Growth remained disappointing in many countries, but there were some initial indications of an upturn in commodity prices and US wages as well as confirmation of a US rate hike. Globalisation had been a fundamental trend for 20 years but appeared to be losing some steam in 2016. Last year suggests we should be humble about making forecasts for 2017 which will be another year of elections.
Double-sided risks are emerging. Some risks like political events or oil prices could turn into opportunities while key anchors in recent years, and interest rates in particular, could become risks. This new situation has disrupted portfolio construction. In 2017, investors will need to be agile, go for convexity and prove highly selective; the stock market year has already started judging from the rapid gains chalked up by indices in the last weeks of 2016. Far from representing an impossible hurdle, this acceleration phase is clearly not yet over.
Market Outlook 2017
Interview with Philippe Uzan, Chief Investment Officer
US: sharply higher nominal growth
Since 2009, the US has seen real growth rates of 2.1% a year, or less than in previous cycles. Donald Trump is openly intending to trigger a jump in economic activity, mainly through fiscal reform, infrastructure projects and government spending. But Republican control of Congress does not necessarily mean these measures will actually be adopted. The Grand Old Party is still a bastion of fiscal conservatism.
The US bid farewell to disinflation in the summer of 2016
For the time being, a sharp rise in real growth is just an assumption but nominal growth rates are almost certain as prices flirt with the Fed’s 2% target. The US bid farewell to disinflation in the summer of 2016. That is why the Fed decided on a quarter point rise in Fed funds last December, the second rise since December 2015, and explicitly referred to inflationary anticipations and the strong jobs market.
The context has changed, first because of commodity price trends. Since the summer of 2014, they had seen annual falls but are now rising. And the turnaround at the base level will drive price rises at least in the first months of 2017. US unemployment is running at 4.7% but full employment has no doubt not yet been reached. This is because people who have given up looking for a job –some 600,000- and the 5.7 million workers on part-time contracts who would like to be full-time, are not included in the calculation. And yet wages are already accelerating. According to the Atlanta Fed’s calculation, November’s median hourly wage increased by close to 4% over a year, or higher than the official figure of 2.9%. In fact, many sectors are seeing tension on starting salaries.
The US bid farewell to disinflation in the summer of 2016
Wage costs represent 70% of company expenditure. Barring productivity gains, companies will seek to protect margins by passing on wage rises to prices.
For the Fed, it is vital to move towards monetary normalisation. The move should be gradual but the new administration’s fiscal stimulus approach could encourage the Fed to be more responsive. So far, however, it has been very cautious and higher interest rates do not yet look likely to present a serious risk for the cycle. 2017 should be another year of growth.
Europe is improving but still needs support
Six months after the Brexit shock, growth in Europe and the UK has been remarkably resilient. True, France and Italy have not yet seen a genuine upswing but other countries have enjoyed very encouraging results. There were doubts over Germany in 2015 but 2016 was a year of vigorous growth and the picture in Spain, Ireland and the Netherlands was similar. All these countries have seen higher wages, lower unemployment, rising household confidence levels and robust domestic demand.
Europe, too, should enjoy faster nominal growth, mainly thanks to rising producer prices. The deflation debate is over and nobody, including the ECB, is arguing in favour of austerity. Quite the opposite: even Germany, along with the Netherlands, will be stimulating the economy with limited but still concrete fiscal measures.
However, it is still too early for normalisation and the ECB has extended its bond-buying programme to the end of 2017 even if it has reduced monthly purchases from EUR 80 to 60bn. The bank has said it stands ready to do more if necessary.
The economic horizon is now clearer but 2017 will be a very busy year for elections
The economic horizon is now clearer but 2017 will be a very busy year for elections. France will elect a new president in April/May, the Netherlands will hold parliamentary elections in March and Germany will follow suit in the autumn. Italy, too, will probably go to the polls again. Companies and international investors could be put off by this electoral uncertainty, not to mention the difficulties of organising Brexit.
The emerging zone is more contrasted than ever
Emerging economies will contribute to nominal growth rates. Following the steep drop in oil prices in 2015-16, we will have to wait a few months to see the possible effects of the agreement reached by OPEC in November.
Growth momentum in the zone is rather weak and China, the main source of growth, has become marginal. In the US, shale oil production could recover after a big fall. Costs have shrunk and producers can already turn a profit with oil at USD 50.
Each commodity-producing country is a special case but all are struggling with the same difficulties and some have made the situation worse with mismanagement. The worst seems to be over but the outlook is uncertain and China’s economic transition model will force radical change on its suppliers.
Mexico, India, Vietnam and the Philippines all saw strong growth in 2016 but for different reasons. A moderate rise in commodity prices will not hurt them. But all emerging countries will suffer from the effects of the rising US dollar on the cost of their debt.
China: vulnerable because of debt levels
Given the 2015 stock market crash, China’s success in stabilising its economy was probably the most remarkable event in 2016. The shift to services and domestic consumption is continuing at the expense of investment and exports. Services now represent more than half of China’s GDP and are growing by more than 8% a year.
This transition is impacting commodity and energy imports. China’s move towards renewable sources - it is one of the biggest global players in solar and wind energy - is also having an impact on global energy markets. China is emerging from disinflation and industrial prices have stabilised after a long decline. Overcapacity in steel and coal is being reduced and companies, often state-held concerns, are seeing operating results improve.
