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Aon Retirement and Investment Blog

Fourth Quarter 2017 Market Review and Outlook

Equity markets continue to march on – reaching the second longest successive quarterly run in the last ten years
 
Global equities ended 2017 as it started the year with equity markets advancing higher. A strong earnings season for corporations combined with continued supportive monetary policy and synchronized pick-up in global growth helped global equities (as measured by the MSCI All Country World Index) earn a 5.5% quarterly return in local currency terms. A slight weakening of the US dollar led to a higher return of 5.8% in US dollar terms for the quarter.
 
Performance was strong across all regions, with the exception of the European (ex-UK) market which returned -0.6%. Japanese* equities managed to shake off a slightly stronger yen over the quarter, posting the strongest returns amongst all major markets in both local currency and US dollar terms; returning 8.6% and 8.5% respectively. A positive result in the snap Japanese election and expectations of continued easy monetary policy were the principal drivers, and in recent months Japanese equities have seemingly decoupled from its relationship with the yen, with equities climbing ever higher while the yen has strengthened slightly.


The impressive run for US equities was sustained in the latter stages of 2017 as it became increasingly clear that the tax reform plan would be signed into law, entering 2018 with fourteen consecutive months of market gains. The Dow Jones Total Stock Market was up 6.3% over the quarter. US equity market valuations do look very expensive relative to its long term history which does have the potential to constrain future gains but the long bull run could well be extended further into 2018. 
 
Over the quarter, Europe (ex-UK)* was the only market to post negative returns in local currency terms. The momentum in European markets which saw it return 9.4% in the first half of 2017 all but dissipated with a disappointing return of -0.6% to end the year. Euro strength, which has dampened economic growth and inflation in the region, has also been accused of contributing to the curtailment in the upswing of European equities. The euro ended 2017 breaking through the $1.20/€ level. A 1.6% weakening of the US dollar against the euro, led to a positive return of 1.0% in US dollar terms.  The UK equity market closed 2017 in stronger footing with a 4.9% return over the fourth quarter in local currency terms; sterling appreciation led to a 5.7% gain in US dollar terms. The upturn in Australian* equities, following six months of lackluster performance, saw a return of 7.2% in local currency terms over the quarter. Canadian equities also benefitted from higher commodity prices with the Canadian market returning 4.6% in local currency terms over the quarter.
 
Twelve month global equity returns (MSCI AC World) were 20.4% in local currency terms, and 24.6% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 21.2% over the 12 month period to 31 December 2017.
 
*MSCI Investible Market Regional Indices
 
US expansion rumbles on and looks long in the tooth. Fiscal stimulus this late in the cycle especially with limited spare capacity could create unintended consequences
 
The big headline grabber of the fourth quarter was clearly the signing into law of the tax reform package, which may provide a boost to the economy over the coming year. The trouble is, the economy is already strong and capacity is beginning to look scarce now.  We saw an example of this in the labor market. Unemployment moved slightly lower to a seventeen-year low of 4.1% with over 600K non-farm jobs being added to the economy in the fourth quarter. However, the tightness in the labour market has yet to translate to inflationary pressures through higher wages with wage growth remaining relatively benign - the Core Personal Consumption Expenditures index, the Fed’s preferred inflation measure grew at only 1.5% in November. Leading economic indicators such as the Institute of Supply Management’s manufacturing index (an indicator of activity in the sector) slipped from a thirteen-year high of 60.8 to 59.7 but remains firmly in expansionary territory, suggesting further expansion in the US economy albeit at a decelerating rate. This would bring the current expansion within touching distance of the second longest in post-war records.  Finally, Gross Domestic Product (GDP) growth accelerated further with a 3.2% (quarter-on-quarter, annualised) expansion recorded for Q3 2017. Expansion phases rarely come to an end solely due to extended longevity but with the output gap (the difference between potential and actual GDP) narrowing, the pace of growth is likely to slow. However, there is a risk that the US fiscal package threatens pouring stimulus onto an economy with a tight labor market after years of strong employment growth. If the end to the US cycle comes from rising inflation, there is a risk of worse than a renewed slowdown, as interest rates rise to keep up.


