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Aon Hewitt Retirement and Investment Blog

Third Quarter 2017 Market Review and Outlook

'Goldilocks' environment helps equity markets advance even higher
The combination of low financial market and economic volatility (see chart below), continued supportive monetary policy as well as a synchronized pick-up in global growth has played a role in sustaining equity market momentum, even as equity market valuations reach heady heights. Global equities (as measured by the MSCI All Country World Index) returned 4.5% in local currency terms with a broad weakening of the US dollar leading to a higher return of 5.3% in US dollar terms.
 
While all regions posted positive returns over the quarter in local currency terms, relative performance was more varied. Emerging Market* equities were the strongest performers, returning 7.7% in local currency terms and 8.0% in US dollar terms; supported by a weaker US dollar and strong performance from the technology sector. Similarly, the strong performance from US technology companies continued the impressive run for US equities as the Dow Jones Total Stock Market was up 4.6% over the quarter. While equity market valuations do look very expensive, renewed talk of tax reform alongside robust economic data could well extend gains. Canada* (8.1%) was the strongest performing region in US dollar terms, benefiting from the upturn in energy prices and the Bank of Canada's decision to hike rates which benefits the significant financial sector.
 
Over the quarter, European (ex-UK)* equities were up 3.2% in euro terms, mainly due to strong gains over September on the back of positive economic releases during the month. The US dollar continued its slide against the euro, breaking through the $1.20/€ threshold for the first time since 2015. A 3.6% weakening of the US dollar against the euro, led to a higher return of 7.0% in US dollar terms. The UK continues to lag behind other regions over the year with a return of just 1.8% in local currency terms during the three months to September. Despite increased geopolitical tensions in the neighboring Korean peninsula, Japanese* equities returned 4.3% in local currency terms and 4.1% in US dollar terms. Japanese equities which have been inextricably tied to the performance of the yen in recent months has shown greater resilience in a period where the yen was flat against the US dollar. The uptrend in commodities was not enough to benefit Australian* equities which returned a sluggish 0.8% in local currency terms over the quarter.
 
Twelve month global equity returns (MSCI AC World) were 19.0% in local currency terms, and 19.3% in US dollar terms. US equities (Dow Jones Total Stock Market) returned 18.7% over the 12 month period to 30 September 2017.


Macroeconomic data continues to show strengthening in the US economy but inflation continues to undershoot expectations
A series of inflation data releases that undershot forecasts led many analysts to downgrade their expectations on the pace of interest rate hikes undertaken by the Federal Open Market Committee (FOMC). Headline core consumer price inflation (as measured by the Core Personal Consumption Expenditures index, the Fed’s preferred inflation measure) disappointed throughout the summer of 2017, slowing to an annual rate of 1.3% in August – the lowest reading since November 2015. This came against a backdrop of higher energy prices, a weaker US dollar and supportive monetary policy. While Janet Yellen, Chair of the US Federal Reserve, believes transitory factors (cheaper mobile phone deals as an example) are to blame for the recent slowing and undershooting, this has not done enough to dissuade market forecasters from lowering their expectations on the pace of future rate hikes. Elsewhere, other macroeconomic releases pointed to a resurgent economy after disappointing releases earlier in the year. Gross Domestic Product (GDP) growth accelerated to 3.1% (quarter-on-quarter, annualised) for Q2 2017. The outlook for third quarter growth looks equally promising, especially as the Institute of Supply Management's manufacturing index (an indicator of activity in the sector) surged to a 13-year high of 60.8 in August, and consumer confidence was buoyant – the Conference Board's Consumer Confidence Index increased to 119.8 in September from 117.3 at the start of the quarter. However, spare capacity in the economy looks to be falling as unemployment fell to a fresh low of 4.4% in June while job growth, as reported by the Non-farms payroll, decelerated with only 156k new jobs being added in August; down from 210k in June. As the output gap is seemingly shrinking, more attention will therefore be focused on the ability of the US administration to enact tax reform and fiscal spending to further stimulate economic expansion that is already quite long in the tooth.