But debt levels, estimated at more than 250% of GDP and still growing, are a potential source of financial instability. The most fragile area is among government-owned industrial groups and local authorities which have excessively high financial commitments and dwindling resources. Nevertheless, the state sector should have the means to service its debt in 2017. In a politically sensitive year, the government will be doing its best to ensure stability.
This all means that global financial stability will be tested throughout the year. Recent elections have shown how dissatisfied voters are with politicians for failing to provide the expected solutions. Hostility to globalisation goes hand in hand with this resentment. And even central bank action has come under serious fire.
Once again in 2017, successful active investing will mean integrating risks so as to turn some of them into investment opportunities.
The market outlook for 2017
2017 will not be plain sailing. It will instead be littered with bouts of volatility, mainly due to short-term economic and inflationary trends in major zones, as well as a crowded political agenda.
"Changing perceptions on inflation represent a powerful catalyst for a new market dynamic."
Equity markets: the rise will continue
In recent months, financial markets have risen sharply with very strong rotation into cyclicals, financials and value plays. But some major themes have only made up a little of the ground lost.
Changing perceptions on inflation represent a powerful catalyst for a new market dynamic on the US market while the expected shift in the yield curve has triggered an investment style rotation.
Now that the uncertainty has lifted, markets can once again focus on valuation levels and fundamentals. This should help some segments cash in on the new US administration’s bias towards deregulation.
For example, the halt to regulatory projects will be good for bank stocks and life assurance plays. Investors are effectively betting on Trump following through on his campaign pledge to water down the DoddFrank regulations that were introduced after the 2008 crisis. And financials should also benefit from rising interest rates as the new president’s economic policy is resolutely pro-growth and inflationary.
We can also expect companies with a domestic focus to gain from reduced taxation and infrastructure plays should also do well. This new environment will also favour makers of industrial equipment like oil pipelines and construction companies like Caterpillar.
Elsewhere, healthcare, a non-cyclical sector, enjoys strong visibility, especially as concerns earnings growth. It is trading at undemanding valuations and has an attractive risk/return profile. With Hillary Clinton’s defeat, the risk of increased pressure on drug prices has abated and there should now be fewer curbs on mergers and acquisitions.
Europe offers good fundamentals and significant catch-up potential. As new governments take office, equity markets should benefit from a recovery in investment and the introduction, and possible reinforcement, of structural reforms. We can also expect to see less austerity.
The pursuit of tax-cutting policies will provide powerful support to companies, most of which are in good health. Earnings growth in Europe, the real market driver, could even outpace US companies. Meanwhile, reflation could trigger some price rises and result in higher sales. And the improving jobs markets should also underpin consumer spending.
The M&A theme will be one of the main catalysts if the market rally is to continue.
“Old Europe” has been seriously lagging as far as stock market performance and fund flows are concerned
After a few months of wait-and see following Brexit, deal-making should resume. The low euro is whetting the appetite of US companies for European targets. “Old Europe” has been seriously lagging as far as stock market performance and fund flows are concerned. Although valuations are attractive, it is interesting to note that foreign investors are still very wary of the zone, probably because of the busy political agenda in 2017. But once some of these elections are over, international investors could once again start to look more closely at Europe’s advantages.
As for emerging country markets, we should be rather cautious because of the rise in the US dollar and interest rates. Outflows resumed after Donald Trump won the White House race. The current improvement in the global manufacturing cycle is also good news for most emerging countries but we should be wary of companies shouldering heavy US dollar-denominated debt. The downward pressure on some currencies should also continue.
Bond markets: reducing interest rate sensitivity
Against the backdrop of sharply higher US yields, investors are wondering how to manage their bond investments. Passive investing is no longer enough as maintaining yield and balance in portfolios has become a particularly difficult exercise. But some asset classes offer attractive characteristics.
Our preferred theme is subordinated financial debt. The regulatory environment will provide support up to at least 2020. And banks and insurance companies should benefit from the end of falling long bond yields. Financial debt also offers good liquidity while recent solutions for problems facing Deutsche Bank and the Italian banking sector have reduced systemic risk in the sector.
We are also very keen on European high yield bonds. The financial ratios of issuing companies are still healthy and we expect the default rate to stay low in 2017 at below 2%. The segment will also benefit from improving economic fundamentals and indirect support from the ECB.
Elsewhere, emerging country debt offers a useful way of diversifying bond investments. This is an area which requires a flexible and opportunistic approach as well as a selection of contrarian positions. Investors need to embrace selectivity and idiosyncratic risk if they want to tap into emerging country debt’s opportunities.
Lastly, convertible bonds can be used to diversify an equity portfolio with a less risky bias. Thanks to their convexity, they can capture equity market rises while reducing volatility during market shocks. Convertibles will benefit from improving lending conditions and company margins as well as their low exposure to interest rate moves. These characteristics will help to reduce downside from the political events that lie ahead in Europe in 2017.
2016 was a year of political upheaval which should lead to genuine opportunities in 2017 which we see as a year of change. Provided Europe manages to resist the current populist wave and China remains stuck with its contradictions (i.e. maintaining high and stable growth rates but at the expense of debt imbalances):
- a gradual normalisation in inflation will be good news for the big rotation back to equities and away from bonds, as well as for value stocks, cyclicals and financials
- European equities, the first victims of the current political premium, could outperform once elections are over and done with
- as the political premium wanes and thanks to a wave of US deregulation, we can expect to see a resumption in M&A deals. Ultimately, 2017 could see the grand return of a feature that disappeared after the Lehman Brothers’ collapse, namely the cycle!
Written January 10, 2017. Non binding document. This document is for information only.
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