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Aon Retirement and Investment Blog

First Quarter 2018 Market Review and Outlook

Returning equity market jitters push markets lower. High equity valuations mean not a lot of disappointment is required to move markets significantly
It had to end at some point. After posting the second longest consecutive quarterly run in the last ten years and a positive initial start to 2018, bouts of volatility later in the quarter saw global equities slip from their heady heights and even move into "correction" territory (signified by a 10% downward movement from a recent market high). February's sell-off, triggered by expectations of a pick-up in inflation, exacerbated by technical factors (investors exiting short volatility positions), and then later extended by growing fears over a possible trade war between the US and China were key drivers of underperformance last quarter which resulted in global equities (as measured by the MSCI All Country World Index) posting a return of -1.7% in local currency terms. The continued weakening of the US dollar meant unhedged investors were slightly better off with a return of -0.8% in US dollar terms. Market volatility, as measured by the CBOE's VIX index, rose to its highest level (a closing price of 37.8) in more than two years.

The strong start to the year for US equities was not sufficient to cushion the subsequent 5.6% fall over February and March, but did mean the US was the best performing region. The Dow Jones Total Stock Market moved just 0.6% lower over the quarter. This downward movement made only a slight dent in US equity market valuations which continue to look very expensive relative to its long term history. We believe that there is better value in other equity markets but the high valuations would not necessarily preclude US equities resuming their upward trend given fairly robust fundamentals (strong earnings growth and a positive macroeconomic backdrop). As such, we take a neutral stance on US equities relative to other regions.
All other regions recorded negative returns in local currency terms over the quarter; all similarly impacted by the pervasive upturn in volatility. The weakest performing market was the UK which returned -7.3% over the quarter, furthering UK equities' underperformance relative to global equities. Uncertainty over Brexit was reduced, or at least delayed, with the agreement to a 21-month transition period from the UK's exit in March 2019, but this could not offset the weak performance over the quarter. All but one sector (health-care) fell over the quarter. 

The decoupling of Japanese equities to the yen may have been short-lived with a stronger yen detracting from Japan's export-sensitive equity market. Japanese* equities posted a return of -4.7% over the quarter in local currency terms and 1.0% in US dollar terms.
Political uncertainty engendered by the Italian general elections that resulted in a hung parliament piled more pressure on European equities which returned -3.4% in euro terms. The euro peaked at just under $1.25/€ in mid-February before ending the quarter at $1.23/€, resulting in a 2.4% weakening of the US dollar against the euro in the first three months of 2018, and therefore a return of -1.1% in US dollar terms. The investigation into misconduct in the financial sector led Australian* equities 4.3% lower over the quarter in local currency terms. Despite higher energy prices, Canada's energy sector recorded high single-digit falls over the quarter with the unscheduled shutdown of oil sands production having an adverse impact. The wider Canadian equity market returned -4.5% in local currency terms but the depreciation of the Canadian dollar relative to the US dollar saw US-denominated returns fall to -7.2%.
Twelve month global equity returns (MSCI AC World) were 11.8% in local currency terms, and 15.4% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 13.8% over the 12 month period to 31 March 2017. 

*MSCI Investible Market Regional Indices

Can improving economic conditions continue to help withstand era of 'Quantitative Tightening'?
Economic data emanating from the US remains particularly strong with no indicators suggesting an imminent downturn from an economic expansion that appears very long in the tooth. Whilst robust economic data would not typically be associated with increased equity market volatility, the acceleration in previously benign US wage growth raised prospects of a more hawkish Fed, and with it the loss of support of easy monetary policy. The unemployment rate held firm at 4.1% but tightness in the labor market appeared to finally take hold and led to stronger wage growth over the quarter; the US economy added a further 605k jobs over the quarter while wage growth rose to 2.7%. Core inflation, as measured by the Core Personal Consumption Expenditure index, inched slightly higher to 1.6% from 1.5%; though remains short of the Federal Reserve's 2.0% inflation target.
The US economy, as measured by Gross Domestic Product (GDP), grew at a healthy clip of 2.9% over the last quarter of 2017, although it marked a slight moderation from the 3.2% recorded in the previous quarter. The current expansion part of the cycle, now at over 100 months, is on pace to break the record for longevity, which is welcome, but the long period of expansion brings with it increased risk of capacity constraint, inflationary pressures and higher yields. The Institute of Supply Management's manufacturing index (a leading indicator for activity in this sector) rose to a seventeen- year high of 60.8 in February before falling back to 59.3 in March. By year end, US policy interest rates are expected to be over 2%, levels which may look low by past standards, but will be well away from the near zero level which persisted for a long time. 'Quantitative tightening', whereby the US Federal Reserve no longer reinvests maturing bonds from earlier purchases, has begun and will accelerate over time. The withdrawal of significant monetary support would likely stoke greater downside pressures, but economic conditions have improved in most regions in the past year and this helps economies withstand tighter money. Nonetheless, we see more challenging market conditions coming and a loss of market support on this scale is not trivial.

