Quarterly market update: Q3 2017 key takeaways

Worldwide expansion continues with recession risks low, though liquidity is posed to tighten.

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Key takeaways

✔  Steady economic backdrop supported a calm market environment for the past 3 months.

✔  Global recession risks remain low, but upside to growth may be constrained.

✔  A tightening of global liquidity may be on the horizon.

Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update. Here is a summary of their outlook, plus 6 key investor takeaways for the third quarter of 2017. For a deep dive into each, read the Quarterly Market Update: Third Quarter 2017 (PDF) or the interactive PDF.

First, let's look at how the markets did in Q2.

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 5 years. This steady economic backdrop, combined with ample global monetary accommodation, supported a relatively tranquil environment for the past 3 months.

Bolstered by a weaker dollar, non-U.S. stocks 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 4 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 5 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 4 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 7 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.

Economy/macro: Growth and inflation firm but not accelerating

The global economy continues to expand in a synchronized fashion, with most developed economies in more mature (mid-to-late) stages of the business cycle. Relatively steady economic growth has been underpinned by a turnaround in export-oriented sectors and manufacturing activity. Nearly 90% of countries are reporting higher new export orders, and global trade growth has risen to its highest level since 2011.

China’s reacceleration supported these trends, although late in 2016 policymakers began to rein in policy stimulus. China’s economy remains broadly steady, but signs of slowing momentum in industrial activity and housing suggest most of the upside has already occurred.

Elsewhere, the eurozone is on a mid-cycle upswing, with consumer and industrial-sector confidence at multiyear highs and rebounding core inflation. The U.S. economy remains a mix of late-cycle dynamics. Manufacturing activity has reaccelerated over the past year amid strengthening global demand, but rising wages are crimping profit margins and banks have tightened their lending standards for potentially overextended segments of the economy such as commercial real estate and autos. Inflation may be range-bound as moderating shelter costs and lower oil prices act as headwinds, but tighter labor markets and a possible rise in food prices present upside pressures.

Overall, recession risks remain low globally, although less accommodative policy in several countries, including China, may constrain any upside to growth going forward.

U.S. stocks: Growth and large cap continued to lead

Growth and large-cap stocks continued to outpace other U.S. equity categories in Q2 due to their exposure to the improving international economic backdrop. Sector performance was varied, though mostly positive, with only energy and telecommunication services experiencing outright declines—due to falling crude oil prices and price competition, respectively.

The continued outperformance of so-called “FANG” tech stocks—Facebook, Amazon, Netflix, and Google (now Alphabet)—has raised concerns that the market has become overly dependent on a small number of stocks. While the breadth of companies driving S&P 500® price returns was somewhat narrow in Q2, this level was not far below the historical median breadth during rising markets. Corporate earnings are still inflecting positively in 2017, and while potential pro-growth policies could boost top-line growth in 2018, margins will likely remain under pressure, suggesting more modest earnings growth ahead. U.S. large-cap valuations are higher than their long-term historical average, but valuations are a more meaningful indicator of long-term future returns, and are therefore more of a headwind for the secular outlook than the cyclical one.

International stocks and global assets: Broad gains helped by weaker dollar, acceleration in corporate earnings

Non-U.S. stocks posted strong gains for a second quarter in a row. A weaker dollar in Q2 boosted returns in most developed markets, but was a minor detractor from emerging markets. Both developed- and emerging- markets equities benefited as international corporate earnings accelerated into positive territory, following several years of profit recession. Attractive valuations are favorable for international equities—P/E ratios for most equity markets are lower than those in the U.S. and the U.S. dollar remains at the upper end of historical ranges versus major currencies.

On a secular basis, we expect GDP growth of emerging countries to outpace that of developed markets over the long term, providing a relatively favorable long-term backdrop for emerging-markets equity returns. The recent flattening of globalization trends could reduce the correlation between U.S. and international equities from such elevated levels, a secular shift that would likely provide greater diversification benefits for non-U.S. equities within a global portfolio.

Fixed income: Falling yields, narrowing spreads supported returns

Most fixed-income categories posted low single-digit positive returns this quarter. Long bonds were the strongest-performing category, benefiting from a drop in long-term yields, while most credit-sensitive categories enjoyed a boost from the continued narrowing in credit spreads. Treasury Inflation-Protected Securities (TIPS) were the worst performer because market expectations for inflation waned. Despite a fourth policy rate hike from the Fed in Q2, bond yields moved even lower across categories the past 3 months. Yields remain extremely low relative to history, with high-yield corporate bonds approaching all-time lows. Credit spreads also compressed further for most categories, making all sectors expensive relative to their own histories.

Investment-grade bonds—the most interest rate-sensitive bond category—have historically offered better downside protection than stocks, even when rates were rising. During the 4 decades of rising rates from 1941 to 1981, high-quality investment-grade bonds provided positive nominal returns as increasing coupons helped offset the negative impact of price declines.

Most leveraged loans in recent years have included a LIBOR floor provision to ensure a minimum rate paid to investors. During Q2, 3-month LIBOR continued to rise above the average floor for the first time in several years, thereby allowing the variable-rate feature to provide an upward coupon adjustment if short-term interest rates continue to rise.

Fixed-income strategies with designated allocations in both high-quality bonds and higher-yielding sectors have exhibited consistent downside protection. The diversification offered by “core-plus” and “multi-sector” portfolios have helped generate fewer periods of negative returns than any individual bond sector, while providing a lower magnitude of losses than lower-quality sectors.

Asset allocation

Late cycles have the most mixed performance of any business-cycle phase, with more limited overall upside than mid-cycle phases. There is less confidence in stock performance, though stocks have typically outperformed bonds. Inflation-resistant assets, such as commodities, energy stocks, short-duration bonds, and TIPS, have typically performed relatively well.

Any inflation erodes the purchasing power of portfolios. In addition, stock and bond returns have historically experienced headwinds during periods of rising inflation. Further, when inflation has been higher and more volatile—as it was in the 1970s—the performance correlation between stocks and bonds increased, leaving inflation-resistant assets such as commodities as one of the few diversifiers for stocks during these periods.

Even though the performance of the major asset classes tends to deteriorate when inflation is rising, inflation-resistant asset classes—such as commodities, gold, commodity-producing equities, and short-duration bonds—have historically held up better in such environments. A strategic allocation to a basket of such assets may help investors manage the risk that inflation could be higher than anticipated over the long term.

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