Our 2017 outlook begins with a focus on six essential questions, intended to help investors develop new narratives to guide market views in a period that is likely to be very different from the post-crisis regime of 2009-2016.
1. Is the US really headed for effective stimulus?
2. Will lackluster global growth continue?
3. Is a breakdown in international cooperation (on trade, security, and regulation) likely?
4. Will we continue to see low, growth-insensitive inflation in developed markets?
5. How will the Trump administration choose a Fed chair and handle dollar policy? 6. Where will oil and commodity prices go next?
On markets, we expect a stronger dollar, higher US yields, structurally higher bond market volatility, higher oil prices, challenged returns for European credit, and sustained tension between positive and negative factors in emerging markets. In equity markets, we expect outperformance from Europe, Japan, and US small caps.
Donald Trump’s election marks a boundary between political economy regimes, as did the fall of the Berlin Wall, September 11, and the global financial crisis. The post-crisis period that began in March 2009 has ended. It was marked by slow growth, low interest rates, rising regulation, high recognition of income distribution dynamics, political disharmony, and a sense of Western decline. It was also marked by good equity and bond returns, falling unemployment, and deflation fears that never materialized.
Central banks were aggressive experimenters, while governments mostly followed orthodox policies. Financial markets clung to views that “inflation would not rise,” and “rates would remain low” due to forces both structural and cyclical. Low interest rates helped finance equity buybacks, and corporate earnings growth coincided with swelling valuations. If a single word summarizes what’s beyond the post-crisis period, we think it is “dissolution.” Trump is a rejection of old norms. The Brexit vote and the Italian referendum are the same.
Dissolution of the EU and the euro will be feared. Dissolution of NATO, unlikely as it is, will be discussed. Markets overreact to political rumors and underreact to political facts. But pressure to dissolve old norms is bubbling up from the political firmament on which markets rest. Price action is superficial compared to shifts in democratic preference. Voters have called for something new. What will it be? We can broadly sketch optimistic and pessimistic versions of an era of dissolution. The truth will likely be in between. An optimistic version sees new forceful leadership fixing unwanted developments.
The normal macroeconomic tool kit does not make it easy to calculate the upside to growth if regulations are cut, but that upside probably exists. Massive growth in productive capacity in Asia while the West’s tradeable sector has slumped is not wholly due to labor cost differentials. Perhaps policy changes can kick-start investment in North America and Europe, where it has long been so weak that some claim it weighs on productivity, workers having been denied sufficient capital, infrastructure, and laissez faire policies. Even in foreign affairs, a break with old ideas might have good effects, especially if NATO is indeed a stale alliance with one country paying its bills and fighting its wars, and if the EU has become an undemocratic rule maker, and if some central banks are blindly carrying dollar reserves as a sort of tribute to the past.
A pessimistic version of dissolution emphasizes the disorder that transitions can portend. Although tax and regulatory change could increase incentives to invest, tightening financial conditions and new sources of risk aversion could prevent a capex renaissance. Renewed euro or EU breakup fears could have severe financial repercussions once again. Speculation that great power war is not quite as unthinkable is it was a short time ago could be even more damaging. If one part of nature most abhors vacuums, it might be geopolitics: we expect governments to test the new rules in an era of dissolution. A dark thought is that if early dissolution goes badly, institutions can suffer deeper fractures. And we agree with the work of Daron Acemoglu and others that emphasizes institutions as the ultimate foundation for markets, growth, and prosperity.
Personal income tax cuts, business tax reform, infrastructure spending, and regulatory rollbacks. It sounds like a lot. Will it be? We think fiscal policy will be a tailwind to growth in 2017 and 2018, but market expectations of a game-changing stimulus may already have gone too far. The changes being discussed are about much more than Keynesian stimulus. The economy’s distribution of after-tax income, its built-in incentives for investing and working, and its long-term budget dynamics all may change. The relative importance of these things is debatable, but an imminent dissolution of old fiscal norms is likely. Details will emerge from the political sausage-making process. The Trump administration will not get its way on everything despite Republican control of Congress. A tax package will probably be included in a budget reconciliation bill this spring or summer. That type of legislation cannot be filibustered under Senate rules so simple majorities in both houses of Congress are all that is needed for passage. However, reconciliation bills require spending offsets to planned tax revenue reductions, so that projected deficits do not increase more beyond the next ten years. It is possible that tax reform gets done outside of a reconciliation bill. This would require bipartisan cooperation (to achieve 60 Senate votes) and would allow for a bill with fewer spending reductions (and therefore potentially more short-term stimulus).
