January 2017 - A Brave New Market
Updated: Jul 10, 2018
The investment landscape greeting investors in 2017 stands in stark contrast to the one that existed one year ago. As we entered 2016, financial markets were beset by severe deflationary fears surrounding a slowdown in China’s growth, collapsing commodity prices, tightening financial conditions and the prospect of a U.S. recession. Fast forward twelve months and the world looks much different. Oil prices are nearly 60% higher than they were a year ago, bond yields have bottomed and inflation expectations globally are rising. Deflationary fears have given rise to reflationary hopes.
This new market regime is characterized by higher growth, higher rates and higher inflation, all of which should benefit risk assets over the course of the next year. Our macroeconomic views and recommendations across asset classes and geographies are detailed in our 2017 Investment Outlook entitled A Brave New Market, which will be released later this month. Our core thesis is that global growth, which stabilized in 2016, is likely to improve further into 2017, on the back of stronger U.S. growth, continued resiliency in the eurozone expansion and a further recovery in emerging markets amid U.S. Dollar strength and rising rates. The regime shifts currently underway are the result of a number of cross-currents which occurred this year, all of which served to support the reflationary dynamic. The stabilization in China’s growth stands paramount, given its outsized role in the global economy accounting for 50% of global growth. Expansionary fiscal and monetary policy, including a near 20% rise in credit expansion, helped cushion China’s growth slowdown as policymakers prioritized stabilization measures against longer-term fiscal reforms.
While these policies are unsustainable in the long run, we believe China’s authorities will ultimately be willing to accept a lower level of growth so long as the transition to a more services-oriented economy does not upset China’s social equilibrium and is carefully managed. The policies implemented this past year helped end a nearly-five year period of producer price deflation in China and contributed to the massive gains seen across iron ore (81%) and steel (60%).
The transition from monetary to fiscal policy has further fuelled the reflationary theme. Central bankers and investors alike are increasingly aware of the limits and collateral effects of quantitative easing. This recognition resulted in the Bank of Japan’s September 21 announcement that it would peg 10-year rates on the sovereign part of the curve at 0% as opposed to mechanical balance sheet expansion given concerns over declining bank profitability and the pursuit of a steeper yield curve.
A similar policy approach was contained in the European Central Bank’s December 8 decision to extend, but scale back, its asset purchase program beginning in April 2017 which has also resulted in a steeper yield curve. Going forward, we expect central bankers to be far more discriminating in the tools they employ to achieve their objectives with greater concern for second-order effects.
Meanwhile, the Federal Reserve is on track to raise rates three times this year to 1.25% according to their own estimates. 2017 is likely to be the first year since the Great Financial Crisis in which there is no major monetary easing from the world’s systemically important central banks.
As a result, the baton is passing to fiscal policy. Over the last eight years, monetary policy has been the only game in town to support growth and cushion against market shocks. Under this new regime, both policymakers as well as voters are encouraging the transition to fiscal policy.
The rise of populist political movements, including the UK decision to exit the European Union as well as the victory of Donald Trump, attests to this fact. Constituents are demanding that governments do more to narrow income gaps, increase spending and compensate for the last eight years in which investors saw outsized gains versus savers. In announcements alone, Japan, Canada, and Korea have already signalled their intention to increase government spending in 2017. We believe there is more to come.
The election of Donald Trump has accelerated the reflationary theme given his proposals for fiscal expansion including corporate tax cuts, infrastructure spending, and the repatriation of U.S. overseas profits. While policy uncertainty remains high, this would have a stimulative effect on the U.S. economy and helps explain the 60 basis point rise in yields on the U.S. 10-year Treasury bond since his election as well as the 5.2% rise in the U.S. Dollar on a trade-weighted basis.
What does all of this mean for our asset allocation going into 2017? A stronger backdrop of real economic growth will benefit risk assets and underpins our preference for equities over fixed income and credit over sovereign debt. The global earnings recession came to a close in the third quarter of 2016 and we expect high single digit earnings growth across equity markets for 2017.
Selectivity remains critical. While growth in the U.S. remains strong, equity valuations are less favorable while a strong U.S. Dollar poses risks. Weaker currencies in the eurozone and Japan, along with still-highly accommodative monetary policy and more attractive valuations will lead to outperformance in our estimation. Within emerging markets, we remain cautious given the risks associated with Trump’s restrictive trade proposals and U.S Dollar strength and prefer the Asian region given stronger growth, inflation which remains under control and economic reforms.
Notwithstanding higher government bond yields, credit remains an attractive asset class. A variety of structural forces including ageing demographics, the deflationary influence of technology and weak productivity trends will cap the extent to which rates can rise. This will keep the search-for-yield dynamic alive especially among institutional investors across Europe and Japan. The stabilization in commodity prices has created an inflection point in default rates in the U.S. which will trend lower in 2017 and support high-yield.
The reflationary theme will support risk assets in 2017 though we remain prepared for continued bouts of volatility. Europe has a jampacked political calendar including elections in Germany, the Netherlands, and France. In the U.S., policy uncertainty remains high and we await more clarity on issues related to tax reform and trade policy. Meanwhile, the process of interest rate normalization in the U.S. will generate additional volatility as the Fed responds to higher inflation.
The interplay of these market drivers should give rise to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation in credit. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.