First Quarter 2017 Market Review and Outlook
Global equities continue to climb higher, but reflationary tailwinds appear to stutter
The so-called "reflation trade" that followed from the US Presidential election continued well into 2017 as global equity markets advanced higher. Bolstered by improving economic fundamentals and rising inflation, global equities, as measured by the MSCI All Country World Index, returned 5.8% in local currency terms. US dollar weakness led to the index returning 7.0% in US dollar terms. US equities (Dow Jones Total Stock Market) matched the performance of the wider equity market and returned 5.8% over the quarter. In US dollar terms, Emerging Market (EM)* equities (11.5%) were the strongest performers, rebounding strongly after suffering from a period of significant capital outflows. Equity returns in Japan* were flat over the period, weighed down by a strong yen which appreciated by approximately 4.5% against the US dollar over the quarter. European* equities performed well, returning 7.6% in local currency terms on the back of strong economic data and a loss of momentum in populist political campaigns across the continent towards the end of the quarter. Meanwhile, UK* equities had a relatively sluggish start to the year, returning 3.8%, as a number of key economic indicators disappointed. Despite indications of a robust economy alongside accommodative monetary policy still in place, Canadian* equities only returned 2.1%. Conversely, a strong earnings season provided fresh impetus for Australian equities which returned 5.4% in local currency terms. 12 month global equity returns (MSCI AC World) were 17.6% in local currency terms, and 15.7% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 18.1% over the 12 month period to 31 March 2017.
*MSCI Investible Market Regional Indices
The US economy moves from strength to strength
US economic growth surprised on the upside with fourth quarter growth of 2.1% (quarter-on-quarter annualized) against consensus expectations of 1.9%. There were further signs of a strong US economy as the manufacturing ISM index, an indicator of activity in the sector, surged to a six-year high of 57.7 in February. The index did slip by 0.5 points to 57.2 in March but this is still firmly in expansionary territory (a contraction is indicated whenever the index falls below 50 while an expansion in the sector is indicated when the index rises above 50). Meanwhile, US consumer confidence, as measured by the Conference Board's Consumer Confidence index remained near a 16-year high, indicating that the consumer boost to the economy remains robust. Similarly, headline Consumer Price Index (CPI) inflation rose to its highest level in five years on the back of higher prices for energy goods and commodities. Core inflation, which strips out food and energy costs, was relatively unchanged at 2.2%. The unemployment rate ticked upwards after falling as low as 4.6% in November. Although the economy remains near full employment, real wage growth continued to disappoint as wages were unable to keep track with inflation and growth turned negative for the first time since 2014.
Federal Reserve hikes benchmark rate for only the third time since the Financial Crisis, two more planned this year
Further signs of an economy approaching full employment and building inflationary pressures led the Federal Reserve ("Fed") to increase the target for the Federal Funds rate for a second consecutive quarter to 0.75-1.00%. Despite the possibility of reflationary policies, the Fed struck a fairly dovish tone, indicating that while they still expect interest rates to increase, it would be done at a cautious pace. Moreover, the Fed noted that its inflation target is symmetric - suggesting the Fed could tolerate inflation above its 2% target.
Europe provides a halt to the rising populist political trend, at least for now. Improvements in economic data suggest future monetary policy tightening
Eurozone GDP grew at an annualized rate of 1.7% in the fourth quarter of 2016; slightly slower than the upwardly revised rate of 1.8% in the third quarter of 2016, but still relatively healthy. Meanwhile, growth picked up in the manufacturing sector, where the purchasing managers' index (PMI), which is similar to the US ISM index, increased to a five-year high of 54.9. Eurozone unemployment continued on a downward trend, reaching 9.5% in February – whilst clearly not very impressive, it is still the lowest level since May 2009.
Despite the positive set of economic data emanating from Europe, the rising tide of populism in European politics weighed on equity and bond market returns in the region initially, which rebounded somewhat later in the quarter as populist momentum waned. The surge in populism in European politics in the first couple of months of 2017, particularly in France and the Netherlands, added to the existential threat that overhangs the European Union (EU). This was reflected in European bond markets as European government bond spreads over Bund yields widened over the quarter. In particular, the spread for French 10 year government bond yields widened to a peak of 79bps in February. Following rejections of the Brexit Bill from the House of Lords (the UK parliamentary upper house), Article 50 was triggered in late March. Whilst largely a formality with no new elements beyond what has already been declared, it sets out a two year window in which the UK must negotiate its terms of exit from the EU. Uncertainty remains around how Brexit may unfold (and the impacts it may have) over the next couple of years with the potential for transition agreements to extend the divorce period. Eyes now turn to the response from the remaining members of the EU27 following the summit on April 29th.
