Market update: Fourth quarter 2016

Here’s our outlook for interest rates, and what lie ahead for the U.S. and global economies.

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During the third quarter, the financial markets remained focused on interest-rate movements and monetary policy.

Long-term government bond yields remained low around the world, and were anchored by extremely low policy rates—even negative rates—in Europe and Japan. Here in the U.S., the Federal Reserve kept rates unchanged, but the Fed continued to express an expectation to lift them later this year.

So while the low-yield/low-inflation global environment still exists, yields actually ticked up during the third quarter. For that reason, I think the odds are good for a Fed rate hike in 2016.

Meanwhile, movements in interest rates have been having a particularly large influence on asset prices. For instance, high-dividend paying sectors of the stock market—also known as bond proxies—have had a very strong negative correlation to movements in bond yields over the past couple years.

In other words, as yields have moved down, the valuations of many sectors like utilities and real estate have moved up, and in some cases have become quite expensive.

However, during the third quarter, the modest upward move in yields caused prices of these bond proxies to fall, even though the rest of the U.S. stock market posted positive returns. Ultimately, the outlook for interest rates depends on the growth and inflation outlook for the U.S. and global economies

Business cycle framework

The global economy is slow but stable, and most recently it has been boosted by an improving cyclical trajectory for China and some other emerging markets, including Brazil.

Although Europe’s growth is slow, it’s been resilient so far after the Brexit vote.

And the U.S. economy appears to be shifting toward the late-cycle phase, but it remains in a solid expansion.

Inflation on the horizon?

This steady growth is creating a slow upward climb in inflationary pressures. Core inflation in the U.S. is well above 2% and has been firming as labor markets tighten and wage growth continues to rise.

If oil prices stay in the $40-$50 per barrel range during the next few months, overall inflation will likely be headed higher. So while I don’t think we’ll see a rampant outbreak of inflation any time soon, I do believe an inflation surprise is quite likely—given the market’s low expectations.

Election outlook

Lastly, let’s turn to the U.S. presidential elections.

Rising political risk around the world may be a multiyear is one word trend because sentiment in many countries has become more critical of the underpinnings of globalization; namely, more open trade, capital flows, and migration.

In the near term, it’s possible that these pressures manifest themselves in the form of greater government spending. So while budget deficits here in the U.S. have shrunk in recent years, it’s possible no matter who wins the election that we’ll see some shift toward fiscal easing.

Conclusion

When we put this all together, the backdrop for the markets is not bad—but it’s mixed. Market volatility could pick up as we move deeper into the business cycle, and this means a well-diversified portfolio may be more important than ever.

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