The political storm that began in the UK with the June referendum result hit the US in November with the surprising victory of Donald Trump in the presidential election. After the result, investor focus quickly shifted to what a Trump administration will seek to achieve in the Oval Office. The potential for tax cuts and infrastructure spending has boosted equity market performance, with developed market equities returning 2.7% in November. Commodity prices have also benefited from the possibility of increased infrastructure spending, with copper prices hitting a 17-month high in November. Meanwhile, Opec was able to agree a production cut of 1.2 million barrels a day, pushing Brent crude prices to USD 52 a barrel.
Exhibit 1: Asset class and style returns (local currency)
Source: J.P. Morgan Asset Management, Barclays, Bloomberg, FactSet, MSCI. REITs: FTSE NAREIT All REITs; Cmdty: Bloomberg UBS Commodity Index; Global Agg: Barclays Global Aggregate; Growth: MSCI World Growth; Value: MSCI World Value; Small cap: MSC World Small Cap. All indices are total return in local currency. Data as of 30 November 2016.
For much of 2016, investors have enjoyed solid returns in both US equity and bond markets. In the first 10 months of the year, US government bonds rose 4.1%, while the S&P 500 was up 5.9%. However, November saw a sharp divergence in performance. US equities rose a further 3.7% this month, their best monthly performance since March 2016, but government bonds fell 2.8%, their worst month since January 2009.
The reason for the divergence is that the key driver of economic growth is expected to shift from monetary policy to fiscal policy under Trump’s presidency. For much of this year, loose monetary policy has been supportive for both fixed income and equity markets. However, fiscal policy is not quite as generous. More infrastructure spending and tax cuts should help boost domestic growth in 2017, a positive for stock markets. However, loose fiscal policy could generate inflationary pressure and trigger tighter monetary policy next year, which has seen investors exit bond markets this month.
Exhibit 2: World stock market returns (local currency)
Source: J.P. Morgan Asset Management, FactSet, MSCI, Standard & Poor’s, TOPIX; data as of 30 November 2016. All indices are total return in local currency.
As the US economy begins to pick up speed, there is potential for increased divergence in monetary policy between the US and the rest of the world. The difference between the yield on the US 10-year Treasury and the German 10-year Bund is now the largest in over two decades. A growing interest rate differential between the US and other developed economies saw the US dollar reach a 13-year high on a trade-weighted basis in the month.
Exhibit 3: Fixed income sector returns
Source: Barclays, BofA/Merrill Lynch, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. IL: Barclays Global Inflation-Linked; Euro Treas: Barclays Euro Aggregate Government - Treasury; US Treas: Barclays US Aggregate Government - Treasury; Global IG: Barclays Global Aggregate - Corporates; US HY: BofA/Merrill Lynch US HY Constrained; Euro HY: BofA/Merrill Lynch Euro Non-Financial HY Constrained; EM Debt: J.P. Morgan EMBI+. All indices are total return in local currency. Data as of 30 November 2016.
Europe & UK
After the political surprises from the UK referendum and the US election, investor attention has now turned to the busy political calendar ahead in Europe, kicking off with the Italian referendum on 4 December. The referendum was originally called as a vote on political reform but has increasingly been seen as a vote of confidence in prime minister Matteo Renzi and his coalition government. Polling data currently suggests that voters will vote down the proposed political changes, which could lead to the collapse of the coalition government and snap general elections in Italy.
November also brought a political surprise in France, where Francois Fillon was selected as the Republican candidate for next April’s presidential election. Polling prior to the primary election had suggested that Fillon’s rivals, Nicolas Sarkozy or Alain Juppe, would emerge victorious. The result matters as Fillon is likely to face off against Marine Le Pen, the National Front and eurosceptic candidate, in the second round of the presidential election.
In the UK, Philip Hammond delivered his first Autumn Statement as chancellor, unveiling a new infrastructure plan that should boost GDP by 0.4% a year over the next five years. There was also a focus on boosting UK productivity growth, which has lagged many other developed economies since the financial crisis. Overall, the change in fiscal policy to help boost growth is welcome, albeit a few years late.
Exhibit 4: Fixed income government bond returns
Source: FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. All indices are J.P. Morgan GBIs (Government Bond Indices). All indices are total return in local currency. Data as of 30 November 2016.
On European government bond markets, the combination of a stronger global economic outlook, the potential for more fiscal support and mounting inflationary pressure pushed up yields across the eurozone in November. The German 10-year Bund yield reached 0.16% in November, its highest level since April 2016. The percentage of eurozone government bonds trading with a yield of below 0% has fallen from a high of 52% in September to below 33% in November.
Following gains of more than 12% in the first 10 months of 2016, emerging market (EM) equity investors looked for the exit in November as the index declined 2.2%, its biggest monthly fall since January this year. The Institute for International Finance (IIF), which monitors equity and debt fund flows for a sub-sample of emerging economies, identified the second-biggest weekly outflow on record in the middle of November.
The change in investor sentiment towards emerging markets has been driven by concerns over the stronger US dollar and the potential policy implications of a Trump administration. First, dollar strength has historically been bad news for emerging markets. Over the last 20 years, the US dollar has a -0.78 negative correlation with EM equities. The potential for more interest rate hikes from the Federal Reserve (Fed) in 2017 could see the dollar continue to weigh on emerging markets in the next few months.
On the political side, EM investors are worried about the potential for a reversal in globalisation. President-elect Trump has talked extensively about renegotiating trade deals and removing the US from any unfavourable trade agreements. Such an increase in protectionist measures would reduce global trade, hurting emerging economies—particularly south-east Asia, where equity markets fell 1.6% in November.
Exhibit 5: Index returns for November (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management; Data as of 30 November 2016.
The road ahead for the Fed
Since the election of Trump and a Republican clean sweep of the White House and Congress, equity markets have been rising on expectations that additional fiscal policy stimulus will boost US growth. However, there has been a surprisingly limited change in the market’s outlook for US monetary policy.
The market is currently pricing in a 100% chance of a Fed rate hike at the December meeting. But looking into 2017, markets are pricing in just over one interest rate hike in all of next year, a strange position considering the relatively upbeat growth outlook for the US economy.
It is understandable if investors are sceptical about the potential for rate hikes in 2017. At the end of both 2014 and 2015, markets were braced for multiple rate hikes in the coming twelve months, just to be surprised when the Fed opted to hold fire. However, one factor missing from the last couple of years, which looks to be emerging for 2017, is inflation.
Even before the election, there were signs that inflationary pressure was beginning to build within the US economy. The labour market is tight, unemployment is below 5%—its lowest rate since the financial crisis—and the number of people claiming unemployment benefits is at its lowest level on record. Meanwhile, oil prices have risen 41% this year. Now add into the mix tax cuts, protectionist measures on overseas goods and infrastructure spending and we have a recipe for higher inflation over the next few years.
There is a chance that the Fed will hold fire on further rate cuts and decide to run the economy hot. As headline inflation has been below the Fed’s 2% target since May 2014, policymakers may decide that some above target inflation is acceptable in the near term. The risk with this approach is that the Fed loses control of the situation and finds itself behind the curve, leading to a steep increase in interest rates in a short period of time, and hurting financial markets and the economy.
If the Fed instead decides to raise rates at a faster pace than the market expects next year, what will it mean for investors? The biggest impact will be on the US dollar, as a growing interest rate differential between the US and the rest of the world pushes the currency higher. That would spell bad news for US exporters and emerging markets, but good news for firms outside the US with a strong exposure to the American economy.