7 questions, 7 answers for 2017
Question 1: What will a Trump presidency mean for markets?
The election of Donald Trump added to a year of political surprises around the world, and his policy agenda is a key focus for global markets.
With a Republican majority in both houses of Congress, Trump will have latitude to implement executive decisions that could significantly alter the status quo of US eco-nomic and social policy, with global impli-cations. This period of change could be long lasting. Senate Democrats will need to defend twice as many seats as Republi-cans in the next election, suggesting that the Republicans have a high probability of preserving their majority for the next four years.
CIO believes that investors are well-advised to consider three broad policy areas:
The promise of an expansionary fiscal policy. Trump ran on a platform of tax cuts and higher public spending. He pledged to invest USD 1tr in American infrastructure over the coming decade, and reiterated his commitment in his first speech as president-elect. The fiscal stimulus pro-vided by lower taxation and higher federal spending will have broad macroeconomic and investment implications. Military con-tractors and construction firms stand to benefit, for example. We also expect to see incremental pressure on wage inflation, increasing the appeal of Treasury Inflation Protected Securities (TIPS) versus other US government bonds.
The pledges to enact pro-business policies, lower corporate taxes, and reduce regulation. The president-elect has promised to boost economic growth by scrapping intrusive federal regulations, lowering corporate tax rates, and by reducing the cost of regulatory compli-ance. We believe the US energy sector stands to benefit from operating in a more lenient regulatory environment. The elimi-nation of a risk premium assessed on financial services and pharmaceutical stocks should also free these sectors for better performance next year. Headline risk over drug prices will persist, but gov-ernment intervention is far less likely under the next administration. And companies more broadly could see their tax bills reduced. Pro-business legislation, lower corporate taxes, and reduced regulation can support US equities, where we already expect 8% earnings growth next year.
The threat to trade and immigration Trump vowed to adopt a tougher negotiat-ing stance with US trading partners. If this translates into policy, it could prove to be a serious economic challenge for Mexico, which relies on the US for 80% of its exports and 98% of the remittances it receives from Mexican workers abroad. CIO believes that a Trump presidency will create some volatility. However, while the shift may pose chal-lenges for some trade-focused emerging nations – such as Mexico, South Korea and Colombia – countries with larger domestic economies like Brazil and India should be less vulnerable. Added to this, US relations with Russia may improve, given indications of mutual respect between Vladimir Putin and Trump. Barring radical policy develop-ment, we believe the economic and earn-ings revival now underway in most emerg-ing markets (EM) can continue. We head toward 2017 overweight EM equities and have a preference for select EM curren-cies.
After the initial uncertainty over his unorth-odox trade and immigration policies abated, equity markets improved on optimism that fiscal stimulus and reduced regulation will promote economic growth. CIO believes that TIPS, US equities, and EM equities can continue to advance through next year.
Question 2: Is anti-globaliza-tion a threat to my wealth?
Protectionism looks to be on the rise. After almost three decades of hyper-globalization, we have learned that while its benefits, and those of free trade, tend to be spread across society as a whole, the costs of it can be con-centrated, and are often deeply felt by those affected. Amid stagnant median incomes and rising wealth inequality, resistance to trade is increasing, and protectionist sentiment is on the rise. The political consensus that had pro-moted trade liberalization is now shifting, with an increasing proportion of votes now attainable by offering protectionist rhetoric.
In 2016, Brexit, Donald Trump’s victorious run for the US presidency and tortured negotiations over global trade deals such as the Trans-Pacific Partnership, Transatlantic Trade and Investment Partnership, and Com-prehensive Economic Trade Agreement all demonstrate growing skepticism about the merits of globalization.
What are the consequences for investors?
The end game (ubs.com/end-game) demon-strates how changes in policy can have meaningful consequences for markets, economies, and portfolios. As protectionism rises, we see two main effects: First, the markets of smaller, more open economies that depend on trade with a single larger country or trading bloc are particularly vulnerable. The poor performance in 2016 of the British pound, Mexican equities, and the Mexican peso that resulted from fears of a reverse in trade clearly illustrates this situation.
Second, even if countries do not repeal trade agreements or erect trade barriers, competitive devaluation still remains a risk as countries attempt to boost weak growth through beggar-thy-neighbor currency policies (or policy moves to that effect). Since 2012 the euro, Japanese yen, and British pound – three of the world’s four most heavily traded currencies – have, at some stage, declined by around 20% in the course of a year.
What to do about it?
