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Aon Retirement and Investment Blog

Second Quarter 2017 Market Review and Outlook

Global equities advance higher with strong earnings providing the impetus
The momentum triggered by the prospects of US reflationary policies that carried global equity markets higher in late 2016 and earlier this year stuttered and was ultimately replaced by strong corporate and economic fundamentals. Performance was, however, far more varied on both a regional and sector level. Global equities (as measured by the MSCI All Country World Index) recorded a return of 3.3% in local currency terms. A weakening of the US dollar, particularly against the euro, led to a higher return of 4.4% over the quarter. Despite the best earnings season in six years, US equities (Dow Jones Total Stock Market) slightly underperformed the wider equity market and returned 3.1% over the quarter. In US dollar terms, Europe ex-UK* equities (8.9%) were the strongest performers, although much of the return was due to the weakness of the US dollar as the euro moved to €0.88 against the US dollar; down from €0.94/U$ at the start of the quarter. Political risk within continental Europe subsided following the win of pro-EU candidate, Emmanuel Macron which encouraged greater risk appetite in the region. Emerging markets continued on their impressive rally since the start of the year, as they returned 6.4% in US dollar terms; slightly below the 6.6% local currency return. Japanese* equities which have been the laggard so far this year, returned 6.1% in local currency terms (5.2% in US dollar terms), as yen weakness supported the export-oriented equity market.  UK* equities continued on a sluggish path over the quarter, returning just 0.8%, as the rebound in sterling dented foreign revenues. Commodity-sensitive equity markets, such as Canada* and Australia*, struggled over the quarter posting negative returns of -1.8% and -2.4% respectively. 12 month global equity returns (MSCI AC World) were 19.8% in local currency terms, and 19.4% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 18.5% over the 12 month period to 30 June 2017.
*MSCI Investible Market Regional Indices

US economic expansion continues albeit with some bumps along the way
A plethora of disappointing economic releases weighed on the US equity market at the start of the quarter. The initial estimate of first quarter annualized GDP growth of 0.7% was not only below forecasts but also markedly lower than previous GDP growth of over 2.0%. Whilst GDP growth was subsequently upwardly revised twice over the quarter to 1.4%, it still represents a deceleration in the US economic expansion. There were further signs of deceleration as the manufacturing ISM index, an indicator of activity in the sector, fell back by nearly 2.5 points to 54.8, although remaining 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). It has since recovered to a new peak of 57.8 in June (reported after quarter end). Concurrently, US consumer confidence, as measured by the Conference Board's Consumer Confidence index fell from a 16-year high of 124.9 to 118.9 at the end of June. Headline Consumer Price Index (CPI) inflation stood at 1.9%; the first time since the 2016 Presidential election that the rate has moved below 2.0%. The unemployment rate moved marginally lower to under 4.7% in March. A softening in sentiment and actual economic data that has driven equity markets to record highs in the absence of reflationary policies being implemented does present some challenges to US risk assets going forward. Successful implementation of the US administration's tax reforms and fiscal spending policies may go towards supporting the US economy and with it, return-seeking assets that are already in expensive territory.
Federal Reserve maintains course as the Fed rate hikes benchmark rate for the third successive quarter

