In today’s Capital & Conflict… 14 forecasts… a bond market nightmare… time to look at the banks… China’s new export… a buying signal for emerging markets… protectionism… Trump… inflation… and more.
Last week Goldman Sachs released a research note to its clients with its key themes and outlook for 2017.
The short version is that Goldman expects Donald Trump to be the “inflation president”, returns next year will likely be slightly higher than this year and so will risks.
You can find the note online easily enough. But today I thought I’d share our own version of the idea – a sweeping look at what you can expect to see across the world next year. To do that, I asked Eoin Treacy – our in-house technology and trading expert. Eoin has come up with a series of forecasts for next year, looking at everything from which markets to look at next year, to what’s next for the dollar, yen, pound and euro, which markets to avoid, and why it’s time to look at the banks and resource stocks.
It’s a detailed analysis, so I won’t keep you too long here. But when you’re done, I would like to know what you think. Where is Eoin right and wrong? What key trends do you think will shape the world economy next year? Write to me at [email protected].
I’ll hand you over to Eoin…
Best,
Nick O’Connor
Associate Publisher, Capital & Conflict
14 forecasts for 2017
Before thinking on what 2017 holds, let’s first take a step back and think about where we are in the economic cycle.
The last recession was a deep one but it ended in early 2009, which will be eight years ago in March 2017. The monetary response to that recession was epic in proportion and lengthier than just about anyone expected. By and large, the political response was to adopt some form of fiscal tightening in order to contain runaway deficits and pay down some of the debt. That’s as true of Europe as it is of the US.
The US has come out of the crisis in better shape than either Europe or Japan because it forced banks to write down debts; it endured a sweeping foreclosure process in residential property; and the Federal Reserve was much more proactive than other central banks in using the monetary tools at its disposal. The result was that central bank debt ballooned but the wider economy was able to get back on a modest growth footing.
The problem has been that the growth achieved from quantitative easing (QE), primarily that tied to higher asset prices, has been decidedly lopsided. Those who already had assets, benefited from a substantial wealth effect; meanwhile those with few assets saw the cost of living rise as health, education and insurance costs soared, with the net result that living standards fell. That has translated into a belief, not quite without foundation, that the economic system is heavily skewed towards the haves, and that the have nots are being exploited and neglected in equal measure.
Brexit, Donald Trump’s electoral success and the potential success of eurosceptic parities in upcoming 2017 eurozone elections are all symptoms of the situation that has built up since 2008 – where risk takers have continued to be rewarded even though it was their specific risk-taking that led to the crisis in the first place, while everyone else is paying higher taxes for fewer benefits.
So what can we expect in the coming year? And where should your money be to take advantage? Here are my 14 forecasts.
Government stimulus is back
Prior to the US presidential election there was growing acceptance that monetary stimulus just does not generate broad-based growth. The experiment with negative rates has been a disaster for the financial sector and central banks are looking for ways to reverse it without losing face.
That alone makes the case for fiscal stimulus more compelling because it is more broad based by definition. If a Trump administration does indeed succeed in introducing a $1 trillion fiscal stimulus, it is reasonable to expect that the eurozone will follow suit. It will be even more likely in Europe if eurosceptic parties continue to gain power because it is the only solution that can hold the eurozone together.
Inflation dead ahead
However, fiscal stimulus usually comes at the beginning of an economic expansion… not after an eight-year bull market. The US is pretty close to full employment, even if we account for the fact that labour force participation is low by historical standards. Meanwhile, wages have broken out on the upside. A large fiscal stimulus against that background is inflationary by any definition.
Generally speaking, inflation is good for stocks and property because they both have the potential to raise prices or rents and therefore act as pretty good hedges. Bonds with fixed coupons are more exposed to higher rates than just about any other asset class.
I believe we are moving into a period when inflation surprises on the upside. That’s an easy forecast because the received wisdom is that discount rates will stay close to zero indefinitely. Even a small move would be a surprise to many investors.
A measure of just how ingrained that view is can be found in the US yield curve. Even after a substantial sell off since the US presidential election outcome, it is still only pricing in one 25 basis point rate hike within 12 months.
2017: bond market nightmare
Considering the Fed is highly likely to raise in December, that suggests a high degree of complacency in the bond market. One big prediction from me for 2017 is that bond yields will surprise on the upside and that bond funds generally will be among the worst performing asset classes for the year (with the exception of those focusing on floating rates and inflation-protected strategies).
The bull market in stocks continues…
The flip side of that is the earnings recession, which has acted as headwind for corporate profits over the last two years. This is probably close to ending because inflation is picking up. Companies always use inflation as a justification for raising prices. Therefore, if we are moving into a period where inflation surprises on the upside, it is reasonable to expect corporate profits to do the same. That suggests the breakouts on Wall Street to new all-time highs are likely to be sustained.
