Investor confidence on the rise.
Developed and Emerging Markets
Perhaps the most noteworthy development has been the major shift in investor sentiment. After spending years viewing the world through bearish lenses, investors have become more upbeat on the outlook for global growth. Indeed, market sentiment managed to hold up in the face of Brexit, the U.S. election and the Italian referendum. As a consequence, various confidence measures have risen. In many ways, the U.S. election acted as the catalyst for investors to realize what was already a solid fundamental backdrop. While Donald Trump dramatically increases uncertainty, the Republican sweep removes years of gridlock in Washington that has limited the use of fiscal policy. The Republican Party now has an incentive to encourage economic strength, rather than weakness as was the case during the Obama administration. This curtails downside risks. At the same time, Trump is a proponent of short-term gains even at the expense of long-term stability.
Following the Brexit vote and U.S. Presidential election, the recent volatility in currency markets has calmed down. The U.S. Dollar has shown some weakness against all major developed currencies.
Energy and other commodities
Economically-sensitive commodities (including crude oil and copper) have rallied sharply since the beginning of the year. Part of this is merely an upward revision to investor global growth expectations. Investor optimism on commodities is also being driven by the prospects for simultaneously solid Chinese and U.S. demand growth, as China’s housing market remains hot (in response to previous stimulus measures) and the next U.S. government plans a sizable infrastructure spending program. The hope is that stronger demand growth will absorb excess supply and keep pushing prices higher. The recent OPEC production cut was also well received in the crude oil market.
Illustration (Section “Macro-Economics and Currencies”):
Asset Class Comparison
Higher rates as inflation expectations rise
Global Bond Markets
During the month, capital markets were once again shaped by political surprise and financial turbulence. The US Federal Reserve raised rates for the second time in a decade, as expected, underlining positive developments in the plight for stability and domestic growth. Fed Chairman Yellen indicated a more hawkish tone in her post-FOMC statement, revising economic projections upwards for the coming year. Three rate hikes are now featured in the dot plot for 2017. The European Central Bank announced an extension to their current stimulus program by nine months, however they will reduce ongoing monthly asset purchases from €80bn EUR to €60bn EUR. Although ECB President Mario Draghi advised that this was not an announcement of tapering accommodative policy, investor behavior indicated otherwise. The Bank of Japan was the final major central bank to meet in December, reviewing monetary policy and announcing no changes to existing asset purchases while maintaining negative interest rates into 2017. They positively revised their economic outlook, supported by a recent string of strong domestic data and improving export and output measures. Major government interest rates trended higher throughout the month, with sharp upward moves in longer duration maturities. Credit spread moves were contained as High Yield and Emerging Markets provided a cushion to Treasury yields shifting higher, stabilizing underlying cash prices. Uncertainties surrounding the Italian Constitutional Referendum were soon quashed post the result, with markets absorbing another vote for change and re-pricing of any assets: a non-event.
Illustration (Section «Fixed Income»):
Government Bonds vs. Corporate Debt
Equity market powering ahead.
Global Equity Markets
We have characterized the U.S. equity market in recent months as having the most appealing risk/reward profile, despite being relatively pricey. The reasons are that the economy is in an extremely durable expansion that until recently was underappreciated, deleveraging pressures are easing, while changes in monetary policy will still leave it very accommodative. At the same time, corporate earnings are on a solid underlying trajectory (much stronger than elsewhere on the globe) despite concerns earlier this year about the previous surge in the U.S. dollar and collapse in energy prices. That said, the U.S. market may now be getting a bit ahead of itself, at least in the near term.
Illustration (Section “Equities”): Major Equity Indices
The global economy together with profits are firming, which should continue to put upward cyclical pressure on both equities and yields. Monetary policy will remain pro-growth and fiscal stimulus may also contribute, at least within the U.S. economy.
The global stock/bond ratio has had a strong move in recent weeks, boosted by both a rally in equities and rise in G7 bond yields. This rise is becoming somewhat technically stretched based at least on shorter-term momentum measures, implying that a digestion phase is warranted. However, we believe that further upside looms in 2017.
US Monetary Policy favors an improving economy with a trajectory of increased tightening over the year ahead. Rhetoric from the Trump administration being that of pro-growth with a relaxed fiscal and possible less-regulatory environment, supports the growth path and leading global improvement. Any events to the contrary will keep rates low as investors are quick to sell risk and buy quality assets, ultimately dragging yields down. Strength in the US Dollar will lead and allow competition amongst global trading partners in both developed and emerging markets, although intense appreciation to a domestic currency could prove counterproductive and dampen growth, a clear risk to be managed by the US Federal Reserve. Major government yields (G7) should move higher in 2017, supported by improving global fundamentals. Global credit markets should find support in this context too. Within Fixed Income we favor: short-to-medium duration, US domestic High Yield bonds and government-related issuers from the Emerging Markets. We continue to manage a reduced duration profile to the overall portfolio, maintaining a bias to corporate credit instruments situated in the lower segment of the investment grade universe.
U.S. stocks still offer a good risk/reward profile, despite the recent run-up. That said, the U.S. equity market may be setting up for some near-term disappointment and a case of “buy the rumor, sell the news” once Trump takes office. Provided bond yields do not continue to spike higher, stock prices are more likely to consolidate laterally rather than correct meaningfully given the solid underlying earnings trend. Further absolute-return gains loom. In relative terms, there is a building case for a rotation away from U.S. equities to some of the laggard markets once investor confidence broadens to other economies. Euro area equities are becoming appealing, although reduced pessimism regarding regional politics and the banking sector is needed for a sustained period of outperformance.
We remain long the U.S. dollar, but expect it to slow and become more narrowly defined.
The positive price move may persist in the near term, but economically-sensitive commodities appear to be setting up for disappointment in 2017. In short, it is unlikely that strong commodity demand will result simultaneously from both China and the U.S.
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