If the world economy becomes less global, investor portfolios will need to become more global. Despite the direct fallout from Brexit, UK-based investors exposed to multinationals (whose profits rose in local currency terms) fared well in 2016. As political risks proliferate, investors may feel more inclined to keep money closer to home, where they better understand the political climate. But they will need to fight this instinct and invest in a glob-ally diversified way.
Investors will also need to reduce their vulnerability to global currency risks by hedging overseas investments back into local currency. Anti-globalization ten-dencies raise the risk of sudden declines in individual currencies – hedging can help investors shield local purchasing power from the dangers of excessive currency volatility. Investors who bought UK or Mexican assets in 2016 without hedging currency likely saw deeply nega-tive returns.
Slower global growth that results from rising protectionism is clearly not a boon for investors. Global trade as a percent-age of GDP climbed from 26.9% in 1970 to a peak of 61.1% in 2008, almost per-fectly matching the rise in global pros-perity. It’s not surprising that the Interna-tional Monetary Fund’s World Economic Outlook (October 2016) cited the return of protectionist measures as a key risk to the continued health of the world’s economy.
But this trend need not unduly impair portfolio performance, provided inves-tors avoid concentration in small mar-kets, diversify globally, and avoid taking undue currency risks.
Question 3: What are the main risks for 2017 and how should I deal with them?
Accept
We have listed 28 risks that could impact markets in 2017. But the biggest single risk individual investors will face is not displayed. That risk is panic.
Panic can lead to inertia, i.e. investors remaining under-allocated to asset classes essential for their long-term portfolios and forever waiting for the “right time to buy.” It can also lead to selling at the worst pos-sible time. Quantitative market research group DALBAR estimates that investors have lost more than 2% annually over the past 20 years from ill-fated attempts to time markets. In a world where a 5% return can be hard to achieve, that is significant.
Creating a long-list of risks to track can help investors accept that many risks exist, keep a long-term mindset and therefore respond in a less emotional manner when risks flare.
Diversify
Investors can reduce their exposure to some of the risks listed through diversification across asset classes, regions, and securities. Many of the risks are region or country-specific, so investors who avoid excessive concentration in any one country or mone-tary regime can reduce their vulnerability.
Even when global risks arise, they do not impact all assets equally. For instance, higher inflation might be bad for cash but good for real assets and equities. Or higher inter-est rates might hurt high quality bonds but boost senior loan returns. Effective diversification across bonds, equities, and alternatives can lessen vulnerability.
Some risks will also affect individual compa-nies more than entire markets. For instance, disruptive technologies and cyber-attack concerns can exacerbate single-security risk while affecting the overall market in only a minor way. Reducing exposure to individual companies generally helps improve financial returns relative to risk.
Hedge
Investors can diminish their risk exposure even further through hedging. In an environment of increasing protectionism and monetary policy uncertainty, currency risks are high. This adds to portfolio vola-tility while providing no clear prospect of return.
Risks today are numerous. But by accepting, diversifying, and hedging, investors can reduce their vulnerability to more manage-able levels.
Question 4: How can I achieve 5% returns?
Interest rates available on cash have been pushed to record lows, as central banks have attempted to revive weak economies. Investors have sought returns elsewhere, but the prices of investment grade bonds, high yield bonds, and equities have now all been pushed up. The search for yield could take on new impetus in 2017, with inflation rising even more quickly than interest rates.
We can’t reasonably expect more return without more risk. And aiming for any set return level if one cannot realistically cope with the associated risk is always a bad strategy.
But assuming risk tolerance is suitably high, we see three ways investors can consider to boost returns in 2017:
Investing in riskier assets
Financial theory tells us that investors can’t expect more return without more risk. But equally, more risk is no guarantee of more return. Investors therefore need to be selective.
As we enter 2017, some of our preferred areas are:
a) US and emerging market equities. We believe that global equity markets are set to deliver positive returns in 2017, and prefer US and emerging market equities. Accelerating economic growth, improving earnings, and only gradual increases in interest rates should support appreciation in both markets.
b) US senior loans offer an attractive alternative to more “traditional,” low-er-yielding, fixed income investments. We expect the asset class to benefit from resilient US economic data and the global hunt for yield amid still low real interest rates. Senior loans are also “floating rate,” meaning that, unlike most fixed income assets, they will likely benefit as US interest rates rise. At the time of writing they offer a running yield of 5.9%.
c) Select emerging market currencies. After years of underperformance, emerging markets finally began to revive in 2016. Although Donald Trump’s electoral victory has added a layer of uncertainty, we believe some emerging market currencies look attractive for investors looking to boost returns. We have a positive view on a basket of EM curren-cies – including the Brazilian real, the Indian rupee, the Russian ruble, and the South African rand, equally weight-ed – versus a basket of equally weighted developed market (DM) currencies – the Australian dollar, Canadian dollar, and Swedish krona.