Looks like business as usual, with Jerome Powell announced as new Fed Chairman
 
In line with the market’s expectations, the Federal rate target was increased to 1.25-1.50% in the last meeting of 2017. This was despite inflation remaining stubbornly muted. The more important news over the quarter was the nomination of Jerome Powell as the next Fed Chairman. This nomination represents a continuation of the more steady-as-she-goes approach that broadly characterized Janet Yellen’s term at the Fed. Indeed, expectations of three rate hikes in 2018 changed little on the announcement.
More importantly, “business-as-usual” also includes the increasingly large reduction of the Fed’s balance sheet and a persistent tightening of monetary policy.  Given that the economy has been growing consistently for so long, the risks to the cycle are growing. 
 
While the tipping point may not come in 2018, developments in 2017 are surely bringing the date closer.
 
Weaker equity market performance belies robust economic fundamentals in the Eurozone. Historic divorce bill signals progress in Brexit discussions.
 
In contrast to the European equity market which has decelerated in the last few months, the European economy continues to gather pace. Eurozone GDP grew at an annualized rate of 2.6%. Moreover, there was a pick-up in growth in the manufacturing sector, where the purchasing managers' index (PMI), which is similar to the US ISM index, increased to an all-time (albeit short) record of 58.0 in November, suggesting economic fundamentals remain robust in the region. Meanwhile, unemployment continues on a downward trend, reaching 8.8% in October. Volatility that hit European equity markets in the aftermath of the unofficial Catalan independence referendum proved to be short-lived, but the collapse of coalition talks in Germany added to the uncertainty in the region.
 
As was the case for most of 2017, attention centered on the progress and outlook of Brexit negotiations for the UK. The change in stance away from a harder-style Brexit seen after Theresa May’s Florence speech in September was reinforced as the historic divorce agreement was reached late in 2017 between UK and European leaders. The exit terms involved much of arguably more contentious elements of the break from the European Union including the status of European citizens, the settlement of liabilities (between €40-60 billion) and the eleventh-hour sticking-point relating to the status of the Irish border. Despite the breakthrough, time is ticking until the March 2019 deadline with much left to resolve including notoriously difficult trade agreements, and so uncertainty is likely to remain a large factor for UK markets.
 
The Bank of England (BoE) restored their base rate back to the pre-Brexit level of 0.5%. Although the central bank forecasts consumer price inflation to be at the very top end of the BoE’s 2% +/-1% range, Mark Carney (Governor of the BoE) stressed the path of interest rate hikes would be shallow and gradual. Euro strength dragged down the implied probability of a European Central Bank (ECB) rate hike in 2018 over the quarter, but it was announced that the ECB’s quantitative easing programme would be extended to September 2018 albeit at a slower rate of €30 billion per month.
 
A continuation of Abenomics following Shinzo Abe’s election win will help support Japanese markets as well as provide an anchor for the yen
 
Economic releases showed both economic growth and inflation picking up in Japan, with the economy expanding by 2.2% in the year to September 2017 while consumer prices rose by 0.6% in the twelve months to November. The Japanese economy has now been growing for seven quarters in a row – the longest spell in over a decade. The uptick in both readings, while positive, came in at or below analyst forecasts. Inflation is still a fair distance from the Bank of Japan's 2.0% target with annualised consumer price inflation at 0.7% in the year to August. Unlike their other main central bank counterparts, the Bank of Japan seem entrenched in their dovish stance and this was reinforced with the re-election of Shinzo Abe with Governor Kuroda likely to maintain one of the three arrows of Abenomics – monetary easing. The likely yield differential between Japan and other countries could well cause the yen to depreciate.

Trump tax reform - a potential shot in the arm for small cap stocks?
 
With a higher effective tax rate, US small cap companies stand to benefit more than their large cap peers from the tax cuts passed by the US government. Whilst there may be some small upside to economic growth forecasts, we believe that the direct impact of lower tax rates on after-tax earnings is now priced into equity markets at a macro level. We think it is telling that when the legislation was finally passed, the market drifted slightly lower suggesting that the proposed tax cuts might be a “buy the story, sell the fact” type of event. The Russell 1000 index posted a return of 6.59% over the quarter while small cap equities (Russell 2000 index) were behind at only 3.34%.
 
