On December 4th, Italians overwhelmingly voted ‘no’ in the nationwide referendum on a set of constitutional reforms, the latest in a global populist tide. Prime Minister Matteo Renzi resigned after his proposed changes were rejected. Subsequently, concerns around the Italian banking system and its high level of non-performing loans prompted the Italian government to create a rescue fund for troubled banks, notably Monte dei Paschi di Siena.
In December, the European Central Bank (ECB) announced it would extend its quantitative easing program set to expire in March of 2017. The additional purchases will be for a lower monthly amount, with the ECB decreasing monthly purchases to €60 billion from €80 billion effective April. Rules governing the details of the purchases have also been modified. One of the questions in the market as to whether the ECB could extend the program was whether the ECB would run out of securities to purchase as part of the program. To expand the universe of eligible purchases, the ECB lifted the maximum percentage of an issuer it could own from the one-third limit and ended the requirement that securities must yield the deposit rate (currently -0.4%) to be considered for purchase. These changes not only enhance overall ECB support for European fixed income but reduce the lower limit for yields.
The Fed raised the range for Federal Funds rate by 25 basis points to 0.50% – 0.75% at its the December 13-14th meeting. The move was fully anticipated by the market as Fed Funds futures had priced in a nearly 100% likelihood of the hike. For 2017, Fed officials forecast three hikes of 25 basis points each through their ‘dot plot’. The consensus long-run projection was increased 25 basis points versus the September meeting. At the end of the year, Fed Funds Futures imply the Fed’s next rate hike to be around mid-year 2017 with almost no chance (12%) at the next meeting in February.
After agreeing to their first production cuts since 2008 at the end of November, Organization of Petroleum Exporting Countries (OPEC) made a further agreement with nations outside of the cartel regarded reducing output. If adhered to, the deals will reduce OPEC output by 1.2 million barrels a day and non-OPEC output by over half a million barrels a day. OPEC quotas have been notoriously difficult to enforce with member countries often exceeding their allotted production. In combination with increasing growth expectations, oil closed the year near $54 a barrel, the highest level since July 2015.
The final estimate for U.S. third-quarter gross domestic product (GDP) showed a 3.5% growth rate versus the prior estimate of 3.2%. Consumer spending increased compared with the prior estimate, which helped drive the best quarterly growth in two years. Consensus expectations are for GDP growth of 2.2% for the fourth quarter, with the Atlanta Fed’s GDPNow forecasting a modestly higher 2.5% growth.
In our view, increases in inflation and growth expectations combined with recent Fed actions have created a fresh opportunity for bond market investors entering 2017. With the Fed continuing, albeit painstakingly slowly, to normalize U.S. monetary policy at the same time as economic outlook improves, yields across the curve have become more attractive. Despite the worst quarter for the broad bond market in several decades, bonds still delivered a positive return for the year and set investors to begin the new year with yields at their highest levels in over five years. Further, with the ECB extending their already massive quantitative easing program until the end of this year as their policy objectives have yet to be achieved, global support for the asset class remains strong. U.S. fixed income yields, attractive in their own right, continue to be the most attractive in a global context for developed markets.