Investment Outlook 12.2017
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
US tax reform – another boost for markets
The market revised up its Fed rate-hike expectations. It is seen almost as a certainty that the Fed will hike interest rates by 25 basis points at its next policy meeting on 13 December. In addition, the market currently prices for a 68% probability for a March 2018 rate hike, a 33% probability of a second hike in June 2018, and a 21% probability of a third hike no later than December 2018. As a result, the short end of the US bond market continued to sell off. Since ongoing inflation as well as inflation expectations remained firmly anchored, the long-end of the US yield curve hardly moved. This has led to a significant flattening of the US yield curve. Meanwhile the European yield curve did not change much in November.
High-yield bonds sold off in the first half of November but retreated thereafter. Dispersion has increased, which is tantamount to market participants differentiating more between idiosyncratic, i.e., issuer-specific, factors. As an example, European high-yield widened against the broader trend, which was driven by pressure on lower rated telecom companies.
Emerging-market local currency bonds recovered somewhat from a marked sell-off in previous months. The year-to-date performance remains very strong.
Insurance-linked bonds continued to recover from the storm and earthquake-induced correction in September.
Emerging-markets equities were flat or slightly positive in November. Chinese growth slowed, which may have had an impact. The Chinese stock index (CSI 300) was flat in November, while the Indian Nifty index fell 1.1% and the Brazilian Bovespa index 3.2%.
Developed markets were up 2.0%, driven by strong performances of the Nikkei 225, up 3.2%, and the S&P500, up 2.8%. At the same time, European stock markets made a pause, as Angela Merkel has been facing difficulties with regard to forming a new coalition in Germany and Theresa May had difficulties in reaching an agreement with the EU. The German DAX fell 1.6%, the British FTSE 100 2.2%, and the MSCI Europe 2.2%.
REITS were slightly up in November (by 0.2%) with US REITS strongly outperforming (up 2.5%).
The broad commodity index fell 0.5% in November. Especially industrial metals corrected after a very strong performance this year, the correction certainly being driven also by a weaker growth outlook for China. Oil prices continued to surge: the price for Brent oil rose 3.6%. Meanwhile the price for gold was only slightly up, by 0.3%.
In November the EUR strengthened across the board, despite rising US yields and a widening US-European yield spread. After the JPY weakened in September and October it was able to recover somewhat in November.
The November manufacturing PMIs signal continued robust growth. Although, the US ISM index dropped to 58.2 after 58.7, it remained far above the 50 level. The EMU Markit PMI improved further to reach a very solid 60.1 level, up from 58.5. The Japanese PMI also improved clearly to 53.6 after 52.8, which suggests that the massive stimulus program may finally be generating an improved growth dynamic.
November non-farm payroll figures were very healthy and above expectations. After hurricane-related disruptions the US economy added 228,000 jobs in November. At the same time, wage growth remained muted, with average hourly earnings rising 2.5% yoy. Despite a very low unemployment rate, this may suggest that there is still some slack in the US labor market.
The country which raises most questions is China. The manufacturing PMI in November fell to 50.8 after 51.0. So manufacturing growth in China is poised to be sluggish at best. Furthermore, as discussed in our IMT Investment Outlook 10.2017, we expect the Chinese government to address a number of structural issues, which will dampen growth, at least short-term. We therefore take a more cautious view on China, in particular, and emerging markets in general.
The Brexit talks proved to be very difficult. But the EU commission concluded that sufficient progress had been made to move to the second phase of the negotiations, i.e., to discuss the future relationship between the UK and the EU. EU country heads must approve this, however, at the EU summit on 15 December.
Three major issues have been controversial. Firstly, the exit bill for the UK. An agreement was reached on the method to do the calculations. It is estimated that the bill could amount to EUR 40-45 bn. Secondly, the status of EU citizens in the UK. An agreement was reached to protect the rights of EU-27 citizens living in the UK and British citizens living in the EU. The third issue, however, how to proceed with the Irish border, remains very tricky and largely unsolved. If the UK leaves the EU’s single market and customs union and Ireland remains in both, it seems impossible to avoid frontier checks. At the same time, the open border has been crucial for the Good Friday Agreement, which underpins peace in the province. This issue has additional political importance for Mrs May since she needs the votes of the ten members of parliament of Northern Ireland’s Democratic Unionist Party (DUP) for her ruling majority.
Even if negotiations move to the second phase, many controversial issues remain. The outcome of the Brexit talks will remain unclear for much longer. The longer the uncertainties prevail, the more the UK economy will suffer.
The US Fed and the ECB will have their final meetings for this year next week. The Fed is very likely to deliver another rate hike on 13 December. The ECB policy meeting on 14 December, however, is likely to be rather uneventful.
If – as we expect – the US tax reform goes through, this could give equity markets another boost. There is a likelihood it will be passed before Christmas. The positive macro environment should help equities to outperform bonds in general. However, the strong performance of 2017 limits the upside potential for next year.
The outlook for emerging markets assets looks to us somewhat clouded due to an expected slowdown of Chinese growth, rising US bond yields, and potentially a stronger USD.
Credit markets will continue to deliver positive carry, but we see little potential for further spread tightening.