So far 2017 has been an interesting year for investors. Buoyed by a rally in risk assets at the end of 2016, which was sparked by US President Donald Trump’s election victory, investors started the year confident that the “Trump reflation rally” would continue.
As the first half of the year ends, we look back at recent trends and examine which were the best broad asset classes and markets in which to invest.
What happened to the Trump reflation rally?
The Trump reflation rally continued at the start of 2017, but has faded away in recent months. From a macroeconomic perspective, his extra fiscal spending and deregulation measures could spur faster growth, and with unemployment already at cyclical lows, concerns over inflation have returned.
As time passed, investors have lost some faith in the president’s ability to deliver on his promises. The clumsy and combative nature of the administration has seen delays to promised reforms on the Affordable Care Act, which in turn has delayed progress on budget reforms in the House.
To make matters worse, questions over both Trump and members of his team’s conduct before and since the election have raised the possibility of impeachment. While this is unlikely given both the House and Senate are controlled by Republicans, investors’ confidence in Trump has taken a blow.
As a result, the “Trump reflation trade” has been unwinding, although this has not stopped equities from performing well.
Oil prices slip despite OPEC cuts in output
After almost two years of battling with other energy producers for market share, the Organization of the Petroleum Exporting Countries (OPEC) came together towards the end of 2016 and agreed to cut oil production by a million barrels per day. OPEC had suspended its quota system over the previous year in an attempt to drive less competitive producers out of the market.
However, as the momentum faded, OPEC decided to cut production to help push prices higher and extend new quotas in May 2017 through March 2018. Yet, as some analysts had expected, a further cut in production, combined with some concerns over global growth and inflation, caused oil prices to come under pressure once again.
The ramifications of the decline in oil prices do not appear to have been fully considered by markets. First, oil producers will be negatively impacted, although oil consumers will eventually enjoy the savings made. Meanwhile, inflation is likely to be lower everywhere, which is likely to lead to a more dovish sentiment from central banks.
While the Federal Reserve is the only major central bank actually raising interest rates, the Bank of England (BoE) came close to doing so in its June meeting. At the same time, pressure for the European Central Bank (ECB) to scale back stimulus has also risen.
Undoubtedly, fears of secular stagnation will return, but investors should consider whether oil prices are really signaling a slump in demand or, more likely, whether they are reflecting improvements in productivity.
Equity markets’ performance
Within equity markets, high-beta markets have generally performed well against a backdrop of positive risk sentiment. The best performing market was the Spanish IBEX 35, returning 21.8 percent (in US dollars), amid a stronger domestic economy and a pickup in world trade. The absence of a major European crisis also helped, although the huge liquidity provided by the ECB also played a role.
The second-best performer was the MSCI Emerging Markets index (+18.4 percent). Despite fears over the impact of Trump on trade, the improving macro environment has helped these markets regain the momentum they had in 2015 (pre-November).
Next is a group of European markets again, while the US S&P 500 (+10 percent) is in the last position. Although, given the concerns over the Trump rally unwinding, the positive performance from US equities is a solid achievement.
Currency markets’ performance
Part of the reason why the European and emerging markets outperformed in equities was the weaker US dollar, which has depreciated 4.9 percent so far this year. Meanwhile, the euro has been stronger, helped by stronger growth and a less dovish outlook from the ECB.
Also, the current account surplus remains substantial, with the monetary union benefiting from the pickup in world trade. Sandwiched between the two is the British pound, which is down just 1 percent – not a bad performance considering the Brexit and election uncertainty over the past year.
Are current trends sustainable?
The fall in government bond yields alongside the ongoing rally in equities suggests investors are split on the current outlook. Volatility remains very low despite the Fed tightening policy. While liquidity is ample and has in the past been a major factor in causing these markets to move in the same direction and suppressing volatility, history suggests that this trend is unsustainable.
The fall in oil prices is a possible factor for the current state of markets. Although lower oil prices will hit the energy sector, with lower inflation ahead, some central banks like the Fed and BoE may become less ambitious in tightening monetary policy, while some, such as the ECB, may be forced to step up stimulus again.
This suggests risk assets can continue to do well, especially as growth continues unabated, while inflation remains low.
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