Financial markets in 2016 endured an escalation of negative interest rates, the collapse and subsequent rebound in commodity prices and fluctuating stock market valuations.
The test for investors began in week one, as fears of a China slowdown roiled stock indices weeks after the Federal Reserve began to normalise policy. Over the ensuing months, the Brexit vote and US election would prove significant mile markers, shift thinking and prompt broad repositionings.
Negative interest rates
The role of the central bank policymaker, the efficacy of quantitative easing and potency of negative interest rates were among the most hotly debated points this year. Bond-buying programmes pushed government borrowing costs lower and yields on nearly $14tn of debt traded below zero at one point this year.
Policymakers, keen to jump-start growth after the financial crisis, are now expected to cede some of their role to governments as investors ready for a departure from austerity.
Willem Buiter, an economist with Citi, characterised policy as “dysfunctional”. “The conduct of monetary policy has been poor at best and at times dismal.”
The inklings of inflation
As share prices slipped in the first quarter, concerns mounted that central bank policymakers would be unable to release the global economy from deflation’s vice. Nine months on, those worries have receded.
Commodity prices advanced and Donald Trump’s promise to boost government spending and cut taxes when he enters the Oval Office in January 2017 was seen as a reflationary catalyst. That has prompted a surge in so-called five-year, five-year forward swaps — a measure of the average inflation expectation over five years beginning in five years.
A hawkish Fed
Rising inflation expectations also refashioned projections for the Fed, as investors anticipate a faster tightening cycle to counter the prospect of a hotter economy and increasing consumer prices.
Interest rates implied by federal funds futures for 2019 have climbed nearly 1 percentage point since the election. The view diverged further after the Fed jolted markets in December as policymakers projected a faster than expected pace of rate rises next year.
Diverging monetary policies between the European Central Bank and Fed drove the difference or spread between yields on benchmark 10-year German and US notes to the widest level since 1989, the year the Berlin Wall fell.
Borrowing costs start to rise
The closely followed three-month Libor rate — a global floating interest rate benchmark that trillions of dollars of corporate loans, credit cards and derivatives contracts are tied to — neared 1 per cent for the first time since the US emerged from recession in 2009.
New rules affecting money market funds drove much of the increase throughout the year, despite the Fed’s target holding between 0.25 and 0.5 per cent until mid-December. The US central bank’s December rate rise provided an extra propellant in lifting Libor above its post-crisis lows.
The sector rotation
US banks were among the chief beneficiaries of higher Treasury yields and a steeper yield curve. Financials are expected to earn more money from lending as long-term fixed rates for loans and mortgages climb further above overnight and short-term borrowing costs. Banks are also seen gaining from an easier regulatory regime under the incoming Trump administration.
The S&P 500 banks index has gained 22 per cent since the election, putting the sector’s annual performance behind only the 24 per cent rally in energy shares.
Higher commodity prices provided the ballast for the US energy sector’s rebound, with Brent crude — the international oil benchmark — up more than 90 per cent from its February low.
But gains were spread across the commodity complex, with sugar, natural gas, soyabeans and copper all up by more than a tenth.
High yield energy outperforms
At crude’s nadir in February, roughly 24 per cent of the bonds in the iBoxx high yield index traded below 80 cents on the dollar, according to Goldman Sachs. That figure dropped below 5 per cent as commodity prices rebounded.
Bonds issued by risky high yield US energy companies were among the hardest hit as oil cratered. The subsequent rally has been mouth watering for those investors who bought at the lows in price. The debt has returned 38.5 per cent this year, far ahead of Treasuries and US stocks.
European banks whipsaw
European bank stocks enjoyed a powerful rally after a battering in the first half of the year, when news of looming legal penalties, negative interest rates, the UK’s Brexit vote and fears over the Italian banking sector sunk share prices.
The Euro Stoxx banks index has climbed 49 per cent from its low in the weeks after June’s Brexit referendum, including a 26 per cent gain in the fourth quarter. The rebound followed a broad market rally after the US election with sentiment improving as the value of negative yielding sovereign debt declined.
The pound plummets
The Brexit vote was an unforgiving weight on the British pound. Despite resilient economic data that showed activity in the country remained robust after the referendum, sterling tumbled nearly 17 per cent in 2016.
The currency briefly slid to a 31-year low of $1.18 against the US dollar during October’s flash crash.
The yen’s back-and-forth
The Japanese yen was among the hardest hit by the election of Mr Trump, reversing a nearly 10-month long period of strengthening. The drop to roughly ¥117 against the dollar has fuelled the country’s stock bourses and provided a bump to Japanese exporters.
China’s renminbi is set to suffer its greatest annual drop since authorities depegged it from the US dollar in 2005. The currency has weakened 6 per cent this year and investor scrutiny has intensified as the country’s foreign reserves near the $3tn level.
Mexican peso slumps
The ascent of Mr Trump provoked sharp movements across global markets in the immediate aftermath of election night. But in Mexico, swings in the country’s currency began long before the ballots had been counted.
Mr Trump’s antitrade rhetoric and promise to build a wall on the US-Mexico border weighed heavily on the peso — the world’s second-most traded emerging market currency — throughout the year. But on November 9, the peso suffered its greatest one-day fall since the Tequila Crisis of the 1990s.
Passive strategies narrow the gap
Actively managed funds suffered a bruising 2016, as investors shifted further into passive strategies that track an index. Assets managed under a passive strategy surpassed $5tn for the first time on record. Active funds counted more than $358bn of outflows this year by contrast, with assets hovering below $10tn. A report from S&P Global added salt to the wound: nine out of 10 US equity funds failed to beat their benchmark in the year to June 30.
Additional reporting by Adam Samson