Adding leverage
Investors could also consider leveraging a well-diversified portfolio to improve returns. Current market interest rates are low by his-torical standards, providing a conducive envi-ronment for leveraged strategies. For inves-tors with a high risk tolerance, it may, in some cases, be more attractive to leverage a medium-risk portfolio than to invest directly in a high-risk portfolio.
That said, with interest rates expected to rise in the US in the coming years, investors will need to carefully consider their investment time horizon. With prospective returns also low by historical standards, small changes in borrowing costs can have a significant effect on risk-return ratios.
Seeking alternative risk premiums
Available returns from a traditional “buy-and-hold” strategy in stock and bond mar-kets are lower than before. So we consider it important for investors to now look at a wider range of investment options.
This could include investment in alterna-tives, such as hedge funds and private markets. New approaches to portfolio construction could also help deliver risk-adjusted returns superior to more traditional methods.
Question 5: Can markets survive without easy money?
Inflation is increasing. Consumer prices in both the US and Europe are climbing at their fastest pace in more than two years. Bond market quivers suggest that investors are beginning to cast a watchful eye on poten-tial central bank responses: higher US inter-est rates and a slower pace of ECB QE. We expect the Fed funds target rate range to rise to 1.00-1.25% by the end of 2017, and for the ECB to reduce the pace of its bond buying.
Investors have clearly benefited from easy money in recent years. Can they survive without it?
The short answer is no – or at least not yet. Markets have historically performed relatively well in rate-hike cycles, but they tended to come at an earlier stage in the economic cycle, and against a backdrop of strong economic and robust corporate earnings growth. Today, many markets have already reached full valuations, and it seems unlikely that growth will return to what was once considered “normal.” Therefore, investors are right to be mindful of aggressive rate hikes. The “taper tantrum” of summer 2013, when bonds and equities fell in tandem, served as a warning of the kind of market environment investors should be fearful of.
That said, we do not believe that the com-ing year will bring the end of easy money. Indeed, real interest rates could in fact fall to the lowest level in two years as inflation increases more rapidly than nominal interest rates. Like in The end game, it comes down to a policy decision. Faced with a choice between aggressively hiking rates to combat a still unconfirmed inflation threat or maintaining loose policy to aid deleverag-ing and improve muted growth, central banks remain heavily incentivized to keep interest rates low. The policy orthodoxy remains focused on avoiding repeating the mistakes of the Great Depression, when monetary policy was tightened too soon.
Fed Chair Janet Yellen has pointed out that she is comfortable with inflation that runs above target in order to encourage greater labor market participation. ECB President Mario Draghi “remains committed to pre-serving the very substantial degree of mone-tary easing,” suggesting that the ECB is still heavily predisposed to continue with consid-erable QE, even if the extent of it declines in 2017. And the Bank of Japan has only recently committed to capping the level of bond yields, a policy we expect it to main-tain in 2017.
Against a backdrop of still-easy monetary policy, and a potential loosening in fiscal policy in the US under the new leadership, we overweight the US equity market. We also overweight US senior loans, which can benefit from investors’ hunt for yield in a negative real rate environment and provide some insula-tion against rising rates, thanks to their vari-able coupons. US inflation-protected bonds (TIPS) will also likely outperform nominal government bonds when inflation increases.
Investors should also consider allocations to less-correlated assets, such as hedge funds and private markets. History shows us that, even if interest rates remain low, equities and bonds can move in tandem when mar-kets fear turning points in monetary policy, which raises portfolio volatility for diversified investors. Even if such episodes of higher volatility have typically lasted for only a few months, hedge funds can reduce vulnera-bility to this uncertainty. Meanwhile, private markets investments can help prevent ill-advised emotional responses to volatility that can permanently impair wealth.
Question 6: China: Risk or opportunity?
A “China panic” or two has become par for the course in financial markets in recent years. Global equities dropped 4% in August 2015 after a surprise change in China’s currency policy. And they fell 11% in the first weeks of 2016 on fears that China’s capital outflows were running out of control.
In 2017, it seems as though there is plenty of fodder for similar fears to resurface. Parts of the property market appear to be overheating. Prices in Tier-1 cities are up by close to 30% year over year, and prices in Shenzhen are now the most expensive in the world on a price-to-income basis. The average 100 sqm property sells for almost 20 times average income. The yuan has depreciated and foreign exchange reserves have begun to fall again in recent months. And financial leverage continues both to rise and to become less productive. The total debt-to-GDP ratio in China has climbed from 150% before the financial crisis to around 250% today, and it now takes approximately four yuan of credit to gener-ate one yuan of growth.