Despite the disinflationary pressures of falling commodity prices and lower expectations of future fiscal expansion, the US Federal Reserve ("Fed") increased the target for the Federal Funds rate yet again to 1.00-1.25%. The rate hike was widely expected and follows the expectation of three rate hikes over 2017. Questions, however, remain on how substantive the US administration's fiscal policies will be, which complicates the outlook on the pace of further hikes. The market, however, is pricing in a less aggressive hiking pace than both the Fed and our forecasts. As such, we continue to expect moderate and positive economic growth in the US but, with the current expansion now approaching the length of some of the longest on record, we cannot escape the conclusion that late cycle jitters may keep a lid on further progress.
Europe leads the way with strong economic and corporate growth, after battling a rising populist trend. Increased uncertainty over Brexit clouds the economic future of the UK
Eurozone GDP grew at an annualized rate of 1.9% in the first quarter of 2017; slightly higher than the upwardly revised rate of 1.8% in the fourth quarter of 2016. 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 a six-year high of 56.8 up from 54.9 at the end of the first quarter. Eurozone unemployment continued on a downward trend, reaching 9.5% in March. Despite the decrease, there remains significant slack in the economy to absorb any inflationary pressures.
A confluence of factors including lower political uncertainty, indications of a strengthening economy and corporate earnings recovery led to European equities' outperformance over the last quarter. These factors should continue to support European equity markets which are attractively priced relative to other regions. The retreat of populism in European politics that weighed on bond markets in the previous quarter was supportive as European yields and Bund spreads fell. The bailout of Greek debt led to a larger narrowing of 175bps over the quarter. There were contrasting fortunes for the UK; meanwhile, as a snap general election called in April with expectations to enhance a Conservative majority in Parliament backfired for UK Prime Minister Theresa May. The loss of a parliamentary majority has hampered her hand in negotiations which began in late June. While we still see a harder Brexit being pursued, the rise in anti-Hard Brexit sentiment has led to a wider funnel of doubt in terms of potential outcomes. Moreover, a cliff-edge scenario where no deal is agreed by the end of the two year period should not be wholly discounted. We believe that in this extreme scenario, it would lead to significant economic disruption which will be a drag on risk assets. We therefore see the greater uncertainty strengthening the case for liability hedging in UK investor portfolios.   
In stark contrast to last quarter, the European Central Bank (ECB) President Mario Draghi signalled that stimulus tapering could be closer than the market had previously anticipated. Moreover, factors that were weighing on inflation in the Eurozone were deemed to be temporary in nature, with the likelihood the ECB would look through them. This hawkish twist sent the euro higher against its major currency pairs whilst also providing a boost to short term rates. Similar comments intimated by senior officials in the Bank of England suggested interest rate hikes were not far off, especially if economic data remains resilient. 
Japanese economy continues to plod along but deflation risks are still present
Japanese economic growth slowed to 1.3% in the first quarter, down from 1.6% in the previous quarter. It marked the longest run of continuous growth in over a decade with five quarters of successive economic expansion. The labour market continues to be tight with the lowest levels of unemployment in decades (of only 2.9%) whilst the job-to-applicant ratio was unchanged at 1.43. Despite a very tight labour market, inflation remains at very low levels; annualised inflation stood at 0.4% in the year to May, well below the Bank of Japan's target of 2.0%. Unlike their US, UK and European peers, we expect the Bank of Japan to remain entrenched with their monetary easing in a bid to stave off deflation.
Diverging monetary policies should lead to a lower yen which will be supportive for the export-sensitive equity market, as will ongoing corporate governance reforms that should see more capital being transferred to investors in the form of dividends and share buybacks.
Large cap stocks built on their strong start, largely thanks to tech giants
US large cap stocks (Russell 1000) outperformed US small cap stocks (Russell 2000), benefiting from its larger exposure to the technology sector which performed strongly on the back of a solid earnings reporting season. US small cap stocks returned 2.5% over the second quarter, while large cap stocks returned 3.1%.
No hard landing to be seen in China whilst contrasting political fortunes leads to mixed performances within Emerging Markets. US shale provides a challenge to OPEC cuts 
Supported by strong capital inflows which have been positive since December last year, Emerging Markets continued on their impressive run since the start of the year. Fears of a China hard-landing have partially abated as the People's Bank of China's deleveraging efforts do not seem to be too much of a hindrance on economic growth so far. Official PMI figures for the manufacturing sector remain in expansionary territory and have outperformed expectations after falling short of forecasts early in the quarter. Political risk continues to affect the region with corruption allegations levied at Brazilian President Temer leading to a fall in the Brazilian equity market over the quarter. China and South Korea outperformed with the latter benefiting from the election of President Moon Jae-In and prospects of greater fiscal spending. The broad commodity index (S&P GSCI Commodity Index) was driven lower by falling energy prices. The S&P GSCI Energy index fell by 10.2% in the three month period as oil prices, in particular, continued on a downward trajectory as US shale producer's output offset the production cuts agreed by OPEC late last year. Oil inventories remain stubbornly high and have put downward pressure on prices. Despite agreement by OPEC and Russia to extend production cuts until 2018, we do not see this as changing the current dynamic in the market place and as such we see limited upside for oil prices currently. The industrials sector experienced their first decline in over a year, as the S&P GSCI Industrial index moved 1.0% lower. There were more muted falls in the agricultural sector as the S&P GSCI Agriculture index ended the quarter just 0.1% down following a strong recovery in June.
Lower inflation expectations amid falling commodity prices have led yields lower
10 year US treasury yields moved lower over the quarter, driven primarily by lower inflation expectations amid falling oil prices and lower expectations of reflationary policies in the US. The 10 year yield decreased by 8bps to 2.30%. An upswing in commodity prices may see yields recover but this is far from guaranteed given current demand-supply imbalances particularly in the oil market. The Barclays US Treasury 20+ year total return index returned 4.2%, while the Barclays Global Aggregate Index returned 2.6%. In the corporate sector, high yield bonds underperformed credit on a global basis, returning 3.2% (Barclays Global High Yield Index), versus 3.4% for investment grade credit (Barclays Global Credit Index).
European yields join other markets by heading lower but risks remain
European yields followed a similar trend to US yields, as lower inflation expectations weighed on nominal bonds. The Barclays Euro Aggregate total return index rose by 0.4% in euro terms but this translated into a 7.0% gain in USD terms due to euro appreciation against the dollar. European credit marginally underperformed government bonds, returning 0.3%.Within Europe, the election of Emmanuel Macron which stemmed the rising tide of populism in European politics helped to narrow both French and other European government bond yields from German Bund yields. The existential threat that overhangs the Eurozone has not fully disappeared and may lead to a widening of Bund spreads should it resurface. Elections in Germany and especially in Italy next year, where the anti-euro Five Star movement has gathered significant support, are the next two big signposts. For now, attention remains firmly placed on the ongoing Brexit negotiations that will establish the UK's new relationship with the remaining EU countries.

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

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