The Fed continues to normalize interest rates – Not yet in restrictive territory
The Federal rate target was increased to 1.50-1.75% in Jerome Powell's first meeting as the new Chairman of the US Federal Reserve. This was largely expected, especially following the strengthening wage growth (from previously weak levels) seen in the previous month. Moreover, it can be perceived that the FOMC has taken a more hawkish stance with a boost in the projections for future rate hikes. Although monetary policy is not currently at restrictive levels, there is a risk that the Fed may overtighten in the future thereby removing support for risky assets such as equities. This is not our central view but we are cognizant of this material risk which tempers our optimism for the US economy and equity market. While yields are headed higher for now, we see limits appearing in the not too distant future on how high yields can go.  We also know from past experience that if yields go up too much too quickly, it will act as a brake on the economy, as well as injecting volatility to risky asset markets.

Contrasting fortunes in Europe – political risk resurfaces in Italy with an unclear election outcome while a soft Brexit is agreed
Political risk resurfaced in the Eurozone over the first quarter with the Italian general elections resulting in a hung parliament. There were significant wins for the Eurosceptic Five Star Movement although uncertainty remains around who will govern the country. Eurozone GDP grew at an annualized rate of 2.7% - the same rate as the previous quarter. However, more recent data indicated that activity may be slowing down in Europe. For example, there was a marked deceleration in the manufacturing purchasing managers' index (PMI), which is similar to the US ISM index, falling four points to 56.6. In contrast, however, unemployment reached 8.5% in February – the lowest level in nearly 10 years.
With just over a year to go before the UK leaves the European Union, an agreement was reached between the two parties to organize the orderly transition. This removes, or at least, delays a degree of uncertainty involved with the UK's relationship with Eurozone countries. The transition period will run up to the end of December 2020. A previous sticking point of EU citizens' rights living in the UK who arrive during the transition period was also agreed. Despite the advances made over the quarter, much is still left to be agreed, which still clouds the region. We believe the uncertainty that continues to dog the UK, makes UK equities unattractive relative to other regions and why we advise to underweight the UK market.  
Both the Bank of England (BoE) and the European Central Bank (ECB) left their respective policy rates unchanged at 0.5% and 0.0%. The former, however, looks set to increase the base rate by a further 25bps to 0.75% next month. Although the current level of inflation has fallen from its post-EU referendum high of 3.0%, building wage pressures suggest that monetary policy will require tightening in order for inflation to fall back to the BoE's 2.0% target. While a rate hike may be further away for the ECB, tapering of the ECB's sizeable quantitative easing program appears to be firmly on their agenda for later this year which could provide further support for yields.
A strong yen may present headwinds to the export-sensitive Japanese economy and equity market
As was the case last quarter, economic data in Japan reflected a pick-up in both economic growth and inflation. Real GDP growth showed that the Japanese economy grew by 2.0% in the last quarter of 2017. Previous releases were however revised lower from 2.2% to 1.9%. Meanwhile, consumer price inflation accelerated to 1.5% for the year to February 2018, moving it closer to the Bank of Japan's target, albeit falling short of analyst forecasts. Similar to Shinzo Abe's re-election in 2017, Governor Kuroda's reappointment to a second term provides a stable policy environment which is likely to be supportive for risk assets in the region as well as downward pressure on the yen with monetary easing likely to be continued.  The manufacturing Purchasing Managers' Index moved down slightly throughout the month from 54.0 to 53.0 in March. Despite the differential between the US and Japanese 2 year yields widening to a decade high of nearly 2.5%, FX investors have seemingly not taken much notice with the Japanese yen closing in on the ¥100/$ mark as the yen benefited from its safe haven status in a quarter filled with volatility.

