Last year at this time, the BMO Multi-Asset Solutions Team remarked that the approximately 7% return for a typical 60/40 balanced portfolio in 2016 was slightly above our expectations. In 2017, that same portfolio was up around 13% and went even further beyond what we expected going forward. Some may argue that markets have managed to compartmentalize policy risks and focus on positive global economic data. While we all might like to gather around the punch bowl and sing a holiday chorus of “synchronized global growth,” it is important keep some risks in mind and be judicious about exactly how much of that eggnog we are consuming.
Investors have grown weary of the Federal Reserve’s (Fed’s) inability to offer a comprehensive explanation for persistently low inflation. We’ve noted previously that market participants are seeking answers elsewhere and have developed expectations that diverge from the Fed’s guidance for gradually increasing inflation to their 2% target. Complacency in the market increases the chances of a market correction in the event of an inflation surprise. In the short term, we are watching prices within the inflation components of health care, telecommunication services and housing, which have dragged down inflation over the prior year. In the long term, globalization and technology will continue to raise questions about how inflation is currently measured and whether new ways of doing so would be more appropriate for evolving global markets.
Fed leadership: From Janet to Jerome
In November, President Trump nominated Jerome Powell to succeed Janet Yellen as Fed chair when her term expires in February 2018. Most observers expect Powell’s Fed to continue along the policy course laid out by the Yellen Fed. Powell does diverge from Yellen in terms of his views on regulation. Under his leadership, the pace of new regulation could slow and we may see some relaxation of the rules put in place following the financial crisis. While Powell is regarded as the “continuity candidate” who will mitigate market uncertainty regarding the transition, it is important to remember that three Fed governorships remain unfilled and thus offer President Trump the opportunity to further reshape the board. Moreover, the widely expected December rate hike, the last under Yellen, lacked the support of two members (Charles Evans and Neel Kashkari) in part because of low inflation. The risk here is that dissent concerning inflation broadens and causes deeper fractures within the Fed, causing monetary policy to become even less predictable.
ECB: Mario meets the money markets
The European Central Bank (ECB) plans to reduce the pace of its bond buying in 2018, and potentially end quantitative easing (QE) completely later in the year, but President Mario Draghi has consistently stated that the ECB is prepared to continue QE if necessary and expects to keep interest rates at their present levels “well past the horizon of the net asset purchases.” However, with economic indicators in the eurozone remaining quite strong, yields on the short end of the curve have begun to rise. Low inflation remains the bête noire here too, but we are very interested in whether market sentiment will diverge further from ECB rate guidance in the first half of 2018. The European interest rate market remains well behaved under the ECB’s direction but looks quite vulnerable to a correction if markets question the direction or will of the central bank.
European policy: Was that the Grinch I just saw?
Markets appear to have skirted policy risk in 2017 but there remains a chance of a reversal for a number of reasons. The prelude to Brexit has finally concluded, but the next phase of negotiation includes the crucial component for markets: the trade agreement between the U.K. and the European Union. While fears of an inexorable populist wave spreading across Europe subsided earlier in 2017, the recent alliance between mainstream conservatives and the nationalist, anti-immigration far right in Austria is an important development. Austria holds the EU’s rotating presidency in the second half of 2018 and will thus figure prominently in the discussions of fiscal policy and bloc integration. Meanwhile, the path forward for Germany’s government remains murky, though the country’s Social Democrats recently approved talks to potentially rejoin Chancellor Angela Merkel’s CDU in a continuation of their coalition. These factors and the upcoming elections in Italy will clearly influence policy discussion in the EU and serve as a reminder that Europe’s economic course in the coming years has yet to be fully charted.
U.S. policy: Giving generously (at least to corporations)
In the U.S., tax reform arrived just ahead of the Christmas holiday and finally gave President Trump and congressional Republicans a key legislative achievement. As we commented recently, at its core the new law is a corporate tax cut. The reduction in the federal corporate tax rate should provide a near-term boost for equities and support higher earnings in the future. In addition, the new law allows capital investments to be expensed immediately rather than depreciated over time. This provision expires after five years, which will provide a strong incentive for companies to undertake capital expenditures and thereby further support the economy in the near term. While these developments bode well for the overall economy, if they are followed with a more isolationist trade policy the positive effects could be undermined. Moreover, with the tax bill failing to gain any support from Democrats, questions remain regarding the administration’s capacity for achieving compromise on other important matters such as trade policy or infrastructure spending.
2017: Reflections and evaluations
To read our reflections on 2017, as well as our near-term expectations for 2018, please download the full report below.
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