Synchronized global growth, improving corporate earnings, benign inflation, and positive economic surprises have contributed to the solid performance of U.S. equities in 2017. Earnings growth has been the driver of stock appreciation in 2017. Potential economic outcomes from the Trump administration’s policies, if effectively implemented, could boost U.S. economic growth, but the impact of Washington’s partisan conflicts and the Federal Reserve’s unwinding of its bloated balance sheet are unknown.
Increases in the target fed funds rate have continued to move short-term yields higher, while the modest reduction of stimulus has partially relieved fears of rising inflation, resulting in modestly lower longer-term yields. The taxable bonds yield curve has flattened with a historically steep position, and we expect it to assume a naturally flatter shape as the Fed continues to normalize monetary policy. As a result of the Fed’s implementation of balance sheet reduction, we expect spreads to increase modestly on current coupon mortgages and, coupled with the anticipated rise in interest rates, could lead to meaningful increases in mortgage rates.
The AAA tax-exempt municipal bond yield curve flattened during the second quarter due primarily to sizable yield declines across the middle and the long end of the curve. Meanwhile, yields rose slightly on maturities of two years and less. All durations of municipal bond indices posted a second consecutive quarter of positive returns, with longer maturities performing best for the period. All investment-grade municipal bond index returns continued to be positive on the year. Bonds with A and/or BBB ratings have generally outperformed more highly rated bonds.
In Europe, Brexit-related uncertainty, the Italian general election, and the eventual moderation of accommodative monetary policy remain key issues, but Euro Area economic data has consistently surprised to the upside in 2017. Business activity and consumer confidence measure are near historically high levels, with domestic demand continuing to be the driver of incremental growth. Employment conditions are improving, yet economic momentum is starting to show signs of moderation.