Quantitative easing now in reverse but long term expected Fed rate is lowered
As widely expected, the Fed announced its programme to start reducing its multi-trillion dollar balance sheet (starting in October 2017). However, this news was not accompanied by a further rate hike – the first quarter that rates were not raised since Q3 2016. As the chart below reflects, unemployment is at very low levels and at points where we have historically seen sharp increases in wage growth. If factors that are currently depressing inflation figures are indeed transient, as the Fed believes, a narrowing of the output gap would lead to an acceleration in inflation and therefore shift the onus back onto the Fed to maintain its tightening bias.  A more inflationary backdrop would hurt fixed interest bond investors who would see a fall in real returns.


The market continues to price in a less aggressive hiking pace than both the Fed and we expect. As such, we continue to expect moderate and positive economic growth in the US but are cognizant that recession risks can build this late in the economic cycle which may put a cap on yield rises.
 
With populism in Europe fading, the economy goes from strength to strength. Bank of England hawks help sterling to rebound.
Economic expansion in the Eurozone gathered pace over the second quarter, as Eurozone GDP grew at an annualized rate of 2.3%. 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. Although significant slack remains in the Eurozone, unemployment continues to be on a downward trend, reaching 9.2% in June.

Economic sentiment, as measured by the European Commission, maintained its ascent as it reached a 10-year high of 113.0. Improving economic sentiment has historically preceded faster economic expansion which alongside lower political uncertainty would be supportive for European equities. However, expectations for corporate earnings have been on a downward trend and the earnings revision ratio for the region has moved into negative territory in September, probably due to the strength of the euro, suggesting difficulties in achieving previous earnings estimates. Despite this, equity market valuations are favourable compared to the US market. The resurgence in Catalonia's bid for independence from Spain raises uncertainty for Spanish assets but has yet to have had a significant impact on the rest of the region. The hope is that the situation will be resolved quickly and without too much disruption but we cannot completely rule out the risk of a local crisis spreading to affect Eurozone assets.
 
Brexit continues to dominate news-flow in the UK. Prime Minister Theresa May struck a more conciliatory tone at a press conference in Florence at the end of the quarter. However, the economic outlook continues to remain uncertain as there is little clarity on what deal is brokered between now and the end of the two-year negotiating window in March 2019. The change in stance away from a harder-style Brexit alongside expectations of a rate hike by the Bank of England provided support for sterling which ended the month of September up 2% in trade-weighted terms. We believe that the recent upward movement in sterling has been overdone as considerable political risks remain. These risks could well force sterling back lower should negotiations prove to be not as productive as the incumbent government wishes or should the precarious looking minority government fail and trigger another election.       
 
Meanwhile, there were less monetary tightening overtures from the European Central Bank (ECB) President over the last quarter. Explicit concerns were raised relating to the strength of the euro which provides headwinds to growth and inflation in the region. As such, we see Eurozone yields remaining low relative to the US In the UK, members of the Bank of England took investors by surprise stating that monetary tightening may be needed sooner rather than later. The major reason for this seems to be consumer price inflation, which remains above target and is squeezing real wages. These comments sent sterling to levels not seen since the EU referendum vote in June 2016 against both the US dollar and the Japanese yen – in contrast, the euro remains at a relatively stronger position. 
 
Inflation remains subdued despite record low unemployment
Despite benefiting from stints of safe-haven flow activity over the quarter, the Japanese yen ended the quarter lower on a trade-weighted basis. Japanese economic growth quickened to 2.5% in the second quarter, up from 1.2% in the previous quarter. Although this was a marked downgrade from initial estimates of 4.0%, the Japanese economy has now been growing for six quarters in a row – the longest spell in over a decade. A recovery in trade is also likely to provide some impetus to the Japanese economy. Exports surged by 18% in the year to August. The unemployment rate remains at record low levels (unchanged at 2.9% from last quarter) but 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. Unless this seemingly persistent dynamic changes, the BoJ will keep monetary conditions at easy levels to stave off deflation. As such, the yen is unlikely to strengthen much due to the diverging stance between the Bank of Japan and its other major central bank peers. This will be supportive for the export-sensitive equity market but non-Japanese investors will need to consider the implications of a weaker yen for unhedged assets.

Tech giants continue to lead the way in the US but expectations of tax reform help small caps recover lost ground
Despite its larger exposure to the technology sector, US large cap stocks (Russell 1000) underperformed US small cap stocks (Russell 2000). Most of the outperformance occurred late in the quarter as renewed talks of tax reform saw US small caps make significant gains. US small cap stocks returned 5.7% over the second quarter, while large cap stocks returned 4.5%. However, this nascent outperformance is vulnerable to the outcome of the tax reform process.  Should the current proposals be watered down, an eventuality that is entirely possible, the degree of small cap outperformance may also be limited.

