Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update. Here is a summary of their outlook, plus four key investor takeaways for the fourth quarter of 2016. For a deep dive into each, read the Quarterly Market Update: Fourth Quarter 2016 (PDF).
First, let's look at how the markets did in Q3.
Market summary: Global economy holds up, markets bounce back
Markets recovered from the initial shock of the late-June U.K. referendum vote to leave the European Union, as lower bond yields, expectations of additional monetary accommodation, and stable global economic data soothed investor concerns. While global liquidity remained ample, monetary policy rates remained relatively unchanged during the quarter and bond yields rose modestly. Emerging markets (EM) and other non-U.S. equities led the broad-based rebound, although bond-proxy sectors such as utilities cooled off after a strong run of performance. China’s stimulus-induced steadiness has helped stabilize the global economy, though the pace of growth remains slow and the U.S. and much of the world are in a maturing phase of the business cycle. We favor global equities and inflation-resistant assets, but smaller allocation tilts are merited at this point in the business cycle.
Theme: Is it all about interest rates?
Asset prices have been particularly sensitive to changes in bond yields over the past year. The performance of bond proxy equity sectors, such as utilities, REITs, and some consumer staples, has benefited from the low-yield environment, but the relative valuations of these high-dividend payers have reached extreme levels on a historical basis. Low and even negative policy rates abroad have anchored global long-term bond yields, but central banks in Europe and Japan opted not to reduce policy rates further during Q3 amid signs of the detrimental real-world impact of negative rates. Low rates have kept debt-service obligations manageable amid a historic increase in both public and private-sector debt during the past decade.
While market sentiment has focused squarely on the outlook for interest rates, the drivers of any yield changes are perhaps more crucial for asset prices than just the direction. Since 2013, the performance of riskier asset classes has often been positive during periods when rates were rising, while risky asset prices have both risen and fallen during different periods when rates declined. Several fundamental factors (slow global growth, subdued inflation, easy monetary policies) and technical trends (reduced supply and higher demand for government bonds) have sent bond yields lower. With yield levels implying expectations of perpetually low inflation and a global recession, a modest alternative surprise in these fundamental or technical factors could put upward pressure on yields.
Economy/Macro: Global economic stability continues, U.S. shifting toward late cycle
Most of the developed world is in the mid- to late stages of economic expansion, and China’s improved cyclical trajectory has helped boost many emerging economies, such as Brazil. Improving trends in global activity have been spearheaded by the rebound in emerging-market manufacturing activity, which has benefited from policy-driven stabilization in China and a reduction in inventories. However, a typical early-cycle reacceleration in China is unlikely as the private sector is still burdened with overcapacity and excess debt. Europe’s economy, including the U.K., appears resilient in the wake of Brexit, with surveys of manufacturing activity surprising to the upside. Growth overall remains tepid in the region, however.
The slow pace of global improvement and Fed tightening have stretched the mid-late cycle transition in the U.S., but late-cycle dynamics continue to build. Bank standards for business loans have tightened for several quarters and cyclical productivity growth has started to falter amid rising wages, which typically pressures profit margins. Both dynamics are typical of late cycles. Moreover, contracting global oil production could potentially bring higher oil prices, and inflation, going forward. Inflation is typically a key to late-cycle transitions. Odds of recession remain low though, as tight labor markets and rising wage pressures continue to support the consumer spending outlook.
With the global expansion intact but U.S. late-cycle indicators rising, smaller cyclical tilts to portfolio allocations may be warranted. Rising oil prices and record-low bond yields may indicate that the potential for upside inflation surprises is not priced in. Due to the more mature U.S. business cycle and the expectation of continued political and policy uncertainty, we maintain an expectation of elevated market volatility.
Four key themes
|1.||U.S. stocks: Cyclical stocks outperformed, "bond proxies" declined|
The modest risk-on environment during Q3 boosted cyclical equity sectors, such as information technology, financials, and industrials. Rising bond yields during the quarter resulted in outright declines in bond-proxy sectors, such as utilities, staples, and real estate.
Bond-proxy sectors have been highly sensitive to the change in yields of late. While the earnings stability of some of these sectors has historically resulted in outperformance during late cycles, the potential for rising yields may inhibit their near-term performance. Moreover, mid- and late-cycle phases historically have not been conducive to multiple expansion in equities, which could be a particular headwind for the performance potential of bond proxies given their extreme valuations relative to history.
The persistent weakness in U.S. exporters and multinationals— particularly energy companies—has resulted in declines in corporate earnings since mid-2015. However, most other sectors posted profit gains during that time, and now that oil prices and the global macro backdrop are stabilizing, mid-single- digit earnings growth could once again be achievable.
|2.||International stocks and global assets: Broad-based gains for stocks|
International equity markets posted strong returns in Q3. Commodity-producing regions held up despite a fall in commodity prices, helping emerging-market equities provide double-digit gains year-to-date. After a prolonged period of a rising U.S. dollar, currency performance in 2016 has been mixed, highlighting the difficulty of hedging currency exposure. After a long dry spell of weak earnings, expectations have begun to stabilize from low levels in recent quarters. Although earnings growth remains negative, the pace of decline has slowed, and the profit outlook—particularly for emerging markets (EMs)—has improved. Emerging markets also have favorable long-term growth prospects and historically attractive valuations, which should provide a favorable secular backdrop for EM assets. Security selection is the most significant factor explaining differences in international equity performance.
|3.||Fixed bonds: Credit categories boosted by further spread tightening|
Most fixed-income categories had muted positive returns in the third quarter, and are solidly positive on the year. The strongest performers were high-yield corporate bonds and emerging-market debt, which benefited from spreads narrowing below historical average levels. Across sectors, yields rose slightly during the quarter, but remain near historic lows. As the U.S. transitions from mid- to late-cycle, inflation protection may become an important attribute of a bond portfolio. Inflation expectations remain close to multi-year lows, making Treasury inflation-protected securities (TIPS) an attractively priced hedge against inflation. Short duration may also be an important piece of a portfolio, as short duration has historically outperformed investment-grade and high-yields bonds in the late-cycle phase.
Throughout all cycle phases, diversification is the key to downside protection in a bond portfolio. Historically, fixed-income strategies with designated allocations in both high-quality bonds and higher-yielding sectors have outperformed other investments during phases when the market is declining.
Late cycles have the most mixed performance of any business cycle phase. Stocks have typically outperformed bonds, and inflation-resistant assets such as commodities, energy stocks, short-duration bonds, and TIPS have typically performed relatively well in the late cycle. Combining inflation-resistant assets has increased the frequency of outpacing inflation, a difficult task for cash in today’s low-rate environment. Meanwhile, it’s important to keep in mind that loss aversion and excessive emphasis on short-term market volatility can cause investors to make asset allocation changes that deviate from their long-term plans. Outsourcing asset allocation to a professional investment manager may help investors identify and maintain an appropriate amount of portfolio risk, keeping their portfolio aligned with long-term goals.
Past performance is no guarantee of future results.
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