Infrastructure stimulus is much less likely than tax reform in 2017 because the Trump administration, Congressional Democrats, and Congressional Republicans have very different ideas on what should be done. For the Republicans, this is likely a much lower priority than taxes. Our guess is that eventually, Trump and the Democrats may compromise, and there will be a bill with some money for local governments and some projects for private investors. But such a bill will be expensive, requiring a funding source. With repatriation not a likely short-term possibility, this could take some time. We think an infrastructure stimulus is not likely in 2017.
Finally, there is deregulation. Credit growth, infrastructure investment, and energy investment have all been limited to some degree by financial, environmental, and sectoral rules in recent years. Small business consistently complain that regulation is a major obstacle to doing business. It is impossible to quantify the impact of a US government that dislikes regulation, but the direction of the impact on short-term growth and investment is likely to be up. What is the net effect of all this? Stimulus, yes, especially over a two- to three-year time horizon. But the specifics are not as powerful as recent market reaction would have one expect. In our view, the real chance of a Trump boom rests not from directly, quantifiable reactions consistent with past episodes of policy change, but instead from the great qualitative game changer of animal spirits. A Trump boom may happen because firms become more willing to invest, and some individuals become more willing to work, partly as a result of the set of policy changes above, and also changes in asset prices which also impact spirits and incentives. Recent increases in risky asset prices are a good sign, but then again, rising interest rates and a strong dollar might provide an offset. Conspicuously, we have not changed our growth forecasts much since the election, and this is in the spirit of caution with which we have analyzed the policy outlook above.
Changes in political economy regimes and narratives take time to affect the units of economic accounting – GDP and inflation – as well as monetary and fiscal policy. January 2017 will not mark a clean regime break in the path of recent economic trends. The impact of the transformations discussed in this Outlook will be slow and cumulative over coming years. But the trends and volatility the global economy exhibits over the coming year could easily fortify new market narratives. Stronger growth. The global economy is seeing a sustained, broad-based, quickening in growth. Global real GDP should grow 3.0% this year after 2.5% in 2016. This would be its best year since 2011. And risks seem skewed to the upside. Rising inflation. Commodity and producer prices are improving with growth. So headline inflation rates, extremely low in the last two years, should rise sharply in 2017. Narratives and concerns could shift away from deflation, to reflation and inflation. The end of super-easy monetary policy. That may shift expectations further about monetary policy. Markets may look for the Fed to tighten faster than expected; the ECB and BoJ to pare back on their stimulus; and the PBOC to face a dilemma between supporting its currency and maintaining sufficiently easy domestic financial conditions. The economy should drive as much market volatility as politics in 2017.
The prospects for global growth this year appear promising. A concatenation of factors all suggest cyclical risks are to the upside for once. There is potential for the multipliers from the global trade and inventory cycles to feed back to stronger demand. Economies that have undergone adjustment in the last few years – whether that is Europe or many emerging market countries – are now steadily healing. And economies due an adjustment – China, and possibly the US – do not seem set to face a reckoning in 2017. There will no doubt be new shocks to absorb: a witches’ brew of higher rates, higher commodity prices and a stronger dollar is simmering; trade wars or geopolitical crises could flare up. But for now headwinds are abating, not stiffening.
Longstanding trends of deepening world trade integration appear to have ground to a halt. The Trans Pacific Partnership’s apparent failure is the clearest sign of this. The TPP deal would have lowered some tariffs, especially between the United States and Japan, but it was more about harmonizing regulations and standards across a range of industries, including financial services, pharmaceuticals, and information technology. Harmonizing industry rules makes trade deals more effective, as some countries routinely use arcane regulatory hurdles to prevent imports even where tariffs are low or non-existent. Hardly a strategic encirclement of excluded China, TPP’s “Asian” orientation was overrated. Other than the behemoth Japan, most TPP countries were not even Asian (US, Mexico, Canada, Chile, Peru, Australia, New Zealand); only the smaller Pacific states of Brunei, Malaysia, Singapore, and Vietnam sit near China’s flank. And Chinese officials expressed interest in signing on to the deal late in the negotiation process, in an effort to advance its own domestic regulatory agenda. Of course, TPP was constructed such that other Asian countries, including China itself, could one day sign on. Still, this well-meaning and hard-fought deal may not have completely fallen by the wayside. Some observers suspect that the Trump Administration will attempt to amend – not end – deals like TPP, NAFTA, and TTIP. Notably, macroeconomic models show small long-term effects from TPP in the US and Japan. Ending these deals will not collapse global growth. However, the US might be forfeiting some influence over future trade integration, losing ground to Chinese-backed initiatives such as RCEP, or bolstering a view that world trade will be in decline – a situation that could harm productivity.
