Market Insights: Review of markets over the first quarter 2017 - J.P. Morgan Asset Management
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Market Insights: Review of markets over the first quarter 2017

Contributor Global Markets Insights Strategy Team

February might be a few days shorter than other months, but it was just as packed—if not more so—with economic releases and market movers, equity indices across the globe hit record highs, the US Federal Reserve’s (the Fed’s) interest rate-hike expectations were notably higher, and the political obstacle courses on both sides of the Atlantic provided a steady stream of headlines for investors to digest.

Exhibit 1: Asset class and style returns (local currency)

Source: Barclays, Bloomberg, FactSet, MSCI, J.P. Morgan Asset Management. 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 28 February 2017.

Over the course of the month, survey data around the world surged to new levels. In particular, the Purchasing Managers Indices (PMI) for Manufacturing in both the US and Europe hit new highs. It’s important to remember these PMIs are month-on-month surveys, where respondents compare attitudes and forecasted output compared to the month before, so readings that stay above 50 indicate strong momentum.

Exhibit 2: World stock market returns (local currency)

Source: FactSet, MSCI, Standard & Poor’s, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency. Data as of 28 February 2017.

Developed markets

The month kicked off with three central bank meetings, continuing the theme of slightly hawkish monetary policy affecting sensitive markets. In a backdrop of weaker consumer spending, but booming factory output, strong external demand and a notable pick-up in business equipment, the Bank of Japan (BoJ) increased growth expectations for the next two years. On that basis, the BoJ left policy unchanged, sending the 10-year Japanese government bond (JGB) yield to its highest level in the past 12 months since the announcement. Shortly after these JGB yields tested their highs, the BoJ brought them back down using open market purchases, affirming its stance on a targeted yield levels.

As expected, the Bank of England (BoE) kept interest rates on hold at 0.25% and left its asset purchase programme unchanged. But notably, the Bank now expects the UK to grow by 2.0% in 2017, up from last November’s forecast of 1.4%, which was itself an upgrade from the 0.8% forecast made in August 2016. The BoE anticipates inflation reaching 2.7% by the end of the year—well above its target rate of 2%. However, it will tolerate overshooting of the target to some degree given the massive fall in sterling. BoE Governor Mark Carney emphasised he would watch real wage growth as a barometer for the health of UK consumers when thinking about possible changes to monetary policy through the end of 2017.

Exhibit 3: Fixed income sector returns (local currency)

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 28 February 2017.

The Fed started the month with broadly neutral messaging after its meeting, which increased the market probability of a March rate hike to just above 30%, but as the month went on and positive US continued to roll in, Fed officials and messaging have started to turn even more hawkish. Fed chair Janet Yellen’s testimony in front of US congress provided a further strong signal that the Fed is ready to hike. She highlighted strong labour market data, rising inflationary pressures, her support for President Donald Trump’s recent executive order on financial regulation and the potential for higher growth given his fiscal stimulus plans. By the end of the month, the market probability of a March rate hike had risen to 80%.

Despite the general hawkish sentiment in the global central banking arena, government bonds actually did well in February. UK gilts and German Bunds led the way, gaining 3.2% and 1.6%, respectively (Exhibit 4).

Equity markets hit record highs and all indices in (Exhibit 2) provided positive returns. The S&P 500 gaining 4.0% in February, the FTSE 100 rallied 3.1%, and Europe was not far behind with 2.6%.

Exhibit 4: Fixed income government bond returns (local currency)

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 28 February 2017.

The earnings season in the US wrapped up, with strong earnings-per-share (EPS) growth. A majority of companies that reported beat earnings estimates, although fewer beat revenue estimates. Sectors that provided the highest EPS growth were energy, utilities, and materials. In Europe, the reporting has not concluded, but we estimate that fourth-quarter 2016 EPS growth is around 9% year-on-year (y/y) for the Euro Stoxx 600. A weaker euro and higher commodity prices provide a positive outlook for earnings growth in the next twelve months. Despite a strong fourth-quarter rally, the current inflation and growth outlook for 2017 favours cyclical sectors over defensive ones. In February, European PMIs picked up strongly, with the composite PMI rising to 56 and Eurozone consumer prices rose sharply to 1.8% year on year.

In the political realm, French and Dutch candidates continued campaigning towards their respective elections. Polling data at the close of the month suggests Geert Wilders PVV will be unlikely to gain full control of the Dutch parliament. Projected outcomes for the second round of French elections have either Emmanuel Macron or Francois Fillon victorious over Marine Le Pen.

Emerging markets

Continuing the strong inflationary pressures building around the world, China’s producer price index rose even further to 6.9% y/y in February. India’s GDP growth came in higher than expected at 7%, particularly during Prime Minister Narendra Modi’s demonetisation drive. The cancellation of the majority of cash in circulation was expected to shave off some growth, but at least in this reading, India’s growth exceeded expectations, making it the world’s fastest-growing large economy. Across the emerging world, most currencies are at the cheapest end of their historic range, particularly when compared to pre-2013 Taper Tantrum levels. Over the course of February, emerging market equities gained 1.7% and emerging market (EM) debt rallied 1.9%, posting the highest fixed income returns in Exhibit 3.

Exhibit 5: Index returns for February (%)

Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management; data as of 28 February 2017.

What’s beneath the surface?

Despite the politics dominating investor discussions, markets have made a calm start to the year. Volatility has been notably low on several measures: the VIX (tracking S&P 500 volatility), the VSTOXX (volatility in Europe), and the MOVE (volatility in US Treasuries). In the first two months of 2017, the S&P 500 has not had a single day where it has closed up or down 1%—the most tranquil start to a year since 1966.

So, are markets relaxed about the political risks and higher valuations? Or has the impressive earnings season in pockets of the European, US and emerging market equity universe kept investors in risk-on mode? Neither, it would appear, as the MSCI All Country World Index hit record highs in February.

However, the lack of headline volatility in markets disguises major disturbances at a stock-to-stock level. As Exhibit 6 chart shows, the average stock-to-stock correlation of US equities has fallen to below 25%, the lowest level since the late 1990s. Such a breakdown in correlation means stock relationships are less connected and predictable than before. This makes for a much better environment for active investors, as individual equities are no longer moving in lockstep with one another, allowing active fund managers to generate alpha. With greater potential this year for central banks to change course, governments to change hands and stimulus to change growth trajectories, an active approach may be the best positioned to take advantage of the various currents beneath the calmer surface.

Exhibit 6: Average stock-to-stock correlation
%

Source: Standard & Poors, J.P. Morgan Asset Management. Data as of 28 February 2017.

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