Never mind FAANG[1], Asian internet giants surge higher. OPEC cuts start to have a discernible impact on crude oil prices
The global pick-up in growth and trade has benefited emerging markets, as the equity market continued on its impressive run since the start of the year (up 23.9% YTD). The technology sector has been a dominant driver with Asian technology giants up by more than 50% since the start of the year (see chart below). Despite concerns regarding growing private sector debt levels and an oversupply of housing, the Chinese economy has so far been remarkably resilient. GDP growth estimates have been steady at 6.9% while both the manufacturing and non-manufacturing sectors look to be in good health. Official Purchasing Managers' Index figures for the two sectors show that they remain in expansionary territory (index is over 50) and have risen in recent months. Yet, the upcoming Party Congress is likely to set the tone for future policy, including whether a more aggressive stance is taken to reduce record indebtedness. The economic slowdown in India can be attributed at least partly to the government's demonetisation policy and the imposition of the goods and services tax. As these effects fade, we may see some form of near term rebound in Indian economic activity. Meanwhile, geopolitical tensions relating to the North Korean nuclear programme have acted as a drag on South Korean equities in particular. We expect increased volatility in the region as these tensions persist.



Turning to commodities, rising energy prices led the broad commodity index (S&P GSCI Commodity Index) higher over the quarter. The S&P GSCI Energy index rose by 7.2% in the three month period as oil prices were supported by OPEC's production cuts and falling inventories. This could be seen clearly by the 15.7% surge in the price of Brent crude oil to $56.7/bbl over the summer months. The risk is now that these higher prices will incentivize the more flexible US shale oil producers to increase production and thus push prices back down. The industrials sector was similarly strong with a return of 9.3% supported by a 9.8% increase in copper prices. Agriculture remains the laggard of the commodity sectors, dropping by 8.1% - the fourth consecutive quarterly decline. Elsewhere, a lower US dollar and bouts of geopolitical tension helped gold prices to advance by 3.3%. Our belief that the US dollar is likely to strengthen from its current position may adversely impact the performance of gold. However, gold will continue to benefit from its safe-haven status in an uncertain geopolitical environment.
 
Higher inflation expectations offset the fall in real yields
10 year US treasury yields moved slightly higher due to higher breakeven inflation. Real yields fell across all maturities but were more pronounced at the shorter end of the curve. The 10 year yield increased by 3bps to 2.33%. The Barclays US Treasury 20+ year total return index was broadly flat over the quarter with a modest return of 0.6%, while the Barclays Global Aggregate Index returned 1.8%. Credit outperformed government bonds on the back of improved risk appetite over the quarter. Within the corporate sector, high yield bonds outperformed credit on a global basis, returning 2.8% (Barclays Global High Yield Index), versus 2.3% for investment grade credit (Barclays Global Credit Index).
 
European yields trend higher with stronger economic activity. Only Greece remains non-investment grade following Portugal’s upgrade.
German bund yields followed a similar trend to their US counterparts over the quarter, falling initially before rising in September, ending the quarter unchanged. The Barclays Euro Aggregate total return index rose by 0.7% in euro terms but this translated into a 4.4% gain in USD terms due to euro appreciation against the dollar. European credit marginally underperformed government bonds, returning 0.3%. Within Europe's periphery, Portugal lost its junk-bond status during the quarter, which left Greece as the only non-investment grade country from set that was insultingly called PIIGS (Portugal, Ireland, Italy, Greece and Spain). Portuguese government bond spreads (relative to German bunds) narrowed by 65bps over the quarter. Greek bund spreads were 24bps higher over the same period. Following Angela Merkel's win in German elections in September, eyes now turn to the Italian elections early next year. While the populist Five-Star movement has polled well, they have toned down their anti-euro rhetoric in recent months which lessens fears of a break-up in the single currency area. Meanwhile, uncertainty remains over Brexit despite a recent change in tack by the UK government on their positioning of a transition period.

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

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[1] FAANG = Facebook, Apple, Amazon, Netflix, Google(Alphabet)

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