Our positive economic outlook for 2016 was pretty much correct and, at the end of the year, it looks as if markets reflected that growth with almost all major equity indices in positive territory.
The healthy economic growth of the UK and the US translated to the stockmarkets, outperforming the slightly more sluggish Europe and Japan. By the numbers, 2016 seems to have been something of a conventional year.
However, you would be hard-pressed to find anyone, inside or outside of financial markets, who’d agree with 2016 being ‘conventional’. The prevailing theme was the rejection of the status quo in almost all popular votes. A secondary impact is that being that ‘opinion pollster’ might not be the best thing to have on your CV.
In addition to Brexit and the rise of President Trump, we also saw a bank bailout in Italy, a second interest rate rise from the Federal Reserve, the return of Iran to polite global society, and new all-time highs reached in the Dow Jones and S&P 500 equity indices.
Almost all reviews of the year are looking to paint 2016 as a kind of turning point – for capitalism, for globalisation, for fixed income – the list goes on. In reality, it will be decades before anyone can even start to work out whether that is the case or not.
So rather than try to extrapolate the last year into a long term change in our world view, we will concentrate on the next twelve months – both the upcoming events and their possible interpretation by the financial markets.
2017 – Expecting the unexpected
- Global economic growth is healthy. Now people need to start believing in it! Years of emergency monetary policy have left confidence near all-time lows, with any positive news being dismissed as artificially induced. We feel that there are enough widespread positives for the expansion to continue, even in a rising rate environment…
- …but sentiment is still fragile. Investors are desperate to believe in a surging US consumer, but any evidence to the contrary could see violent market moves. It is almost a given that there will be one or two anomalous data points that see temporary doubt creep in – a weak jobs number, or a decline in house prices – something that will be taken badly with markets near all-time highs.
- The backlash against globalisation seen in 2016 will have repercussions in 2017. While trade agreements are clearly at risk, it is the extension of similar policies to non-economic relations that is most worrying. A decline in the influence of conglomerate bodies such as the UN or NATO would give markets pause.
- In any given year, there are going to be wildcards – unexpected events that disrupt the perceived order of things. For 2017 though, surprise is the consensus. The political turmoil in 2016 has prepared the ground. There are thousands of different ideas of what these wildcards could be, but everyone is now basically waiting to be surprised. Does that mean the markets will be less, or more reactive? Our view is that while very short term volatility might increase, it will be more important than ever to look through to something approaching a sensible investment horizon.
Looking in more detail at the various regions:
Domestically – lots of talking, far less walking. A common analogy used to describe calm but effective people is that of a swan – serene on top, but lots of work going on under the surface. For Donald Trump’s presidency, an upside-down duck might be more appropriate (or a tortoise on its back) – lots of action, with very little achievement – at least in the sense of genuine policy being implemented.
Overseas – talking may be enough. In a legislative sense, the President has more immediate control over US foreign policy than he does in domestic. Yet, given that much of international relationship management is conducted through the media, even that legal power may not be needed. As President-elect, Donald Trump’s public statements have been… less than judicious. As President, some of the same statements may be more difficult for foreign nations to ignore. There is a worrying possibility that in 2017 one man’s Twitter feed will frame the global agenda.
Boringly stable growth. The US economy has been growing at an average of 2% a year since 2010. While there are doom-and-gloom predictions out there, most of 2017’s growth will be dictated by the forces that have carried over from 2016. That means lower unemployment, higher wages and higher consumer spending.
Inflation moves above the Federal Reserve target. If the oil price remains around US$50 a barrel, the mathematical impact will be to push inflation up throughout the first three months of 2017. Add into the mix the benign growth environment mentioned above and suddenly the Fed target of 2% looks likely to be breached to the upside for the first time in two years. This should lead to the rate-hiking cycle beginning in earnest.
US Treasuries under pressure. With both inflation and interest rates rising, US Treasury yields are likely to join the club. In theory, this should be a gradual, gentle rise as the data continues to be positive. In reality, we expect sharp sell-offs, followed by periods of drift. It is likely to be the unexpected volatility of the bond markets that drives cautious investors to cash.
More populist portmanteaus. A portmanteau is "a word blending the sounds and combining the meanings of two others" and is seemingly what Europe focuses on most when facing existential crisis – Brexit and Grexit being the most obvious examples. In 2017 Germany, France and the Netherlands all have general elections, all with candidates that have gained ground in recent months on anti-European Union (EU) platforms. With most media outlets looking to build a narrative of popular discontent sweeping the Western world, expect more linguistic mangling to come.
No break-up of the Eurozone. Anti-EU parties will do well this year, and as we saw with UKIP in the UK, although outright victory is not necessary to cause dramatic change. Yet we do not believe that the Eurozone will split up in 2017. On the continent, there is greater popular support for the European project than in Britain and populist victories are more likely to provoke change within the structures of the Eurozone, rather than an exit from them.
Fiscal stimulus. A simple change in Eurozone policy would be to loosen fiscal deficit targets, allowing more borrowing (at ultra-low rates). Enough political turmoil could lead Eurozone authorities to acknowledge that this is the least ugly of their options, allowing pressured governments to buy off unhappy voters with increased spending or lower taxes.