US tax reform's latent boost to small cap stocks finally takes hold

It may have taken some time, but US small cap companies finally outperformed their large cap peers, though still falling over the quarter. The Russell 2000 index returned -0.1% while the Russell 1000 index returned -0.7%. The emergence of trade tariff talk had less of an impact on small-cap stocks which are less sensitive to US trade or a potential breakdown in trade relationships.
Building idiosyncratic risks could create greater volatility for Emerging Markets
Emerging market equities were the strongest performing region in both local currency and US dollar terms. A very strong start to the year (6.8% over January in local currency terms) provided a sufficient enough cushion to offset later market falls. However, EM investors will be paying close attention to the ongoing trade spat between the US and China. An increase in trade protectionism led to greater volatility late in the first quarter but it remains to be seen if the acrimonious talks descend into a possible full-blown trade war. Away from trade talks, China continues to be focused on managing past excesses. Meanwhile, Russian stocks benefited from central bank easing and an upgrade to its credit rating. However, with Russia embroiled in a saga involving the poisoning of a spy in the UK with the possibility of the imposition of sanctions, there are clear risks for the economy. Brazilian equities performed well as corruption charges levied at former President Lula da Silva were upheld. Economic activity has moderated across emerging markets as a whole, but confidence remains fairly high.
OPEC stays firm on oil production cuts while rising trade tensions dampen returns for industrial metals
Commodities had a mixed quarter but the S&P GSCI returned 2.2% over the quarter. Much of the positive performance was driven by higher energy prices; WTI crude oil rose by 7.3% to $64.87/bbl while the wider energy sector was up 5.1%. Prospects that OPEC oil production cuts would be maintained throughout 2018 helped support oil prices. The upturn in energy prices helped to offset the poor performing industrial sector which fell by 7.3% in the first three months of the year. The impact of the US and China trade tension was particularly felt in the industrial metals sector with fears that any further escalation could severely hit demand for the commodities sector. In stark contrast, the agriculture sector bucked the seemingly relentless downward trend that has persisted over the last few years. A weaker US dollar and bouts of geopolitical tension helped gold prices edge 1.8% higher. A strengthening of the US dollar may adversely impact the performance of gold but it will continue to benefit from its safe-haven status in an uncertain geopolitical environment.
Yields keep marching higher but we do not see bond bubble dynamics
Despite 10 year US treasury yields moving over 30bps higher to 2.74% over the quarter, the slope of the yield curve continued to flatten with the difference between the 2 year and the 10 year yield moving to one of its lowest points since the start of the Financial Crisis (see chart below). Expectations of robust growth and an acceleration in inflation drove yields higher, with the policy-sensitive 2 year yield rising by 38bps to 2.26%. We believe, however, that the negative term premium (the compensation to investors of holding long term bonds as opposed to a series of shorter term bonds) is not sustainable especially with an expanding US budget deficit and Quantitative Tightening likely to boost the supply of Treasuries and exert upward pressure on yields. Yet, we do not ascribe to the view of there being a "bond bubble". Institutional demand for US government bonds will continue to exert some downward pressure on yields, whilst another bout of risk aversion would see a move back to the safe haven of US Treasuries. While our view of slightly higher yields would merit some under-allocation, we think that the risk of a renewed downturn in yields is sufficient for us to recommend keeping allocation deviations moderate.

The Bloomberg Barclays Treasury 20+ year total return index was down 3.4% over the quarter while the Bloomberg Barclays Global Aggregate Index returned 1.4%. Credit underperformed government bonds with greater market volatility triggering a widening of spreads. Within the corporate sector, high yield bonds slightly outperformed credit on a global basis, returning -0.4% (Bloomberg Barclays Global High Yield Index), versus -0.6% for investment grade credit (Bloomberg Barclays Global Credit Index). Although credit spreads did widen over the quarter, they are still at very low levels and in certain cases credit is offering insufficient reward for default and downgrade risk. Like equities, valuations remain stretched and may require review of credit portfolios and in some cases some de-risking. Where corporate bonds are being held in place of treasuries for the added return, corporate holdings should be trimmed to more of a neutral position. Private debt markets offer opportunities if some illiquidity can be tolerated.
Bund spreads benefitting from strong macro fundamentals but Eurozone yields as a whole continue to diverge from their US counterparts
The spread between US government bond and German bund yields widened over the quarter, as the 7bps increase in the 10 year bund yield could not match the 32bps increase in the 10 year US Treasury. Despite the greater uncertainty surrounding Italian politics following March's general election, the 10 year Italian government bond yield fell by nearly 20bps to 1.79%. Meanwhile, Spanish government bonds performed well with the 10 year yield (which moves inversely to the price of the bond) decreasing by 38bps to 1.16% - its lowest level in over eighteen months. The Barclays Euro Aggregate total return index returned 0.7% in euro terms over the quarter, but once again euro strength saw unhedged US investors return 3.2% in USD terms. European credit marginally outperformed government bonds, returning 0.7%. Meanwhile, Greek bond spreads narrowed to its lowest point since the start of the decade but rose late in the quarter to 379bps.

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