hourly earnings continued to pick up over the fourth quarter, which is supportive of rising inflation.
 
The Federal Reserve strikes a notably more dovish tone
In March, the Fed maintained the target rate for the Federal Funds rate at 0.25-0.5%, in line with market expectations. The Fed did however downgrade expectations of how many rate rises they expect to see in 2016, from 4 to 2. Previously, the Fed were much more hawkish than the market with regards to interest rate rises, and they remain somewhat so, although the more dovish nature of their recent comments has brought them slightly more in line with the market. Over the quarter we have revised down our views on the expected path for interest rates and bond yields over the next 3-5 years to reflect slowing economic growth and further downside risks to that growth. Even after these changes we believe that the bond market's pessimism is overdone, and the market is probably on balance underpricing the trajectory of rate rises. 
 
Threats remain to the Eurozone recovery, but the European Central Bank continues to support accommodative policy with the aim of boosting growth
The Eurozone economy remains fragile, but cyclical recovery is expected to continue. Eurozone GDP growth was estimated to be 0.3% for the fourth quarter, with annual growth at 1.6%, in line with growth from the third quarter. Germany and Spain have been driving Eurozone growth, and we also saw an improvement in France which beat growth forecasts in the fourth quarter of 2015. The jobless rate is decreasing and recently reached its lowest level in three years (that said it remains high at over 10%). Industrial production surprised positively in February, after a disappointing January and the manufacturing sector continues to grow.
 
The European Central Bank loosened monetary policy over the quarter, cutting rates and increasing the quantitative easing program from EUR 60bn to EUR 80bn per month. We expect this to be supportive for European markets; however, we must recognize the risks in the Eurozone have increased. If the ECB's actions fail to boost inflation and economic growth we could see fears of deflation once again come to the fore. European economic sentiment and consumer confidence indicators have moved lower recently. Furthermore, there is the threat of a UK decision to leave the European Union following the referendum and the lingering political differences, emphasized over the last 12 months in the various national responses to the migrant crisis. 
 
The Japanese economy shrinks for the second time within 12 months
The Japanese economy shrunk by 0.3% in the fourth quarter of 2015, a marginal improvement on initial estimates of -0.4% growth. This took annualized growth to -1.1%, with the economy having contracted in two out of the last four quarters. The manufacturing sector, which had improved in 2015, has now reversed with the Markit Purchasing Manufacturing Index now below the decisive 50 level, indicating contraction in the sector, with Yen strength over recent months being a significant contributor.
 
Inflation is low and falling, the "core" measure which excludes fresh food and energy is at 0.8%, well below the Bank of Japan's ('BoJ') 2% target, and down from the previous quarter when it was at 1.2%. This has seen a real rise in deflationary risks, and rising real wages will be critical if Japan is to avoid such a situation. In response, the Bank of Japan took the surprise move in January to move into negative interest rate territory, but the market reaction was not positive as it had doubts over the BoJ's ammunition to improve the situation. However, we think that further monetary easing should support Japanese equities and return the yen back up towards 2015 lows, but the risk that 'Abenomics' isn't working has increased.
 
Large cap stocks outperform small cap stocks
US large cap stocks (Russell 1000) outperformed US small cap stocks (Russell 2000) as investors remained cautious in the first quarter. US large cap stocks returned 1.2% while US small cap stocks returned -1.5% over Q1. We stated in the third and fourth quarter reviews that we continue to see large cap stocks outperforming small cap in the current volatile environment, and we have seen little evidence that would cause us to change our position in the near term.
 
Emerging market headwinds are starting to fade
Economic growth continued to stabilize across emerging markets, although Chinese manufacturing remains weak. Both the official and the Caixin manufacturing PMIs for February disappointed expectations, indicating the contraction in manufacturing was greater than anticipated. Chinese growth dynamics are likely to remain relatively weak as the economy re-orients itself to a different growth model. This has meant that Chinese policy has turned more stimulatory which is supportive of growth, but the RMB devaluation highlights policy risks. We indicated last quarter that we did not expect commodities to fall much further, and we have seen some stabilization. The broad commodity index (S&P GSCI Commodity Index) is down 2.5% since the start of the year, as Energy (S&P GSCI Energy) has been a drag on performance (-6.2%), but we have seen Industrial Metals (S&P GSCI Industrial Metals) return 1.9% over Q1 2016. Stabilizing commodity prices, and the marginally more positive stance from Chinese policy makers have relieved some of the pressure on Emerging market assets and currencies.
 
Yields fall to near historic lows
10 year US treasury yields fell over the first quarter by 49bps to 1.78%, close to historic lows and at levels not seen since 2012.  The falls were driven by fears of a global growth slowdown and dovish tones from the Federal Reserve were increasingly priced in over the quarter. The Barclays US Treasury 20+ year total returned 8.5%, meanwhile the Barclays Global Aggregate Index returned 5.9%. In the corporate sector, high yield marginally underperformed credit on a global basis, returning 4.1% (Barclays Global High Yield Index), versus 4.5% for investment grade credit (Barclays Global Credit Index).
 
European government bond yields were mixed
With looser monetary policy announced by the European Central Bank, core and peripheral European yields were driven down. Sentiment moved towards less risky assets, while the spread on riskier Eurozone peripheral government bonds over safer German bonds widened. The Barclays Euro Agg total return index rose 2.9% in euro terms but this translated into an 8.0% gain in USD terms due to the euro's strong appreciation against the dollar. European credit underperformed government bonds, returning 2.5% (7.5% in USD).
 
* All return figures are in US dollar terms unless otherwise stated.
 
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Source: DataStream and Publicly Available through MSCI Investible Market Indices
 
Robbie Sinnott is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.
The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.


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