- In spite of significant changes across the geopolitical landscape, we expect many of 2016’s themes to continue into 2017.
- The global economy could gain some steam if it is dragged upward by stronger growth and business confidence in the United States.
- Global equities may continue to move higher on improving earnings, but upside could be limited by high valuations and as the post-election rally siphons off gains from next year.
- The increase in yields has made high quality bonds “less terrible” going into 2017. Treasury Inflation-Protected Securities (TIPS) and municipal bonds could offer decent relative value.
- Improving growth has the potential to bolster credit quality within corporate bond sectors (high yield, bank loans, etc.), but valuation may not be as compelling as it was in 2016.
- We believe the biggest risks to our base case in 2017 include Trump’s style/inexperience, a disorderly Brexit, an inflation surprise, and the Chinese debt bubble.
- Less confidence in the outlook: both the upside and downside risks around the base case are seemingly growing. Even in a somewhat better growth environment, investors could be tested by market shocks.
Similar Trends, More Dispersion
2016 was a year of significant changes around the world, from the Brexit referendum to the midyear turn in interest rates, to the election of Donald Trump in the U.S. At first blush, you’d think this would call for major changes in our economic and capital market outlook. But ironically, most of the trends we've been anticipating have either continued or been confirmed by events in 2016. Our broadest views for some time now have been that the global economy was slowly gaining traction, that this would lead to modestly higher corporate earnings and stock prices, and put some upward pressure on interest rates, thus detracting from bond returns. Recent market developments haven't changed these broad themes, but they have reduced the confidence level of our economic and market views. (More on this later.)
The Global Economy Gains Steam
Many developed economies languished with positive but sub-par growth in 2016. We believe 2017 could provide a bit more upside. In the U.S., the Trump administration's anticipated trifecta of tax cuts, infrastructure spending, and deregulation could bolster real GDP from near 2.0% to closer to 3.0%. The combination of tax cuts on personal income and improved confidence may provide a modest upward push to consumption, while an infrastructure program could help reverse the longer trend of weak government spending. Lower corporate tax rates and a reduction in regulatory red tape may also provide a long-awaited return to capital investment. Mitigating factors to stronger U.S. growth include somewhat higher interest rates and the deleterious effects of a stronger U.S. dollar — which could affect exports by making them more expensive for overseas consumers. On balance, we believe U.S. growth may improve, but not at a break-neck pace.
Elsewhere, growth across Europe could improve as nascent signs indicate the continent is finally putting its deflation scare in the rear-view mirror. At the margin, the appetite for austerity continues to wane, so we expect there may be a mild uptick in fiscal flexibility. Hurdles certainly remain, but the worst recessionary days for Spain, Portugal, and Greece appear to be behind them. On the downside, we expect a messy divorce for the UK and the EU, we believe it will not derail the broader, more positive momentum within Europe. While the UK economy has held up well since the referendum, it is likely to feel the brunt of the pain in the Brexit negotiations and may be the downside outlier in terms of growth.
In Asia, we see little change in the trajectory for Japan. Policymakers will continue to toy with the levers of Abenomics – Prime Minister Shinzō Abe’s economic reform program – but may not be able to overcome the country’s long-term demographic challenges, which include an aging population and a very low birth rate.
China remains the wild card. The country’s economy has not slowed to the degree that was once feared in 2014-2015, but the debt bubble that supports current growth may well prove unsustainable in the long run. There is no way to know if 2017 will be the year it bursts. We expect the Chinese can continue to paper over non-performing loans1 in the banking system while slowly chipping away at industrial overcapacity. This, however, is whistling past the graveyard, and the greatest risk scenario to our otherwise modestly positive global outlook.
The stabilization of growth in China has done the same for many emerging market (EM) countries. In addition, commodity prices2 have regained their footing and are seemingly starting to improve. This should benefit major EMs from Russia to Brazil to Mexico. Supply side headwinds remain, along with country-specific pockets of weakness, but in aggregate, we believe global growth should continue to improve.
Stocks: Overoptimistic Extrapolation
Our forecast for improving global growth could mean the equity bull market that originated in 2009 will continue into 2017. It is possible that U.S. earnings growth will turn positive after the earnings depression in the energy sector passes. However, bottom-up consensus of nearly 12% earnings growth next year for the S&P 500®,3 as usual, looks way too optimistic. We have upgraded our top-down outlook from 3-5% earnings to 5-7% for next year. An improvement to be sure, but still far short of consensus.
The ultimate question for equity investors will be whether this growth will be on top of current elevated price-to-earnings ratios (P/Es)4 or whether earnings will simply "grow into" lower valuations. The former (strong earnings combined with stable-to-rising P/Es) could result in strong U.S. equity returns. Alas, we're bigger believers in the latter: that elevated P/Es already discount much of the future earnings improvement. While the optimism for stocks may grow, it could be bounded by rising inflation and tighter Federal Reserve policy, two factors that are unlikely to support higher P/Es. Alongside this is the possibility that the post-election rally has already "stolen" equity returns from 2017. Bullish investors may be extrapolating gains into the future that have already occurred. Lastly, the nearly universal prediction of a stronger dollar could also hamper earnings through the export channel. We remain optimistic about solid U.S. equity gains next year, but perhaps not as ebullient as the consensus.
In both non-U.S. developed and emerging markets, we believe growth will improve (as noted above) but perhaps not with the same vigor as the U.S. This should also result in stronger earnings, aided by relatively weaker currencies. Perhaps the biggest difference, however, is in valuation. While far from compelling, many Eurozone and UK stocks still reflect Brexit fears and general growth malaise, and some investors still can't get excited about Japan. Like U.S. stocks, we believe non-U.S. equities will generate solid but unspectacular returns in 2017.