Improving economic data, including Eurozone inflation hitting the European Central Bank's (ECB) target of 2% in February, led to increasing speculation that the ECB will start tightening its very accommodative set of monetary policies. However the ECB President, Mario Draghi, cut a fairly dovish tone as no changes were made to the ECB's monetary policy whilst no future hikes were intimated.
Reflation yet to take full force in Japan, whilst yen strength dampens returns
The Japanese economy saw an improvement with annualized quarter-on-quarter GDP growth of 1.6% in the last quarter of 2016; up from 1.0% in the previous quarter. The labour market continues to be tight with the lowest levels of unemployment in decades (of only 2.8%) whilst the job-to-applicant ratio was unchanged at 1.43. Reflationary forces, which have taken hold in most developed markets, have yet to permeate through Japan, as annual consumer price inflation of only 0.3% remains well below the Bank of Japan's target of 2.0%.
The strengthening of the yen weighed on the export-sensitive equity market, as the loss of price competitiveness resulted in weaker than expected export figures. The Bank of Japan seems relatively entrenched with their expansionary monetary policies, at a time where other developed market central banks contemplate possible shifts away from their current aggressive monetary stimulus policies.
Large cap stocks gain ground on small cap stocks after 'Trump Trade' loses steam
US large cap stocks (Russell 1000) outperformed US small cap stocks (Russell 2000), benefiting from its larger exposure to the technology sector which generated double-digit returns. US small cap stocks returned 2.5% over the fourth quarter, while large cap stocks returned 6.0%.
Capital flows back into Emerging Markets whilst economic fundamentals are alleviating some concerns over China. Markets underestimate the swift response from US shale oil producers
Despite concerns of increased protectionism under the new US administration, Emerging Markets were the best performers in the first quarter of 2017 benefitting from stronger capital inflows. It also marked the best returning quarter for the region in five years. China, which comprises over 25% of the MSCI EM index, rose by 13.1% as official PMI figures for both manufacturing and non-manufacturing sectors continued on an upward trend. The broad commodity index (S&P GSCI Commodity Index) retraced most of the gains made in the back end of 2016 as the index fell by 5.1% over the first three months of the year. This was despite the industrials sector returning over 9.2% whilst the price of copper surged by a 6.3% to $5,849/MT. The sharp fall in the price of Brent crude oil, which dropped to $53.7/bbl, led to the S&P GSCI Energy index falling by 9.6%. Oil prices had previously moved higher on the back of OPEC's agreement to cut production, but the unanticipated swift response from US shale producers to increase production has driven oil inventories higher and prices lower. The S&P GSCI Agriculture index also declined over the three months, ending the quarter 2.1% down.
Dovish Fed and delayed onset of reflationary policies partially retrace recent yield increases
10 year US treasury yields whipsawed over the first quarter, initially driven higher by increasing expectations of interest rate hikes by the Fed. The US administration's failed healthcare repeal stoked concerns over the efficacy of future policy reform, which slowed momentum in the reflation trade and ultimately led US treasury yields 5bps lower over the quarter to 2.39% The Barclays US Treasury 20+ year total return index returned 1.4%, while the Barclays Global Aggregate Index returned 1.8%. In the corporate sector, high yield bonds continued to outperform credit on a global basis, returning 3.2% (Barclays Global High Yield Index), versus 1.6% for investment grade credit (Barclays Global Credit Index).
Political risk adds to diverging European bond yields
European yields followed a similar trend to US yields but ended the quarter higher, as the increasing political risk in the region outweighed downward pressure from waning momentum in the reflation trade. Within Europe, French and peripheral European government bond yields widened from German Bund yields on the back of increased uncertainty following the rise of populism in the continent. The Barclays Euro Aggregate total return index fell 0.9% in euro terms but this translated into a 0.5% gain in USD terms due to euro appreciation against the dollar. European credit outperformed government bonds, returning 0.0%.
James Fernandes is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.
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