Psychological mania
In my book Crowd Money, and at The Chart Seminar, I talk about the psychological perception stages of major bull and bear markets. This is a major bull market and it is looking increasingly likely we are moving from the second and into the third stage; characterised by mania.
Look to resource stocks, banks and infrastructure
However this is not evenly distributed throughout the market. There are substantial segments that are overvalued, have already done incredibly well and are unlikely to lead in this segment. There are others such as the resources, banking and engineering/infrastructure sectors that are only just getting out of the starting blocks. They have enormous potential to engage in catch-up moves as the bullish factors associated with fiscal stimulus play out.
US to outperform
The fact that the US is in a better position overall than other markets, and is farther down the road to recovering from the worst credit crisis recession in recent history, is putting upward pressure on the US dollar. That alone makes the US a more attractive investment destination, because you get the benefit of both capital market and currency appreciation.
Watch emerging market currencies
The flip side is that it represents a challenge for emerging markets where US dollar-denominated debt has been popular over the last decade. With US interest rates set to rise, the additional spread demanded by global investors to invest in emerging markets will be higher and that is now being priced in.
Once complete, the improved competitiveness of emerging markets, coupled with the prospect of increasing demand for exports from developed markets, should be a catalyst for a return to outperformance. Therefore, emerging market currencies are going to be important to monitor in 2017 for signs they are finding support or that central banks are willing to defend them.
Protectionism: all talk and no action?
Protectionism is a double-edged sword for countries like the US, considering how much its corporations rely on international trade. In addition, it is not easy to withdraw from trade pacts that took years to negotiate. It is reasonable to assume that campaign rhetoric is unlikely to have an outsized impact on trade overall, but there are likely to be specific examples where one company or another is affected.
Donald Trump may claim he’ll withdraw from the Trans-Pacific Partnership (TPP). But remember, this is a deal that’s been agreed but not ratified by individual nations yet. It’s easier to withdraw from for that reason. It could be a symbolic move rather than the start of a trend.
Trump could be good news for the banks
Deregulation, coupled with higher interest rates, is very bullish for the banking sector. High rates improve margins and deregulation opens up additional business lines. From an investor’s perspective, the reason so many people owned bank shares before the credit crisis was because they were such reliable dividend payers. With improved prospects they may now be in a position to begin increasing their dividends again, which in an inflationary environment is highly attractive.
Political instability in Europe: fiscal expansion, euro down; stocks up
With so much dissatisfaction with the current status quo in the eurozone and the prospect of electoral upsets in Italy, France, the Netherlands, Hungary and even potentially Germany, the potential for fiscal tightening to be abandoned has to be considered.
In fact I believe it is likely to become central to any solution if a eurosceptic government is installed in a large eurozone country. Giving people an opportunity to improve their living standards is the only way the eurozone is going to be held together. If fiscal stimulus is the root to achieving that, then european equities will stage a recovery while the euro will likely move down to around 80¢ against the dollar.
Japan: 2012 all over again
Japan announced six weeks ago that it is going to buy as many bonds as is necessary to defend the 0% level on its government bonds. That is analogous to unlimited QE even as it tries to step back from negative interest rates. We are being set up for a re-run of the 2012 nominal jump in Japanese equities if the dollar holds its move above ÂĄ108.
If China can export deflation, it can export inflation
A lot of commentary has focused on the fall in the Chinese renminbi of late, but it has been trending lower for more than two years.
The simple fact is that China needs a weak currency to stimulate its manufacturing sector while it attempts to rationalise its outsized industrial sector, which is the primary reason for the thick smog blanketing half the country for most of the year.
Much more important is that producer prices have been rallying all year and broke out to new highs in October. In very simple terms, if China could export deflation, it can certainly export inflation. Additionally, economic growth should pick up along with inflation in China just as it is expected to do in the US.
Tech innovation continues to accelerate
We have been through a period of synchronised monetary expansion and there is a very real prospect that synchronised fiscal expansion will play an important role next year. I generally write about technology rather than dividends, but it is worth pointing out that growth is another strategy that does well during inflationary cycles. Companies can often grow much faster than inflation, and debt tends to be less of a burden as inflation picks up.
Technological innovation continues to accelerate. Even the energy density of batteries is doubling every 5.3 years (14% per annum), while electric car ownership is doubling almost every year. Solar efficiency is rapidly evolving as well, while healthcare and genetics are incredibly exciting and innovating at an exponential rate. Higher rates generally make it somewhat harder for startups to attract funding but those that do are generally of a higher quality, which should make my job of picking winners easier.
Category: Economics