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Aon Retirement and Investment Blog

Second Quarter 2016 Market Review and Outlook

Global equities provided positive returns over the quarter, but there was a notable degree of regional disparity
Though the Reserve Bank of Australia (RBA) was the only major central bank to reduce interest rates over the second quarter of 2016, interest rate hike expectations fell elsewhere. Later in the quarter, focus shifted to the UK’s referendum decision to leave the European Union, which met markets with mixed reactions. The MSCI All Country World Index returned 1.5% in local currency terms, and yen strength broadly offset weakness in sterling and the euro, and the index returned 1.2% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 2.6% over the quarter. In US dollar terms, Canada* (4.9%) was the strongest performer as commodity prices generally rose. Europe ex-UK* (-3.2%) was the weakest performing region as the weakening euro significantly dragged on returns. The UK* (-2.1%) also returned negatively in dollar terms as sterling fell sharply on the back of the vote to leave the EU. Japanese* equities fell sharply in local currency terms as a continuation of yen strength worsened the outlook for exporters, while the central bank neglected to take additional monetary easing action. However, returns in US dollar terms were marginally positive (1.5%) on yen strength. Australian* equities performed well (0.7% in USD terms) as the RBA cut interest rates in response to softening inflation, but strengthening commodity prices also helped. Lastly, Emerging Market* equities provided a modest 0.7% return in USD terms. 12 month global equity returns (MSCI AC World) were -2.9% in local currency terms, and -3.3% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 2.0% over the 12 months to 30 June 2016.
*MSCI Investible Market Regional Indices
The US economy failed to build any substantial economic momentum
US economic growth continued to slow, with first quarter growth of 1.1% (quarter-on-quarter annualized). However, this further slowing was widely anticipated by markets. In contrast, the manufacturing ISM, a widely followed indicator of economic activity, recovered to the crucial level of 50, above which indicates the sector is growing. CPI inflation remained fairly steady, with headline inflation picking up slightly as the impact of the commodity price fall continued to diminish, but core inflation was largely unchanged just above 2%. However, should oil prices continue to rise, we would expect to see a corresponding upswing in headline inflation later in the year. Though unemployment continued to fall, with the unemployment rate even reaching a post-crisis low of 4.7% in May, real wage growth remained lackluster and the May employment report revealed the lowest monthly gain in nonfarm payrolls in over five years for the US economy.
Federal Reserve interest rate hike expectations get pushed back.
In the second quarter, the Fed maintained the target for the Federal Funds rate at 0.25-0.5%, in line with market expectations. However, Fed chair Janet Yellen indicated in June that investors should not be expecting the next hike in short-term rates until the outlook for the US economy looks to be on surer footing. Given the risks that Brexit presents to the global economy, the Fed looks very unlikely to raise interest rates again this year, and we are not expecting the next interest rate rise any time soon. However, we still believe that the bond market's pessimism is overdone, and the market is probably on balance underpricing the trajectory of rate rises.
Brexit is a risk for European economic growth, and the European Central Bank will likely continue to support economic growth with easy monetary policy
Eurozone GDP growth reached its highest quarterly rate in a year, resulting in a year-on-year growth rate of 1.7%. Germany and Spain continued to perform well, while Hungary and Greece saw contractions in quarterly economic growth. The overall Eurozone unemployment rate fell to a new five-year low, but remains above 10%. However, the UK’s referendum decision to leave the European Union presents new challenges to Continental European economies, as the UK is a large net consumer of EU produced goods.
The European Central Bank sounded cautiously optimistic when referring to the economic outlook in the Eurozone, but also emphasized the Bank’s willingness to act in terms of more accommodative monetary policy, should inflation keep struggling to gain momentum. However, uncertainty created by Brexit has increased the likelihood of an accommodative shift in monetary policy by the ECB. Meanwhile, the European political landscape has the potential to become more fragmented as anti-immigration parties have been given a fresh dose of support following the UK’s vote to leave the EU.
Japan’s economy is at a critical point, and the stronger yen doesn’t help
After shrinking over the fourth quarter of 2015, the Japanese economy managed to recover into Q2 to end the first half the year approximately the same size as at the end of 2016. However, the fact remains that the Japanese economy has shrunk two of the last four quarters, and the current year-on-year growth rate of 0% puts the economy in a precarious position once again (the year-on-year growth rate has been negative for seven quarters since the initial recovery after the global financial crisis, during three distinct bouts). Regardless of the seemingly perpetually strengthening labour market, economic growth and inflation remain elusive.
A further drag on the economy has taken the form of a rapidly strengthening yen. With the JPY/USD exchange rate falling back from a recent high of 125 to close to 100, a low not seen since mid-2014, exporters’ competitiveness is considerably reduced, and may provide enough impetus for further monetary easing by the Bank of Japan. Indeed, we do expect the Bank of Japan to up the ante in terms of accelerating monetary easing, and that this will take the steam out of the yen’s bull run, but delivering the right conditions for sustainable economic growth may prove challenging and will likely require a reacceleration of the slightly stalled domestic reform programme.
Small cap stocks outperform large cap stocks
US large cap stocks (Russell 1000) underperformed US small cap stocks (Russell 2000) as the latter's higher beta and domestic focus caused them to outperform in generally rising markets. US small cap stocks returned 3.8% over the second quarter, while large cap stocks returned 2.5%. Given the difficult road ahead for markets and the global economy, we maintain our view that we expect large cap stocks to outperform small cap stocks over the medium term.
Rising commodity prices help emerging markets, but China is losing momentum
Economic growth in emerging economies rose slightly, with yearly growth rising to 4.4% in Q1 2016 from 4.2% for 2015, thanks to better performance from the Russian and Indian economies. However, the all-important Chinese economy continued to slow in its own pace of growth, with year-on-year growth falling to 6.7% in Q1, a new post-crisis low, and forward looking indicators suggest that the Chinese economy will remain challenged; the Caixin manufacturing Purchasing Managers' Index (PMI) has fallen three months in a row, and has not registered a reading above the neutral 50 level since early 2015. Commodities showed signs of recovery, with the broad commodity index (S&P GSCI Commodity Index) up 12.7% over the second quarter. The energy sector drove this strong performance, with the S&P GSCI Energy index providing a 19.0% total return over the period. On the other hand, industrial metals returns were less stellar, with the S&P GSCI Industrial Metals index providing a 5.3% total return. However, industrial metals rose over Q1, whereas energy and the overall commodity indexes partly experienced a rebound after falls in Q1.
Yields hit historic lows
10 year US treasury yields fell over the second quarter by 29bps to 1.49%, a new all-time low as confirmation of the UK’s referendum decision to leave the EU forced investors into safe haven assets.  The Barclays US Treasury 20+ year total return index returned 6.8%, while the Barclays Global Aggregate Index returned 2.9%. In the corporate sector, high yield outperformed credit on a global basis, returning 4.4% (Barclays Global High Yield Index), versus 2.3% for investment grade credit (Barclays Global Credit Index).
European government bond yields also generally fell
For similar reasons, core European yields were driven down. However, some peripheral yields (Portugal, for example) rose over the quarter. The Barclays Euro Agg total return index rose 1.9% in euro terms but this translated into a 0.7% loss in USD terms due to euro depreciation against the dollar. European credit underperformed government bonds, returning 1.6% (-1.0% in USD terms).
Note: All return figures are in US dollar terms unless otherwise stated.

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

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