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Last December, the FT’s panel of investment experts forecast a “year of change” — but even their predictions cannot begin to describe the tumultuous events markets have traded through in 2016.
Twelve months ago, Donald Trump’s US presidential victory and a vote for Brexit were seen as the two biggest risks for investors — yet equity markets are now riding record highs.
Looking ahead to 2017, our experts argue a new investment phase has begun as the yield curve finally turns upwards. Flattened by years of ultra-low interest rates and monetary stimulus, world economies are gradually being weaned off quantitative easing.
Having turned negative in 2016, long-term interest rates are starting to rise, and anticipating central bank policy has ceased to be the only game in town. In the real economy, this will translate into rising inflation — which brings blessings and curses for investors.
After all, loose monetary policy has served the average retail investor remarkably well. Now, the long-predicted rout in the bond markets has begun and there is talk of a “great rotation” as investors retreat from bonds and so-called bond proxy stocks and move into financials and cyclicals in the hope of a return of “normal” economic conditions.
Our panel did not agree on everything, but they were united in their view that volatility will return to global stock markets in 2017.
For now, 2016 will be remembered as a year of the political upset. And while politics will continue to dominate the headlines next year, investors will be nervously watching its impact on economic growth. The key risks? According to our experts, a Trump-inspired slump in global trade volumes; Brexit uncertainty testing the resilience of the UK and Eurozone economies; and dollar appreciation further depressing emerging markets. Here’s their outlook for the year ahead:
Does the Trump rally have further to run?
Market euphoria must be measured against the difficulties of keeping political promises
John Authers: Trump’s election victory was slightly less of a surprise to markets than Brexit was. The real surprise was the speed with which people decided that Trump equals growth. That’s a very strong, very clear narrative. It’s just over a month since the election and you’re beginning to get some reassessment of that now — but only some.
Stephanie Flanders: The big issue is whether Trump’s tax cuts and spending spree will actually raise potential growth or simply shorten the economic cycle. Broadly speaking, the policies he’s suggested spending money on are not ones economists think will give the highest returns. The risk is that any short-term boost to growth will come with a shortening of the economic cycle, rather than an increase in US economic growth, and therefore bring the date of the next US — and global — recession somewhat closer.
John: In his acceptance speech on election night, Trump sounded more like a statesman than he has done before or since. And he talked about infrastructure, which pleased people. Nobody had ever quite suggested among their list of scenarios that Trump would win and that he would have a Republican majority in the Senate. This gave some clarity — he would be able to do what he wanted to do — and then they started thinking about tax cuts . . .
Anne Richards: Over the past few weeks, I’ve heard a number of Asian and European ambassadors speak about the election result. I think they understand very well that Trump is somebody who speaks first and thinks later — they have absolutely got the measure of him. There are fears that his Twitter-storms will set off some kind of chain reaction, but I think political leaders in different parts of the world have already got used to his less than diplomatic style. He is also putting in place an administration which has relatively little experience of government and how political business actually gets done. For both these reasons, perhaps things will take longer and here will be fewer fireworks once he actually takes up office than everyone currently expects.
Merryn Somerset Webb: In the end, Trump probably just wants to do what he’s been doing for the past couple of years — send some tweets, talk to his kids and do reality TV. We get our knickers in too much of a twist.
Jonathan Guthrie: Cutting taxes will be an easy thing to do — whereas reflating America’s regional economies through infrastructural investment is really, really tough. Trump is not going to solve the overall problem of income inequality in America, which is why he was elected. I would extrapolate that financial markets are much too high.
John: A corporate tax cut plainly is good for stocks in the short run. When it comes to stock picking opportunities, there is still uncertainty on where and when the cuts are going to come, but it’s worth taking a look at the effective tax rates that companies are paying at present. A lot of companies don’t pay the full US corporation tax. Some, like utilities, come pretty close. But I’d sound a note of caution over the infrastructure excitement. The House Republicans have been blocking Obama from doing exactly that for the last six years, and there are limits to the hypocrisy. It isn’t obvious to me that they’re going to give the green light to a big wave of infrastructure spending.
The return of yield curve
2016 was the year of negative rates, but the worm has turned, implying more pain for bond markets. Does this mean good news for equities?