Extremely low bond yields in Europe and Japan, driven by central bank asset purchases, have been a powerful anchor to global bond yields. If our expectations for global growth and inflation described above are correct, then the key risk is that in the second half of the year markets will start to price the risk that either or both central banks will start to haul that anchor up. That would be a profound change for markets. And inasmuch as dollar strength may contribute to conditions for a shift in monetary policy from the ECB and BoJ, it will also pose a challenge to the Chinese authorities. The classic trilemma is starting to bite. There is a clear desire for both external and domestic stability – a managed decline in the currency against a strengthening dollar and solid domestic growth. Achieving both at present is challenging with a leaky capital account. So far, the authorities have responded by attempting to seal up the capital account through tighter capital controls and undertaken some modest domestic monetary tightening. A key risk is that that policy response becomes harder to sustain if the dollar strengthens significantly further. China may have to choose between domestic or external stability. In that case, markets would face either a sharp downwards correction in Chinese growth or a substantial drop in the currency.
Widening rate differentials, political risk in continental Europe and potentially a corporate profit repatriation holiday in the US are all likely to keep the USD supported against most G10 and EM FX in 2017. A protectionist turn in the incoming US administration’s trade policy would likely reinforce our bullish take on the USD as a first reaction, given the heavy weight of CAD and MXN in the USD broad index. The increase in US international leverage poses a key risk to a stronger dollar view as rising yields might generate higher coupon payment outflows to foreign holders of US debt, resulting in a rapid deterioration of the US’ income balance. A strong political message from the incoming US administration against further USD strength would also raise the risk of a sharp pull-back, making it hard to trade on persistent USD strength throughout 2017. Relatively high implied volatility means FX options are not cheap either. As such we recommend trades that do not make a direct play on the greenback and give investors some scope for risk diversification. Our trades are pro-carry and also sell implied volatility, which are non-consensus approaches at a time of rising funding costs and perceived high political risk.
What are the risks to this outlook? In simple terms, if any of the assumptions above are materially contested by data or politics, problems emerge for committed USD bulls. Q1 has been notorious for generating USD weakness against other majors in recent years as actual outcomes on data and rates undershoot what was priced in, for reasons that even include US weather shocks. Data in Japan and the euro area could surprise on the upside, leading to surging local yields from historically suppressed levels. Politics may mean that US tax changes do not happen as quickly or effectively as markets expect. European politics could yet deliver upside surprises, with a lot of risk aversion already priced in (see Figure 43 and Figure 44). Perhaps point 4) above poses the most difficult risk for the market to price, and the most likely source of a volatile USD turn that the market finds hard to digest. President-elect Trump was helped by a wave of populism grounded in protectionist sentiment. The political rhetoric in the US from key players like the White House, the Treasury or even the Commerce Department could shift in favour of vociferous complaints about USD strength. And the resulting uncertainty and volatility could wash out USD longs, much like the Fed’s sudden acknowledgment of the risks posed by USD strength in March 2015 helped end the greenback’s seemingly unstoppable rise at the time. In effect, political verbal intervention could mean that, for any given level of USD-positive rate differential, a weaker USD would exist that would otherwise be the case. As one example, the official “strong dollar” policy that has been in place for over 20 years could be formally ended. As another, the US Treasury’s FX manipulation report could be used more aggressively than it has been till now. Another important risk for the greenback in 2017 is a factor that has demanded much less attention: the US current account position. Since the start of the US shale revolution, the US current account deficit has been well behaved against a backdrop of a now-balanced position in energy. Previously, a large energy deficit was the most significant persistent contributor to the trade deficit. While this optically makes the US current account position both muted and stable, we see a risk that needs to be discussed: a possible sudden deterioration in the net income balance. After all, if US rates go higher and the US strengthens, the gap between what the US pays foreigners on their US assets and what it receives on its foreign assets should lead to a deteriorating net income balance.