(Also) boringly stable growth. It has been easy to miss the fact that Eurozone growth has been improving for three years now. Europe remains some years behind the US in terms of recovery from the crisis, but the trend is upwards. Quantitative easing, despite skepticism, looks to have been a success at buying time for the financial system to stabilise and genuine growth shoots are coming through. We expect to
see another year of expansion at around 1.5%.
No deflation and no tapering. The ECB has shown its willingness to keep the taps firmly open in a bid to restore inflation to the economy, regardless of pressure from German economists to tighten policy. With asset purchases in the pipeline until at least September 2017, we have no expectation of materially tighter policy in the Eurozone.
A winner in a Trump trade war? For some reason, Donald Trump does not seem to be targeting Japan in his trade renegotiating rhetoric. It may be because he believes the US won that particular trade war at the end of the 1980s, and therefore there is nothing left to be proved. Regardless, it seems that Japanese exporters would be relatively immune from a trade ‘war’ – despite the Yen weakening once more.
Weaker Yen. For many Japanese investors, the rise in US bond yields has prompted a shift from Yen based assets to US Dollars. In fact Japan has recently overtaken China once more as the largest owner of US Government bonds. Should this capital flight continue, we would expect to see the Yen continue to depreciate throughout 2017.
Economic growth sluggish but positive. Once again, Japanese economic growth is likely to underwhelm relative to the rest of the developed world, although the weaker Yen should help. However, even coming in at 1% economic expansion would be in line with the 10-year average.
Abe needs to produce something special. Should Prime Minister Abe wish to be at the 2020 Olympics (as PM rather than in a Super Mario costume), he will need to change his internal party rules to allow him to lead for a third term. However, polls show that a majority of the Japanese people would not support such a move. Although Japan is historically less likely to see the kind of populism seen elsewhere in the world, without a dramatic policy announcement sometime this year, Abe could well finish 2017 with a political battle on his hands.
(Last year’s headings look like they could fit 2017 just as well: Steady state economy; Brexit becomes a word we’re sick of hearing; Bank of England doesn’t raise interest rates; House prices to go sideways…)
Article 50 is triggered… Second-guessing explicit government policy is tempting, but it seems most sensible to assume that Theresa May will stick to a declared date. Why run the risk of being called incompetent?
…but will Brexit mean Brexit? And what does that phrase actually mean?! With Article 50 triggered, the main focus for 2017 will be on the negotiations. Unfortunately, trade negotiations take place behind closed doors, so there will be a large amount of supposition and guesswork on the part of the media. Very little of this will give any real guidance as to how Britain’s relationship with the EU will look once the two year exit period has elapsed. Our best guess is that once discussions actually begin, business interests will begin to form pressure groups – similar to lobbyists in the US. The finance sector will need to find a spokesperson who can be trusted by both the UK government, and the UK public. We’ll happily put forward our very own Justin Urquhart Stewart.
Inflation certain, at least on a temporary basis. For three years inflation has been well below the Bank of England’s 2% target. This is something unlikely to be the case in 2017. Over the long term, currency movements do not affect inflation. However, on a year-on-year basis, the 15% fall in Sterling’s value since 23 June is going to be important. As most producers hedge their prices at least six months out, the first half of 2017 is likely to see Consumer Price Index (CPI) Inflation continue to rise.
Growth dependent on consumer confidence. In a service-led economy like the UK, most economic sins can be paid for as long as the man in the street continues to feel good about life. Around half the country are demoralised by Brexit, but remember that just over half of the UK have had their wish granted! Consumer confidence is hardly an exact science, but there is a decent chance that Brexit should be neutral for sentiment overall. If this proves to be the case, then GDP growth should surprise to the upside in 2017. This is admittedly not a huge feat given current expectations of 1.2%.
China internally stable, externally less so. The Politburo Standing Committee is responsible for most of Chinese government policy – and in autumn 2017 will undergo a reshuffle. With President Xi keen to maintain stability ahead of this change, economic bad news will not be allowed to disrupt events: bad loans will be rolled over; equity markets will remain supported by government funds; and economic growth targets will be hit on the nose. President Xi may also be thankful for the fuss caused by the incoming US President. Any political discontent in China can be easily channelled abroad, fostering a sense of national identity which is coming under threat from Donald Trump.
China unites Asia? A move towards regionalisation around Chinese leadership is feasible. China is already looking to increase regional unity under its One Belt, One Road policy. Pitched in the right way, this process could be accelerated if it is seen as a way of combatting anti-Asia US policies. For Taiwan and South Korea, this means choosing between a rock and a hard place: protecting growth at the expense of joining an age-old enemy.
India immune from Trump. We believe that India is well positioned to continue its strong growth. India’s economy is service led, particularly focused on information technology. This is not a sector that Donald Trump has paid much attention to, perhaps because there are very few disenfranchised American IT workers claiming that Indians have taken their jobs. If there are some, they lack the unionised punch of the auto or steel industries. India, therefore, should be able to function reasonably freely, allowing the positive domestic story to play out.
Mexico to suffer, but then rebound. Will Mexican equities be one of the top performers in 2017? This one might seem a bit unlikely, but eventually Pesos will be cheap enough for investors to start becoming interested. Any sign of conciliation from Donald Trump would also help improve sentiment.
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This document has been produced by Seven Investment Management from internal and external data. You should not rely on it as investment advice or act upon it and should address any questions to your investment adviser. The value of investments can vary and you may get back less than you invested.