2017 brings with it great uncertainty, but there are still a number of reasons to be optimistic.
2016 was a year dominated by big macro surprises and aggressive swings in market sentiment. January was a disastrous month for equity markets as large declines in the Chinese equity market reignited concerns about the Chinese economy and a deflationary pulse hitting the wider global economy. The latter was compounded by the price of oil hitting a low of $27 in January with markets beginning to focus not on the factors of oversupply, but on the weakness in demand. With weak economic growth and the threat of deflation remaining dominant themes for markets, the 10-year US treasury yield (which move inversely with prices) hit all-time lows in July. Indeed, negative yielding bonds, particularly in the Eurozone, became common place in the first quarter of the year as the European Central Bank (ECB) looked to increase its asset purchase programme. The US Federal Reserve (Fed) which at the end of 2015 had signalled four interest rate hikes in 2016, shifted to a more dovish tone in response to global growth and deflation concerns. Despite both the ECB and Bank of Japan continuing with their Quantitative Easing (QE) programmes, there was a sense that the power and influence central bank policy was having over markets was subject to diminishing returns. However, the ongoing financial repression continued to be a driving factor behind markets and the hunt for yield theme intensified.
As the first half of year drew to a close, Chinese growth concerns subsided and the focus turned to politics. In the UK, the surprise referendum result claimed a number of high profile political scalps and produced a short but pronounced ‘risk off’ move as equity markets fell and bond yields plunged. Sterling remained the main barometer of Brexit concerns and sunk 20% versus the dollar. Fears that the referendum result would lead to a big hit to the UK economy saw the Bank of England cut interest rates and ramp up its asset purchase programme. So far these fears have proved unfounded and the UK’s economic resilience, together with expectations of looser fiscal policy, meant UK equity markets recovered in Q3 and UK growth forecasts for next year have ratcheted higher.
Market focus soon moved onto the US election and in keeping with a year full of surprises, Donald Trump shocked markets by comfortably beating Hilary Clinton in the race to the White House. Perhaps even more surprising has been the market’s response. Markets have looked beyond Trump’s aggressive protectionist, anti-globalisation stance and instead focused on his domestic policies of lower taxes and increased infrastructure spending potentially leading to higher growth and inflation in the US. The final months of 2016 witnessed a surging dollar and a notable rotation out of cash and bonds, and into equities. The steepening (higher) yield curve drove a notable outperformance of cyclical (pro-growth) sectors led by financials.
Looking ahead to 2017 there are reasons to remain optimistic. Trump’s pro-growth policies could well lead to an acceleration in US GDP which could act as key driver for growth elsewhere in the world. The ‘FOMO’ (fear of missing out) effect could well see a continuation of the reflation theme in the near-term, with more cyclical sectors (e.g. financials and industrials) outperforming. However, there is a concern that markets have moved too far on mere speculation and ascribed too high a probability to Trump delivering higher growth and reflation. Indeed, tighter financial conditions in the US (via higher interest rates and a stronger dollar) could actually act as a headwind for the US economy before the impact of any fiscal stimulus has time to take effect. We have yet to see analysts’ upgrade earnings growth forecasts and equity valuations are again looking stretched. With much already priced in and expectations high, markets are vulnerable to any sign of Trump policy implementation failure or delay. If this were to occur then we could well see a rotation back into more defensive sectors and bonds as we move into Q2. • In the UK, Brexit negotiations are likely to be the key focus for 2017. The direction of travel of Article 50 negotiations could be seen as market friendly if the UK maintains passporting rights for the banks and access to European Economic Area (EEA).
The UK’s resilience post referendum has been encouraging but we remain wary of complacency. The reality of the UK exiting the EU and the potential for months/years of uncertainty could lead to the postponement in economic activity. Higher inflation and still weak wages growth is likely to erode disposable incomes acting as a headwind for UK consumption in 2017.
Although markets appear to have become more hardened to political shocks we continue to believe the biggest hurdles to negotiate in 2017 are in the Eurozone. With an awkward political timetable on the horizon and the single currency now facing existential risks, events in the region are likely to be a key source of volatility this year. The rise in populism across the developed world means the French election in particular will be a key event for financial markets.