Turning to Asia, the JPY had an extraordinary 2016, with USDJPY making highs near 122 in Q1 only to trade below 100 by the summer before rallying back towards where it started the year by the end of the year. In the period following Trump’s election victory, long USDJPY has proved to be the cleanest proxy for higher US rates in FX space. To a large extent, this reflects the BOJ’s introduction of Yield Curve Control in September 2016. This has allowed rate differentials to widen steady in favour of the US since November, with the BOJ keeping Japanese rates pinned through its relatively new policy. Our base case is that the BOJ will continue with this policy for now, especially as it is having success in boosting its likelihood of meeting its 2% inflation target as USDJPY moves higher. The current state of affairs is a ‘bonanza’ for the central bank, which can now have its cake and eat it in that it is benefitting from a weaker JPY without having had to resort to radical concepts like “helicopter money” to achieve it. Our base case is that as 10-year US yields push towards 3%, USDJPY will move still higher, to test the 2016 highs around 122. Beyond that level, the risk-return profile for being long USDJPY starts to deteriorate. Our equity strategists think global equities will start to react badly if and when US 10y yields push beyond 3% – weaker equities and higher equity volatility would help cap USDJPY, all things being equal. Meanwhile pressure on the BOJ to hike its YCC target rate will likely rise as markets test the policy in an environment of rapidly rising global rates. If the BOJ were to change the policy by shifting higher its target rate, one of the key premises for being short JPY will be challenged. Indeed the BOJ may also consider too much JPY weakness a threat to real consumption in Japan, a problem that would be heightened if oil prices were to keep rising. Also, it is worth remembering that JPY at these levels is a cheap currency. And with Japan running large current account surpluses and being on the US Treasury’s FX manipulation “Monitoring List”, it’s debatable how high Japan itself would want to see USDJPY go; too much attention would not be a good thing.
As for the G10 commodity currencies, in recent months realised volatility in this space has been low. Improving terms of trade since the summer have been offset by adverse moves in rate differentials as the market has priced in Fed hikes, leaving the likes of CAD and AUD in no man’s land. Into 2017, we prefer being short these currencies vs USD. We see little chance of rate differentials turning back in their favour, especially since macroprudential measures appear to be cooling overheating property markets in countries like Australia and Canada. Inflation also remains subdued in many of these countries. In Canada, the central bank has raised concerns that high levels of household debt pose a threat if Canadian rates rise materially. This suggests that CAD could weaken either because of widening US-Canada rate differentials as the BoC purposefully lags the US, or that it eventually falls if the domestic economy stalls in the face of higher rates. The silver lining for Canada would be the possibility of a strong recovery for non-oil exports if US fiscal easing provides a demand boost.
We believe 2017 will be a year of sustained tension between those EM-negative and EMpositive factors that have been in play since Trump won the presidency. Since Trump won the US presidential election on 8 November, the combination of his plans for large-scale tax cuts and his protectionism has led to a combination of substantial increases in US equity prices, tightening of US corporate credit spreads, sharp increases in US rates across the curve, appreciation of the US dollar, and underperformance of EM assets against comparable US assets, as the EM countries are widely expected to be disadvantaged by possible counter-globalization policies under Trump. However, the vast majority of the EM asset price underperformance happened in the first two weeks after Trump won the election; since then EM assets have generally found support in sturdy macro readings out of China, buoyant commodity prices and a slowdown in the ascent of US rates. Our base case view is that there will not be a clear “winner” between these factors in the first quarter of 2017, and that EM credit spreads will, in that period, broadly track US corporate spreads while EM will continue to move against the US dollar largely in line with the yen and the euro. That said, we do see greater risk of EM underperformance than EM outperformance due to the possibility of substantial new US trade restrictions that may be targeted primarily at countries in the EM universe. This is a powerful argument for holders of EM assets to hold protection against Trump protectionism (such as a put option on the Mexican peso). From the perspective of EM investors, the current risk pattern is similar to the state of affairs in 2013, which was a year in which good G3 news, sharply rising UST yields and bad EM news co-existed – just as they do now. In early 2013 G3 credit and equity markets responded positively to the elimination of “fiscal cliff” risk in the US and the initiation of Abenomics in Japan. They also benefited from Draghi’s credit-supportive policy steps at the ECB. Meanwhile EM-investors were losing faith in the ability of policy makers in China to stabilize growth in domestic demand, which had already fallen for years. In May of 2013, Bernanke’s taper talk pushed up US rates sharply. Rapid increases in US rates inspired talk in some circles about a funding crisis for EM borrowers. For dollar-based holders of EM assets, 2013 was a “pretty bad” year in terms of absolute performance and a “very bad” year in terms of relative performance. The dollar-value of global benchmark indices for EM debt and equity fell by 5%-9% in 2013. Meanwhile the S&P and US high yield debt generated total returns of, respectively, +25% and +8%. Will that experience be repeated in 2017? The current combination of tax cut expectations in the US, rapidly rising US rates, and global counter-globalization threats suggests that it could be – but we see good reasons to think that EM assets will keep up better with comparable US assets this time around than they did in 2013.