Richard Buxton: The start of the year was characterised by the Bank of Japan’s policy mistake of negative interest rates, which crushed bond yields and financial stocks worldwide. Between the Brexit vote and Trump’s election, the BoJ realised we actually need a steeper yield curve. So this is the great year that we can look back on and say it’s the end of the inflation trade, we’re back into a more normal environment and the world needs an upward sloping yield curve. The ECB’s doomsday machine will come to an end at some point next year and three cheers for that say I.
Stephanie: Yield curves are going to steepen; not just because of the end of global deflation fears but because even places that still need a lot of support from monetary policy — eurozone and Japan — have come to the conclusion that when it comes to pushing down very long-term interest rates, you can definitely have too much of a good thing.
John: The reaction across global markets to the BoJ being so clear that negative rates were a step too far is probably more important than Brexit or Trump in the longer term. It might be the single most important market event of the year.
Anne: The real shift came in the second half of 2016. We have seen the turn in the bond market. We’ve seen the beginning of the end of the unconventional period of monetary policy that we’ve been in and we are moving into a new phase. This happened after the Brexit vote, but Trump’s election has confirmed it. We are moving away from austerity being the mantra towards a view that we’ve got to spend our way out of it.
Richard: I completely understand why the market has responded very positively to Trump’s election. It is hugely positive for investors to have someone who says: “We’ve tried this and zero interest rates is not working, in fact it’s now counterproductive; we need a steeper yield curve, we need to throw money at the problem, let’s repatriate all that corporate cash and get it invested.” I think people underestimate what Trump will achieve.
John: The Fed has obviously wanted to raise rates for a long time. We might get a successfully applied Keynesian stimulus next year. But equally, we might get a trade war. Both of those things are far more likely now than they would have been if Hillary had won. As an investor, the thing I would buy on the back of this is the Vix [Volatility Index]. It’s remarkable that the Vix has actually fallen since the election, and by how much.
Merryn: Sky-high transfer values for final-salary pensions are the best signal we are ever going to get that the great bond bubble is about to burst. If retail investors are still heavily invested in bonds then they haven’t been listening. Pretty much everyone has been telling them for years that there is very little left gain-wise. It’s all risk for the retail investor — and the retail investor doesn’t have to be in the bond market. The great joy of being a retail investor is you can invest in what you want. This is more of an institutional problem.
Anne: The positive gloss on this is what it does to corporate balance sheets. Along with the return of inflation, what it will do to pension deficits is just fantastic. The terror of rising deficits is one of the reasons that we’ve seen corporate investment so constrained in the UK and elsewhere.
Claer Barrett: Let’s have a show of hands — who thinks the UK will raise rates next year? [Everyone raises their hands — apart from Stephanie Flanders].
Stephanie: I disagree. Remember that financial conditions are going to tighten without any help from the Bank of England, if global long-term rates keep going up. By the summer the Bank could be considering whether to loosen policy again, if consumption reacts badly to the squeeze on real incomes and investment and exports do not make up the difference. It’s not my base case but it’s eminently plausible given all the Brexit uncertainty.
A year of the stock picker?
In recent years, successful investing has relied on making the right calls about sectors rather than stocks; this is beginning to go into reverse
Jonathan: At the end of 1999, I was editing a piece for the FT much like this one. Back then, we were debating the possibility of the FTSE 100 hitting 7,000. And it does feel a bit like Groundhog Day — or perhaps decade — because I’m still wondering where future growth is going to come from. I cannot understand why UK and US stock markets are at all-time highs when we’re pulling away from trade deals. I always thought trade was something that helped to create wealth, so I’m not sure that the equity highs we see at the moment are sustainable.
Anne: Companies are obsessed about dividends— when you sit down with investors on the other side of the table, the dividend dominates the conversation because of the paucity of yields available in the bond market. If you go back 15 or 20 years, dividends were certainly part of the conversation, but they didn’t dominate it as they often do now. Chief executives are constantly being quizzed about dividend policy but there’s nothing like the same extent of questioning about where and how they are investing in their businesses.
Jonathan: That is enormously depressing. The point about equity used to be that it was a bet on the future, and it was a bet on the possible. Bonds were the instrument of the state and the financial status quo — if equity has only become a bond proxy, then what happened to the function of the stock market?
Richard: That’s why a move away from very high dividend payout ratios is good news. Instead of this massive reach for yield, if the Fed moves rates to 1.5 per cent, eventually we’ll have three per cent long rates, two per cent short rates, and then a bit more a few years down the line. Companies can go phew, I can actually spend on stuff that might have a future return.