Bonds: Less Terrible, Less Fabulous
Fears of Trumpflation (growth plus inflation) have sent yields skyrocketing and many bond investors into a panic. These basic dynamics seem appropriate as nominal rates rise on the back of both yield components: higher real rates (stronger growth) and higher inflation premiums. But like stocks, the same caveat applies: perhaps much of the Trumpflation has already been priced into the bond market in 2016. Will rising rates pressure high quality/sovereign bond returns in 2017? Maybe, but it may not be the disaster that some investors fear. Around the globe, rates are already up dramatically in many countries, which is also resulting in somewhat higher starting yields (after plunging to record lows in mid-'16).
Do we still think high quality bonds look relatively unappealing? Yes, but returns may be "less terrible" moving forward. Within high quality bonds, our preference remains for inflation-protected issues which can mitigate at least one source of pain (higher inflation). For many U.S. taxable investors, counterintuitively, proposed lower marginal tax rates have made municipal bonds more attractive, not less. Given the post-election underperformance of municipal bonds, the yield differential relative to U.S. Treasuries is now larger, even after factoring in the proposed reduction in the highest tax bracket (from 39.6% to 33.0%).
On the corporate side, there is evidence that causes for optimism have waned. BBB-rated, high yield, convertible bonds,5 and bank loans6 offered compelling value in our view last year. Many of the same factors persist today, including muted maturity/rollover risk, a low likelihood of recession, and the yield advantage vs. higher quality. However, across the corporate spectrum, tighter credit spreads and higher prices are already reflecting this rosy scenario. At tighter spreads, corporate issues may incur greater rate sensitivity (less spread tightening as rates rise). So, on a total return basis, we still find the corporate sectors of the bond market more attractive than sovereign, but the gap between the two has closed somewhat. Our "great & hate” view from last year (corporate sectors vs. sovereign/agency) has been downgraded to "not as great & less to hate."
Risk and Uncertainty
A recap of our views reveals only modifications, not wholesale changes, to our investment outlook from 2016. So is 2017 just a "rinse & repeat" of last year in terms of portfolio construction? We don't think so. These views represent our base case scenarios, but the upside and downside dispersion around the base case has widened significantly for several reasons:
- The Republican clean sweep in the U.S. Congress has allowed the market to price an extreme level of optimism into a Trump presidency. Markets have largely failed to discount the very real possibility of significant policy or personnel blunders related to China (tariffs and trade policy), Russia, or fallout from corporations targeted by the soon-to-be President.
- A disorderly and destructive Brexit negotiation could drag down both the UK and EU beyond what current consensus believes is possible. It may be overly optimistic to presume the negotiations will proceed rationally and that "they'll work it out."
- Inflation risks – the chance that cash flows from an investment won’t be worth as much in the future because of increasing prices – are now significantly higher globally than at any time post-Financial Crisis. This in turn may raise the risk of a more aggressive Fed fearful of falling behind the inflation curve and/or an uncontrolled ascent of the U.S. dollar. Both could impair growth in the world's largest economy. More broadly, combined with higher growth and fleeing bond investors, interest rates could become untethered in a highly leveraged world – more than offsetting the growth impetus from other factors.
- With each passing year, debt continues to accumulate in China in nearly every corner of the economy while policymakers fail to institute significant reforms. By controlling both the biggest lenders (banks) and the biggest borrowers (state-owned enterprises), the Chinese can extend and pretend for some time. They cannot, however, repeal the math of credit boom/bust cycles. With each passing day, this risk becomes larger, even if we can't predict the triggering event.
In short, we have less confidence in almost every economic and market scenario going into 2017. In classic portfolio optimization terms, our return expectations have changed only modestly. However, the dispersion around those base case/expected returns has widened dramatically – that is, higher standard deviations (or whatever risk metric you optimize against). In mathematical terms, other things being equal, higher volatilities will likely push allocations towards lower correlation assets. In layman's terms, diversification may matter more. This of course would be muddied by rising correlations in a true flight-to-quality scenario.
Finally, increased volatility often goes hand-in-hand with greater dispersion among assets. In a world of somewhat elevated equity and sovereign bond valuations, the return on beta7 (broad market exposure) may be less compelling than the return on alpha8 (idiosyncratic selection among stocks, bonds and asset classes).
Our somewhat positive base case outlook for 2017 masks the increased potential for major economic and market shocks. In spite of an improving global economy, we expect investors’ patience will be tested in the coming year.
1 A non-performing loan, or NPL, is a loan that is in default or close to being in default.
2 Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
3 The S&P 500® Index is a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large cap segment of the US equities market. You may not invest directly in an index.
4 The "price to earnings ratio" compares a company's current share price to its per-share earnings. May also be known as the "price multiple" or "earnings multiple". Investors should not base investment decisions on P/E alone, as the denominator (earnings) is based on an accounting measure that is susceptible to forms of manipulation. The quality of a P/E ratio is only as good as the quality of the underlying earnings number.
5 A convertible bond is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal.
6 A bank loan provides medium or long-term finance and is the most common form of loan capital for a business. Loan period, rate of interest, timing, and repayments are set by the bank.
7 In finance, the beta (or beta coefficient) of an investment measures the volatility of a security or a portfolio in comparison to the market as a whole.
8 In finance, the term alpha refers to a measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.
Treasury Inflation-Protected Securities (TIPS): Inflation protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.
Credit Quality reflects the highest credit rating assigned to individual holdings of the fund among Moody’s, S&P or Fitch; ratings are subject to change. Bond credit ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Understanding current market conditions and what might be expected in the near term.
Understanding potential market trends in early 2017 requires a look at the market’s recent optimism.
During periods of market optimism, remaining mindful of risk is still important.