For much of the second quarter, there was a dislocation between equity and fixed-income markets. Fixed-income markets responded to three straight months of weaker core inflation data, as well as the impasse in Washington regarding fiscal and regulatory reforms. As a result, long-end Treasury yields fell as much as 25 basis points (bps), and market inflation expectations fell to pre-election levels.
The primary economic theme in recent weeks has been inflation, or the lack thereof. In particular, core inflation has disappointed, surprising to the downside for the past two months. This weakness in consumer prices has been a headwind to the global reflation trade that took hold of the market back in August 2016.
The tone in global risk markets improved in the final week of April. A “less negative” scenario in the first round of the French presidential elections relieved some investor concerns of tail risk from Europe that had mounted in the previous weeks; and at least the announcement of the White House’s principles of tax reform was perceived to be a positive development.
The tone in global risk markets improved in the final week of April. A “less negative” scenario in the first round of the French presidential elections relieved some investor concerns of tail risk from Europe that had mounted in the previous weeks; and at least the announcement of the White House’s principles of tax reform was perceived to be a positive development. The S&P 500 had fallen nearly 3% from early March to mid-April, but it rebounded nearly 1.5% in the final week.
The political realm has monopolized the recent headlines from a financial markets perspective, particularly as it relates to the success of anti-establishment movements and the potential for significant policy changes. In the last 12 months, we’ve seen a successful Brexit vote and a Donald Trump victory; and in France, the anti-establishment Le Pen campaign is gaining momentum. All of these events present some degree of uncertainty as it relates to future economic growth and financial market stability. That said, monetary policy returned to the forefront in the last week of February, with even the most dovish Fed leaders publically stating that a March rate hike was a likely outcome. Prior to these statements, the markets were pricing just a 25% probability of such an action. In this economic overview, we will discuss tax reform proposals, the recent data trend, and the current tone from the Fed.
While there has been a bevy of political headlines in recent weeks related to future policies from the new administration, the markets have largely taken everything in stride, with the Dow Jones Industrial Average breaching the 20,000 mark for the first time ever. Fixed- income markets have held relatively steady as well, with both yields and spreads trending sideways during the first month of 2017. However, markets got a little choppy in the last few days of the month. Popular backlash to a controversial immigration order sparked a retreat in equity markets on concerns that the big three initiatives (tax reform, deregulation, and infrastructure spending) could be delayed or more difficult to push through given heightened partisan tensions. To that end, much of the post-election optimism in equity markets was related to the big three, particularly corporate tax reform.
There was a distinct shift in market sentiment in the final quarter of 2016. During the first three quarters, expectations of tepid global growth/inflation and subsequent increases in monetary accommodation in Japan and Europe, pushed government yield curves flatter. Further, expectations for a Fed rate hike in 2016 fell sharply, particularly following the unexpected Brexit referendum result. However, in the wake of Brexit, central banks were less dovish than anticipated, and government yield curves began to steepen from the summer lows. Weeks later, the U.S. election results accelerated that trend dramatically. In addition to expectations of less dovish central bank policy, market participants were also speculating on potential changes in fiscal and regulatory policies given the sudden shift in the Washington power regime. The market was already pricing in a relatively high probability of a December rate hike before the election, but the post-election increase in market inflation expectations and overall positive performance of risk markets sealed the deal.
November was a good example of how quickly market sentiment can change. For much of the post-crisis period, markets have been lulled to sleep with extraordinary monetary policy, as well as low expectations of significant changes in both fiscal policies and the global growth outlook. The combination of these factors contributed to below-average implied volatility in both fixed income and equity markets and had a significant impact on performance of financial assets in general. The results of the U.S. elections on November 8 were enough to at least temporarily disrupt the intermediate trend, causing the Treasury curve to steepen and long-end yields eclipse 12-18 month highs. To be clear, we have seen other events have a disruptive impact on markets over the last 8 years, including the 2010-2012 European debt crisis, the 2013 QE “taper tantrum”, and, to a lesser extent, the Brexit vote earlier this summer. However, this was the first event to really alter expectations for U.S. growth and inflation on a positive basis, despite a high degree of uncertainty related what changes, if any, in fiscal policy will actually be implemented in the next 6-12 months. Regardless, markets will always attempt to price future events rather than wait for actual results (“buy the rumor, sell the fact”).
The economic data flow in the United States remains mixed, with positive and negative signs largely offsetting each other. This leads to a sideways trend (or “steady” trend to put it in more optimistic terms); and based off the comments of most Fed leaders, it has been enough to justify another rate hike in December, assuming the trend continues. The initial estimate of Q3 GDP showed growth rising 2.9% Q/Q, which was slight above expectations and 150 basis points (bps) above the Q2 rate. However, when you look at the underlying details of the report, the fundamentals are largely in line with the post-crisis trend. Personal consumption was expectedly weaker, given the hot run rate from the second quarter; but the inventory adjustment that weighed on growth in the first two quarters reversed course and positively contributed to the headline growth rate, also as expected.