As an investment manager, I feel that I’ve suddenly got oxygen again; an atmosphere I can breathe, rather than this artificially inflated bubble by the central bankers. It’s going to be volatile, but for the next few years we could see a gradual return to an environment that I recognise from when I first came into this industry — the stock picker’s market. People have traded en bloc — buy the bond proxies, sell financials — and now there’s going to be a huge multi-year reversal of that. Herds of investors have had their money on one side of the boat, and now they are all rushing over to the other side.
John: At this point we’re not seeing stock dispersion, but sector dispersion. People have poured into bank ETFs [exchange traded funds] with the result that the US financial sector is up by around 15 per cent since the election. And they’ve poured out of bond proxy ETFs. I thoroughly agree with both scenarios. If you made those calls, you’re doing nicely. But if you spotted the best bank and shorted the worst bank, it wouldn’t have made much difference.
Jonathan: I really like the sort of companies that don’t get written about very much in the Financial Times. Their results tend to be terribly benign — there are no profit warnings or conduct problems to write about. But I think they are going to show us that globalisation still exists. Large and steady global businesses such as RELX [Reed Elsevier], Compass Group, Bunzl, and Experian are all growing rather solidly by pulling off lots of small acquisitions that rarely go pear-shaped. I’m still un-keen on banks because I think that regulation and capital buffers are essentially a workfare scheme for central bankers. I’m also nervous about construction-related stocks, like Ashtead and CRH, which have a lot of US exposure, because I’m not really convinced that a second New Deal is really going to happen.
Richard: The trouble is, I own Experian, and I sold my RELX, having bought it on 11 times earnings in 2008, and sold at 20 times. Fabulous business, I’d love to be back on board again, but it is just screamingly expensive and it’s in the top 10 of every single one of my rivals’ portfolios. On the banks, I have to disagree violently. In the UK, the Bank of England is now comfortable with capital levels. These stress tests have painted an extraordinary scenario, and yet the banks would still be fine (apart from poor old Royal Bank of Scotland). These businesses are now going to be less leveraged, but you’ve got capital that is rock solid, chastened management, and a stable dividend machine that just throws cash back at you — and yet they’re still trading at book value or single discount figures. Now the sector is so much safer, UK banks should actually be more valuable than they were pre-financial crisis, when they traded at twice book value and then some.
John: The US banking sector is up around 15 per cent since the election, but it is worth noting that a lot of bankers don’t want the Dodd-Frank Act repealed, and that the official Republican platform calls for reinstating Glass-Steagall. So I think a lot of the hopes around banking deregulation are extremely overdone. Yes, if the yield curve gets steeper then the banks will benefit from that, but I think there’s a lot of hope written into their share prices.
The return of inflation
Higher inflation is forecast to return rapidly in 2017. This is good news for stock markets, but what about wage growth?
Stephanie: If the Trump reflation means another period of Wall Street doing better than Main Street, that is hardly going to silence the populist forces that got him elected.
Anne: We are going into 2017 with promises that the fiscal taps will get turned on, whether it’s Trump and his expansionism, or the Autumn Statement investment promises in the UK. That is definitely going to feed the pump. But it is also going to feed inflation — and depending on what happens to sterling and how the Opec announcement pans out, we could hit between 4 and 6 per cent in the UK next year. The economic backdrop could be more difficult than people think.
John: The risk that we really do get wage inflation in the US is quite strong, and inadequately priced in. This would actually be good for Main Street, and bad for Wall Street. Interest rates here might have to rise faster than people think. I’m old enough to remember inflation of more than 20 per cent; that’s not going to happen, but at this point people think inflation of above 2 per cent is high. We could get inflation of 3 or 4 per cent quite quickly. For investors, it’s a very interesting opportunity to try to play that risk.
Stephanie: As Mark Carney recently pointed out, the past decade is the first since the mid-19th century when real median earnings have not risen. Globally, economic output is 9 per cent lower than if it had merely returned to its pre-crisis trend — and in the UK the shortfall is closer to 16 per cent.
Richard: Ultimately, labour has got to get a bigger share of the pie than capital, and that will mean rising wages and falling corporate margins. But, as I have said, that’s kind of what we need.