As Xi Jinping and Putin look to consolidate control, uncertainty builds in other emerging economies
 
President Xi Jinping strengthened his standing as the leader of the Chinese Communist Party following the 19th annual party conference. His government will, however, have to navigate the world’s second largest economy carefully while curbing vast excesses in debt and property markets. Moreover, while economic growth sits close to trend levels at around 6.8%, real-time measures of economic activity such as freight traffic and electricity generation have dipped since the start of 2017. Elsewhere, Vladimir Putin sealed his nomination for re-election in early 2018, while corruption charges levied at Jacob Zuma in South Africa has brought calls for his ousting as well as fresh uncertainty for the ruling African National Congress party.
 
Meaningful OPEC cuts sends crude oil prices higher – how long can prices be supported?
 
It was a tale of two halves for crude oil markets in 2017 with Brent crude oil rising for a second consecutive quarter (17.4%) to close the year at $66.5/bbl. OPEC along with Russia agreed to extend production cuts to the end of 2018. Nigeria and Libya, which were previously exempt from these cuts, were included in the latest agreement adding gravitas to the group’s intent on stabilising oil prices. However, prices may come under pressure should the recent upturn in oil prices incentivise shale oil producers to return to the market and if geopolitical pressures in the Middle East between Saudi Arabia and Iran recede. Nevertheless, crude oil’s strong performance helped the S&P GSCI Energy index rise by 14.8% over the last few months of 2017. The industrial metals sector was similarly strong with a return of 9.2% supported by a 10.4% increase in copper prices. Agriculture continues to be the laggard of the commodity sectors, dropping by 2.0% - the fifth consecutive quarterly decline. 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.
 
A flattening US Treasury yield curve has caught attention but is not necessarily a harbinger of an impending recession
 
10 year US treasury yields moved slightly over the quarter but this was to do with a marked increase in the breakeven inflation rate which rose by 14bps to 1.98%. The 10 year yield increased by 7bps to 2.41%. Conversely, the 2 year US treasury yield climbed 41bps to 1.88%; a level not seen since the onset of the Global Financial Crisis. This created a degree of consternation with the slope of the US yield curve (characterised here as the difference between the 10 and 2 year US Treasury yield) falling to 0.52%. A significant flattening of the curve has led to an inversion of the yield curve in the past which has previously preceded a number of the past recessions in the US. However, we do not see the current flattening as a sign of economic deterioration – the New York Federal Reserve currently predicts the probability of an impending recession at just 11%.  Much of the flattening has been caused by upward movements in short term rates rather than declining long term yields (long term yields are still increasing but at a slower rate) which does not suggest expectations of future economic difficulties. A flattening of the curve has previously occurred concurrently when the Fed had embarked on a rate hiking cycle, which need not culminate in a recession as was the case in the mid-1980s and 1990s. 


The Bloomberg Barclays Treasury 20+ year total return index was up 2.6% over the quarter while the Bloomberg Barclays Global Aggregate Index returned 1.1%. Credit outperformed government bonds on the back of improved risk appetite over the quarter. Within the corporate sector, high yield bonds underperformed credit on a global basis, returning 0.9% (Bloomberg Barclays Global High Yield Index), versus 1.3% for investment grade credit (Bloomberg Barclays Global Credit Index). The accumulation of debt, particularly in companies of poorer credit quality, suggests building risks in the credit space.
 
Europe’s broader recovery has seen peripheral Bund spreads fall below two year lows
 
German bund yields diverged from their US counterparts as the collapse of coalition talks raised uncertainty and pushed 10 year Bund yields 4bps lower to 0.43%. The Bloomberg Barclays Euro Aggregate total return index rose by 0.6% in euro terms but this translated into a 2.1% gain in USD terms due to euro appreciation against the dollar. European credit marginally outperformed government bonds, returning 0.7%. For a successive quarter, one of the main ratings agencies notched Portuguese government bonds back into investment-grade status – Moody’s remains the last of the big three rating agencies to maintain Portugal’s junk-bond status. This helped the Portuguese government’s bond spreads (relative to German bunds) narrow by 42bps over the quarter. Spanish bund spreads ended the quarter unchanged at 114bps despite the initial uncertainty caused by the Catalan independence vote. Meanwhile, Greek bund spreads narrowed significantly over the fourth quarter, falling by 149bps. They still remain 365bps above the equivalent Bund yield.


James Fernandes is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.

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