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Market Comment - February 2017

Market Comment

The market rally continued into February with US equities, high yield and emerging markets continuing to power ahead. Treasuries sold off as expectations of a Fed move in March were raised. Markets were again highly focused on the promises by the new administration in the US and are factoring in significant growth. Economic data continued to show improvement in the economy with good employment, manufacturing and consumer confidence figures all leading to increased expectations of a rate hike.

The release of the January FOMC minutes showed that the committee remained split and there is uncertainty regarding the strength of the labour market. Unemployment numbers look strong but the number of people who have dropped out of the workforce has undermined this statistic as an indicator of inflation. The potential fiscal stimulus due to the impending policies of the new administration has also become a consideration and members believe that this could further stoke inflation. Certain FOMC members were keen to wait and observe how fiscal policy manifests itself in the data. Overall, the likelihood of a raise in March is high and continued strength in employment data should consolidate those chances. The Fed has taken a more hawkish tone.

Equity markets are pricing in significant improvements in growth, due to increased spending and reduced taxation. However, they may not be factoring the possibility of further rate rises this year. There is no strong evidence of inflation at the moment so the risk is that the reaction of markets is indicating higher inflation that triggers further rate rises than expected. It is surprising that a 75% expectation of a March rate hike has not significantly held back the equities market. Investors are buying the reflation concept but ignoring inflation for now.

If the Fed does have the risk appetite for a March hike and investors have already factored that in, then the bigger immediate threat may come from political events. The markets do not fully understand the legislative agenda and what the priorities are for congress and are looking for clues from Trump speeches. The likelihood of implementing the planned infrastructure spending and fiscal stimulus may be examined through the success in repealing or altering the Obamacare legislation, which is the first test for the new administration. Markets are looking to see what the priorities, agenda and timetable are to provide a lead on where to go next.

Despite the fact that we appear to be in a rising rate environment, longer term rates will likely be capped by a combination of the housing market, the strength of the recovery and demographic factors. A significant repricing of the longer end would put a break on the recovery fairly rapidly. The direction longer term rates take from here will be more affected by the success in implementing fiscal stimulus measures rather than the Fed.

Geopolitical tensions and the upcoming French and Dutch elections are simmering in the background. These events, or any weakening in economic data, may give a risk-averse Fed room to pause.