Brexit — the only certainty is uncertainty
The panel believe the UK will remain mired in negotiation for years — but what toll will this take on the economy?
Merryn: As virtually the only FT columnist who argued for Brexit to happen, I really don’t think it is that big a deal. The EU is an incredibly flexible organisation. Exceptions are being made to the “four freedoms” all the time — look at Switzerland, Cyprus and Norway. There will be a bespoke deal for the UK in the same way that there has been for others.
Anne: The challenge is the size of the UK, which will make a bespoke deal much harder. The sheer scale of the task of negotiating a trade deal means this is going to take time.
Merryn: You might see that as a downside, but I see it as a great thing. If it goes on for years and bores everybody to death, the impact of Brexit will be negligible.
Stephanie: I don’t know anyone who thinks that the UK’s global and EU trading relationships will be resolved in two to three years. Some may regard the Office for Budget Responsibility’s forecasts for the UK economy as “gloomy”, but they optimistically assume that the bulk of any hit to growth will have happened by 2019. The debate in the media and Westminster is completely unrealistic compared with what anyone working in a major company or financial institution would tell you about the practical logistics involved with Brexit — let alone trade negotiators and financial regulators, who typically think in two to three-year transition terms for even very small demergers or regulatory reforms.
Richard: I think the eventual break-up of the eurozone is inevitable, but it won’t happen next year — perhaps after I’ve retired. It will be a long, gradual, painful process but people will get on with life. The UK economy will grow more slowly over the next two years. Companies who don’t have the privileges that Nissan has enjoyed will pull back from hiring and spending.
Stephanie: The idea of having a transition is being read as a Remainer plot to buy time to stay in the EU. That is the best way to get businesses across the UK and the EU planning for the worst. The transition deal we need is for both sides to agree, up front, that whatever the outcome of the negotiations nothing will actually happen on the ground for two years after we see that deal. That way, the government gets to keep its negotiating cards close to its chest but the business community gets some assurance that it will have time to respond to the outcome.
Emerging markets outlook
They look cheap — but the strong dollar could make things far from cheerful
Anne: Yet again, the Chinese “hard landing” — the most forecasted hard landing for at least ten years — hasn’t happened, and I still don’t think it’s going to happen. Yes, there are still some issues in the Chinese economy, but we put too much emphasis on them.
Stephanie: The greatest risk for emerging markets now is either an early US recession or, more likely, a further upward move in the dollar which could cause a relapse in commodity markets. However, since the Taper Tantrum, we’ve seen a dramatic fall in the current account deficits among what we used to call the Fragile Five [India, Indonesia, South Africa, Brazil and Turkey]. In the current environment, emerging market assets also have the unique advantage of being risk assets that are still reasonably attractively priced. We need to see a stronger domestic recovery in these economies to feel hugely bullish, but I would say I’m cautiously optimistic. I certainly haven’t written them off because of Trump.
Anne: Looking across the broad sweep of emerging markets, notwithstanding that some countries that continue to have individual challenges, there is still more value to be had across the region. Economic management in China is sound despite a few issues, and momentum in the underlying economies overall make emerging markets an attractive place for investors to put their money.
John: It’s very interesting that very quietly people are much less worried about China. I think it may be premature to have stopped worrying about it, because we still have the issues of the credit overhang that we had before. Is Trump tweeting rudely about China, or talking to the Taiwanese president a reason to short China? No. But is his attempt to change the trade relationship with China fully priced in? I doubt it. Industrial metals have staged something of a recovery in the last matter of months; there obviously is a belief that the Chinese economy is in a recovery stage.
Anne: Sorry, I’ve got to challenge that — recovery from what? It’s still growing at above 6 per cent per year!
John: Export and import numbers show China is certainly taking in very much less money for very much less in the way of goods from the outside world than it did before, which has to raise some questions. The strength of the dollar in 2017 will be the critical issue.
The FT’s investing in 2017 debate took place in London in mid-December and was chaired by Claer Barrett, the FT’s personal finance editor. Taking part were John Authers, the FT’s New York-based senior investment correspondent; Jonathan Guthrie, head of FT Lex; Merryn Somerset Webb, FT columnist and editor-in-chief of MoneyWeek; Anne Richards, chief executive M&G Investments; Richard Buxton, chief executive of Old Mutual Global Investors and Stephanie Flanders, chief market strategist (Europe) for JPMorgan Asset Management.