As widely anticipated, the FOMC unanimously raised the federal funds rate by 25 bps at its December two-day meeting as the committee found current labor market conditions and inflation sufficient. The move by the Federal Reserve was near-certain, but what remains uncertain is the Fed’s rate path for 2017. The materials released show the FOMC aims for three rate hikes next year – more than three would be risky – and reinforces the committee will remain data dependent. This time last year, the Fed aimed for four rate hikes the following year. Yet, international events and uninspiring data throughout the year sidelined the Fed. Thus, only one rate increase occurred in 2016.
Data dependency allows the committee the freedom to respond how it sees best, especially next year which holds great uncertainty from the shifting political landscape. Furthermore, the strength in the US$ has functioned as a tightening of financial conditions in its own right. Yet, market participants tuned into Chairwoman Yellen’s press conference to try deducing from her words any further guidance. During the Q&A session of the press conference, Chairwoman Yellen refused to speculate or give any instruction about fiscal policy, confirmed she intends to serve her four-year term, and emphasized the outlook is too uncertain and thus, the committee will adjust its stance as visibility improves.
Global Equity Markets
Global equity markets have shown a fair degree of volatility in 2016, initially impacted by expectations of weakening global growth and tumbling commodity prices, and then by the uncertainties resulted from the outcomes of the Brexit decision, and more recently Donald Trump’s election to the White House.
On U.S. Equities
Despite the environment and the uncertainties surrounding the Trump administration, investors appeared focused on the president-elect’s promises of expansionary fiscal measures, and the performance of the U.S. equities remained resilient. As of December 19, 2016, the S&P 500 Index rose 10.48% year to date, with the S&P 500 Value Index grew by 15.10% and the S&P 500 Growth Index by 6.12% during the period. Meaningful dispersion returned across equity sectors: A steeper yield curve and the prospect of a shift toward deregulation buoyed financials, while the treat of trade barriers weighed on technology companies dependent on global supply chains. More interest-rate-sensitive sectors such as utilities also underperformed in the month. In addition, small-cap stocks performed well on the potential for reduced competition from foreign firms and a more pro-business domestic political environment, as evidenced by the 10.27% gain in November and 20.03% gain year to date.
On Non-U.S. Developed Markets Equities
The Euronext 100 Index was up 2.14% as of December 19, 2016 and the FTSE 100 Index ended the period up 11.99%. After being pounded for months, the European banking sector is back in vogue, as evidenced by the fact that the Stoxx Europe 600 Banks Index turned positive year to date, a huge reversal for the sector that spent the year as one of the region’s worst performers. Spurred by the prospect of looser regulations and higher interest rates, investors are piling back into the sector. The Australian equity markets, as measured by the S&P/ASX 200 Index, returned 5.11% year to date. Japanese equities rallied on the back of a weaker yen and modestly higher yields, benefitting export-oriented firms and financial companies, respectively; financials have led the Japan equity market to a fresh high for 2016.
On Emerging Markets Equities
In emerging markets, the potential for protectionist trade policies in the U.S. under the Trump administration and a stronger U.S. dollar weighted on returns. Emerging markets equities experienced their largest monthly drawdown since January. Brazilian equities fell 4.6% in November amid a renewed focus on political corruption in the President’s cabinet. Indian equities also fell 4.5% as investors feared that Prime Minister Modi’s currency crackdown could prove disruptive to the cash-dependent economy. Chinese equities, however, gained 4.8%, pushing stocks into bull market territory as government efforts to curb surging property prices may be driving more investment toward the stock market. Russian equities rallied the most among emerging markets, returning 5.8% during the month in reaction to President-elect Trump’s apparent willingness to mend relations with Moscow.
Global Credit Markets
Yields in global credit markets spiked to levels not seen since the end of March as a Fed rate hike in December appeared to be a near certainty, and global investment grade credit returned – 2.0% for the month of November. While spreads widened modestly during the month, overall they have tightened about 60 bps from the wide levels in February, due to continued strong investor demand for stable income above that of global government bonds.
On U.S. Credit
Developed market yield soared in a post-election reflation trade: Investors priced in greater potential for fiscal expansion and infrastructure spending in the U.S., along with a faster Fed hiking path. The reaction was strongest in the U.S., where the 10-year Treasury yield jumped 56 bps to 2.38%. As rates on the long end of the yield curve climbed higher, the spread of 10-year yields over two yields widened 28 bps.
On U.S High Yield Bonds
As investors contended with the sharpest increase in Treasury yields since the Taper Tantrum in 2013, global high yield bonds experienced their first monthly loss since January. Yields rose by close to 30 bps over the month but were far outpaced by the increase in government rates, resulting in spreads that were narrower by about 10 bps.
On Non-U.S. Credit
Other developed markets followed suit, with the German 10-year higher by 17 bps. In Japan, 10-year rates inched into positive territory during the month, but ultimately ended only 7 bps higher at the new target of about 0% after the Bank of Japan successfully defended its new yield curve targeting policy through open market operations.
On Inflation-Linked Debt
Global inflation-linked bond (ILB) markets lost ground in November as rates across the globe moved sharply higher. In the U.S., breakeven inflation rates suddenly jolted higher in the wake of the surprise presidential election result. Ten-year inflation expectations in the U.S. ended the month at their highest level in more than two years as investors perceived Present-elect Trump’s proposed policy measures as inflationary. An OPEC-induced rally in crude oil prices at month-end also served as a tailwind for breakeven inflation rates. The election results reverberated through other ILB markets as well: most notably. Mexican inflation expectations skyrocketed as the peso sharply depreciated, and yields spiked as the Bank of Mexico attempted to curtail the impact of the currency decline on inflation.
On Emerging Market Debt
EM debt assets came under considerable pressure in November following the U.S. presidential election. President-elect Trump’s campaign rhetoric raised uncertainty about the future of global trade agreements, and EM economies most reliant on the current global trade construct posted the weakest returns. Even as developed market yields moved higher, index spreads over U.S. Treasuries for EM external debt widened, EM local yields rose and EM currencies weakened considerably against the U.S. dollar. Investors pulled nearly $10 billion from the asset class, with the outflows serving as an additional headwind. Bucking the trend, oil exporters across the EM universe generally outperformed as OPEC reached a long-awaited agreement to cut production, sparking a rally in crude oil prices on the final day of the month.
The U.S. dollar surged in November. It gained against nearly all global counterparts as Treasury yields soared following the surprise election of Donald Trump. Among G10 pairs, the Japanese yen was notably weaker – down more than 8% against the U.S. dollar – as the interest rate differential between rates in the U.S. and those in Japan widened. The dollar also strengthened substantially against EM currencies on concerns over more protectionist U.S. trade policy under the new administration. The Mexican peso fell almost 9% versus the dollar for the month. China, frequently in the crosshairs of the president-elect, fixed its currency weaker as capital outflows showed little sign of abating. The British pound was the lone currency to beat the dollar on the month after the U.K. high court indicated parliamentary approval is necessary to trigger the country’s exit from the EU.