Dealing with these issues will clearly entail risk. Tightening measures on the property market, if too severe, could have a chilling impact on the wider economy. Real estate has accounted for close to 10% of GDP growth in the past year. And slowing debt growth by shutting down unprofitable industries will be difficult without provok-ing higher unemployment and social insta-bility. Fears of an economic “hard landing” could lead to market volatility at times.
But, as mentioned in The end game?, we believe China’s outlook ultimately comes down to the incentives of its leader-ship. We believe growth and stability are likely to take precedence over long-term reform, if it comes down to a straight choice. The country’s largely captive domestic sav-ings base and current account surplus (USD 260bn) mean the government’s hand is rarely forced by the market. And consump-tion growth remains solid, with retail sales growth rising 10% year over year in Octo-ber, and contributing 73% to China’s growth in the first half.
Amid China’s transition, we focus on opportunities stemming from its steady capital account opening, and transition toward the “new economy” and consumer services.
First, as the government steadily opens its capital account through programs like the Shenzhen-Hong Kong Stock Connect, we believe that small and medium-size Chi-nese companies listed on the Hong Kong Exchange (H-Shares) could benefit as on-shore capital seeks diversification. As capi-tal is diverted from the domestic property sector and toward overseas assets, howev-er, investors should avoid credits of China’s bank and property companies, in our view. We expect the Chinese yuan to continue to depreciate in 2017, forecasting USDCNY at 7.00 in 12 months’ time.
Second, we look to invest in companies that benefit from the changing composition of China’s growth. Tertiary industry (services, excluding financials) is now larg-er than the secondary industry (manufac-turing), and sectors like healthcare, tour-ism, internet, and entertainment are likely to grow at above-average rates in the years ahead as this trend continues.
Finally, in light of the new US presidency, we focus on domestically-oriented sectors that could fare better amid concerns about global trade, or if the Chinese government looks to stimulate demand. These sectors include select consumer staples, telecom-munications, healthcare, and internet.
Question 7: Does the future of Europe matter for markets?
Events in the EU have shaken global mar-kets in recent years. The Eurozone debt crisis in 2011, the fears of a Greek exit from the Eurozone in 2015, and the surprise “Brexit” vote this past summer all intensi-fied global market volatility.
As we look ahead to 2017, the European political calendar again looks packed. The UK is set to trigger “Article 50,” signalling a two-year countdown to leaving the EU, in the first quarter. The Netherlands holds elections in March, France follows in April and May, and German elections will be at some point between August and October. As discussed in The end game?, politicians may now be more incentivized to pursue populist policies, and years of sluggish growth and the recent migration crisis have shifted the political center ground. Brexit was the clearest example of this phe-nomenon, but right-wing parties in the Netherlands, France and Germany (Party for Freedom, the Front National, and AfD) have also gained popularity in opinion polls, her-alding the potential for further political uncertainty.
So, should investors fear Europe again in 2017?
In our view, whether political uncertainty feeds through into market turmoil depends on:
a) Economic performance
b) The impact of uncertainty on corporate profits
c) The potential impact on the banking system
The upcoming elections are unlikely to alter the economic outlook. Underlying growth is fairly solid, although the waning impact of European Central Bank (ECB) stimulus and some drag from the lack of clarity about the Brexit negotiation process mean that we expect the Eurozone economy to expand by 1.3% in 2017 vs. 1.6% the year prior.
Elections also typically don’t have meaning-ful short-term repercussions on overall corporate profitability. Individual sectors or countries might react to adjustments in tax rates, regulation, or trade terms, but investors, provided they are well-diversified, should not see the earnings capacity of their holdings markedly reduced by a changing of the political guard. That said, the underlying picture for corporate profit-ability in the Eurozone is relatively muted at present, largely due to weak growth in the financial sector, which is still suffering from negative interest rates, weak loan demand, and a relatively high share of non-perform-ing loans.
The elections could, however, be more consequential for the region’s banks. ECB actions have managed to contain political fallout – bank credit spreads have actually narrowed since the UK’s Brexit vote. But favorable showings for France’s Front National in particular could raise jitters about the European banking sector, given that even the possibility of a Eurozone country considering leaving the EU would lead to fears of potential asset-liability mis-matches for the region’s lenders.
Political uncertainty, combined with muted economic and profit growth, means that we currently see better places to invest than Europe. For investors with a long-term al-location to Europe, we suggest focusing on companies that transact a high per-centage of their sales in emerging markets or those returning cash to share-holders through dividends and buybacks.
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