Fidelity’s Asset Allocation Research Team (AART) examines major themes in global financial markets and presents its investment outlook in this market update
Quarterly Market Update: Third Quarter 2017
Market summary: Low inflation and global expansion continued
The continued synchronized expansion in global activity provided a steady backdrop for asset markets. With inflation decelerating amid weaker oil prices, most asset markets experienced unusually low volatility during Q2, even compared to the relatively calm levels of the past five years. This steady economic backdrop, combined with ample global monetary accommodation, supported a relatively tranquil environment for the past three months.
Bolstered by a weaker U.S. dollar, non-U.S. equities led the global stock market rally for the second quarter in a row, with particular strength among small-caps. In fixed income, most categories posted low single-digit positive returns for the second quarter. Falling commodity prices dampened inflation expectations and boosted longer-duration bonds. The yield curve flattened modestly as shorter-term interest rates rose, while tightening spreads again boosted the returns to corporate and other credit-bond categories.
While flagging oil prices and muted inflation pressures mitigated any concerns about potential overheating, a major question for the markets going forward is whether the growth and inflation backdrop will remain firm enough for global monetary policymakers to move toward normalization. Changes to monetary policy will be critical to the outlook, as a broad directional move toward reducing accommodation raises the potential to provoke greater market volatility amid maturing business cycles in many major economies, including the U.S.
Theme: Global liquidity poised to tighten?
The balance sheets of the four major advanced-economy central banks—the U.S. Federal Reserve (Fed), European Central Bank, Bank of Japan, and Bank of England—have more than quadrupled since the global financial crisis due to trillions of dollars of quantitative-easing asset purchases. Firming inflation and global growth have given the Fed confidence to continue gradually hiking its short-term policy rate, although both are weaker than during prior periods of Fed tightening. Europe’s progress toward policy normalization may occur sooner than the markets anticipate, with short-term yields implying negative yields for nearly five years and a slower pace of normalization relative to the U.S.
After converging on the 2017 outlook over the past year, investor expectations for Fed tightening have once again diverged materially from the Fed’s forecasts for the next 12 to 18 months. Markets are anticipating the Fed will hike rates only twice through December 2018, instead of the four times the Fed projects. The Fed also announced the outlines of a plan to begin shrinking its balance sheet that would imply additional tightening. Historically, the yield curve typically flattens as the Fed hikes rates and the business cycle matures, with inversions occurring prior to each of the last seven recessions. However, the yield curve remains relatively steep, and a move toward global monetary normalization might boost longer-term rates more than usual at this point in the cycle.