In order to best summarize the 2017 financial year, we will walk through each quarter through the perspective of equity and then fixed income investors. Throughout each we will highlight key points and developing trends
In the first quarter 2017 equity markets began to see whether or not the new U.S. administration would be able to deliver on their promises. While the new regime was not able to repeal and replace the Affordable Care Act, investors still remained optimistic about the potential change in the tax code. In the U.S. and globally, businesses and consumers surveyed as more optimistic about the economy than they had been at the same point last year. Global optimism combined with the passing political fears in the U.S. and Europe set the stage for a roaring U.S., European and Emerging equity market.
Despite a March Federal Funds Rate increase of 25 basis points, the 10 year U.S. treasury yield remanded fairly unchanged for the quarter, demonstrating that the market had expected the move. European bonds saw a slight increase in yield as investors began to speculate over the future of Quantitative Easing (QE) in the Eurozone. Emerging market yields lowered as the global growth that rallied the equity markets spread to the bond market.
The second quarter 2017 saw a bit of a pause in the European equity markets as central banks developed a more unclear tone, bringing into question the future of QE in the region. Concurrently, the U.S. began to experience a continually tightening labor market and another rate hike by the Federal Reserve in June. The historically low unemployment rate fueled hope for rising wage growth, which has been sluggish. U.S. equities slowed their tear upwards that started in the first quarter. Emerging markets continued to outperform on the quarter in part due to a weak U.S. dollar.
While the unemployment rate in the U.S. was within the Fed’s range of full employment, inflation continued to escape central bank targets in both the U.S. and Europe. The result in the U.S. was a June rate hike, the second of the year. The market again showed that the move was priced in as the U.S. ten year yield ended the quarter just about where it started, while declining slightly then recovering throughout the quarter. Mario Draghi, head of the European Central Bank, hinted at reducing QE as the Eurozone recovered, yet noted that the pickup in inflation was likely transient. Eurozone bonds sold off at the time, but remained mostly unchanged for the quarter. Emerging market debt continued to see lower yields as the global growth narrative and search for yield continued.
In the third quarter, global strength allowed the U.S. Federal Reserve to begin to talk about unwinding their inflated balance sheet that resulted from the QE measures taken in the years after the Great Recession in 2008. U.S. equities returned to their steady and stable climb higher, with a larger emphasis being placed on the lack of volatility in the U.S. equity market. The narrative in Europe was dominated by speculation regarding Brexit negotiations and talk of the ECB reducing QE. European equities continued the quarter slightly higher. Emerging markets continued to benefit from their renewed growth driven by a weak U.S. Dollar and a slight rebound in commodity prices.
Again, talk of tightening from the U.S. central bank influenced the U.S. treasury market, but ultimately yields ended the quarter mostly unchanged. European growth and recovery continued to be slow but steady, bolstered by increased clarity on the economic outlook of the U.K. through Brexit talks. The ECB began priming the market for the potential indication of a decrease in QE, to be announced in October, causing yields to end the quarter slightly lower. The search for yield and the global growth narrative again led emerging market debt yields lower.
The most notable event of the fourth quarter was the passing of the tax reform bill in the United States. Optimism leading up to the bill’s passing combined with strong GDP numbers and rebounding inflation led U.S. equities to end the year up over 21%. European equities continued their slow grind upward, ending the year up 14.5% as corporate earnings began to grow quickly YoY and the major political fears of the year did not come to fruition. Most of the gains came in the first and third quarters. The real star of the year were emerging market equities which rallied as earnings growth was fueled again by a weak dollar and strong performance of commodities in the fourth quarter.
The U.S. saw the Fed raise rates by 25 bps again in December, the third rate hike of 2017. U.S. 10 year yields remained unchanged however, as investors balanced the hike with continually low inflation. The ECB signalled that they would be reducing QE in 2018 and also raised rates in November for the first time in 10 years, as the slow recovery in Europe continued. European rates ended slightly lower though, as the fear of lowering QE outweighed the optimism indicated by the rate rise. The flow of capital slowed into emerging markets as growth stories returned to more developed economies; EM yields ended slightly higher for the quarter.
The main factors dominating the year were central bank policies and political risks. Investors worried that the U.S. Fed would either have to raise rates too quickly, thus ending the extremely accommodative policy, or would not be able to normalize rates at all, signaling a slowdown in the U.S. economy. The same fears were also applied to the ECB and Bank of England; investors worried that the accommodative policy and QE would come to a halt. Over the course of the year, markets were able to hit the Goldilocks of scenarios across the board. The Fed raised rates as the U.S. economy showed a good amount of strength, the ECB was able to raise rates once and announce a reduction in QE, but not by too much. Political fears surrounding Russia, Brexit and North Korea all seemed to fade from the limelight. The result was the least volatile period in U.S. equity market history, with a maximum drawdown of less than 3%. While the year was able to pass without incident, it does seem that there is some intangible tension building in the market: the idea that the economies of the world may not be able to maintain the perfect ‘not too hot, not too cold’ that facilitated the surging markets in 2017.
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