Good-bye 2016 – Hello 2017!
16 December 2016
As Christmas draws closer we all have the peculiar habit of looking back at the last 12 months and then attempting to forecast developments of the 12 months ahead, simply because we are nearing the start of new calendar year. Our medium term views at Tatton are not particularly governed by this annual recurrence, but I am happy to bow to popular demand and join in with the tradition.
Looking back at what I wrote a year ago, I can congratulate the Tatton team for getting the 2016 economic forecast right – growth to persist and perhaps surprise on the upside – but have to admit that we didn’t foresee the upheaval in the political landscape. And had we known, we would never have projected double digit investment returns across most major asset classes (as were achieved), or even dared to suggest middle to low single digit returns (as we did forecast).
2016 appeared to become a very difficult year, when it began with a major stock market sell-off that many interpreted as heralding a global recession. We disagreed, held portfolios steady and found our view confirmed as markets recovered rapidly by early March.
The market action that followed from there onwards was treacherous for any ‘high conviction’ active investment manager, with even those who managed to anticipate political outcomes correctly being caught wrong footed with their reasonable positioning towards less risk. Market sentiment seemingly swung 180 degrees from being hyper-sensitive to anything mildly unexpected to adopting a very relaxed ‘benefit of the doubt’ attitude.
What I believe actually happened was that the decisive Chinese economic stimulus intervention to their 2015 growth and stock market slump boosted the global economy sufficiently so that the perspective of a UK Brexit a couple years down the line was not able to derail resurgent economic optimism. On top of this, the combination of stabilising oil/commodity prices and an expectation that the political establishment would be scared enough by the populist uprising to finally fight it with fiscal stimulus programs, further improved market sentiment.
This led to an upward normalisation of long term inflation expectations, which made long term bond yields at or below 0% illogical.
While the US election success of Donald Trump in November shocked the intellectual and political leading classes of the Western world, financial markets and business interpreted it as the final death knell of fiscal austerity and quite possibly the return of more business friendly economic policies. This perspective propelled stock markets further upwards, while longer maturity bond yields rapidly retraced back to levels they had in some cases last been at more than a year ago.
We are ending the year with stronger positive economic growth momentum that has allowed the US central bank to raise interest rates for a second time in 12 months, while projecting another 3 rate rises over the course of 2017. Oil price volatility may have been tamed for a while if OPEC and Russia stick to their newly agreed supply reducing production targets. All in all, evidence that the economic and financial markets environment continues to return to the long term averages and thus a more normal environment.
What is not quite normal is the new political landscape that 2016 created. This has not only brought division to western societies not seen for a generation but also created uncertainties about the future global economic framework of trade, commerce and freedom of movement. It has been a great surprise that capital markets have thus far chosen to cherry pick only the potentially positive aspects of what a future under Trump and Brexit may hold, while discounting the potentially very negative aspects as unlikely because of their obvious destructiveness to the wealth of nations.
This leads nicely to the outlook for 2017.
Just like at the end of last year, the economic outlook is positive and the growth momentum sufficient to generate economic and financial progress. But not strong enough to have to be concerned about possible overheating, with the prospect of a return of boom and bust scenarios. Capital markets appear to anticipate as much and more for 2017, which has driven stock markets higher and fixed interest bonds lower as one would expect in the classic growth scenario. The question now is whether they have overshot and are due a correction or at least flat-lining for a while as we find out whether the high hopes for growth and better corporate profits are justified.
Some doubts are certainly in order. Will Donald Trump really get his promises of significant corporate and income tax cuts through Congress, when it is not clear whether this will increase economic activity and thereby the tax base enough to equalise the lower tax rates. 2 years ago, when the more than halving of US energy bills created a similar windfall, the money was saved, not spent or invested. Likewise, major infrastructure improvement programs will face funding difficulties and are unlikely to get on their way during 2017. Furthermore, the rapid rise in the cost of finance through the risen bond yields and the stronger currency value of US$, have in the past constituted significant headwinds for corporate US as well as US-Dollar dependent Emerging World economies.
Compared to last year there are also more known political risks on the horizon for 2017. What if a president Trump feels obliged to start a trade war with China, or generally restrict free trade? Or the EU’s political establishment gets steam-rolled by a further swing towards nationalistic populism that also seeks to roll back globalisation? These are just some examples, which make forecasts for 2017 very dependent on political developments, which, as we have just found out, are ever more difficult to foresee.
On the other hand, should political influence turn out to be more benign or even supportive by way of measured fiscal stimulus particularly in Europe, then the discussed monetary and currency headwinds could be more than compensated through additional money that is currently still sitting idle.
One may also wonder whether the recent improvement in economic sentiment is sustainable, when the political outlook is so depressing for many. However, improvement in confidence can become a virtuous circle and lack of confidence has been one of the major factors that has held back the economy since the Global Financial Crisis.
I am afraid therefore my 2017 outlook is somewhat conditional. If politics don’t interfere negatively and fiscal austerity does not return, then the economy and investments should have a good year with decent positive returns. However, if the populist politics of simplistic but economically detrimental de-globalisation succeed, then we could be in for a nasty market backlash.
I judge the probabilities for a benign political scenario higher, simply for the fact that the resurging economic momentum is already leading to the largest real wage growth amongst those lower income receivers who have been particularly discontent with the performance of the political establishment. This should reduce the pressure on Donald Trump to attempt anything particularly radical, while allowing to sell the improvements as his own rapid delivery of relief to his voters.
As for the UK, much depends on developing and ever changing Brexit expectation and their impact on the further development of the currency value of £-Sterling. Should the UK’s currency remain weak, then the inflationary impact of higher import prices may erode much of the nominal gains we have seen over the second half of 2016. A stabilisation to slight improvement in the currency value would be the best outcome for the UK. A rapid recovery on the other hand – however unlikely at the moment – would not only be tough on business but also unwind a substantial part of recent investment returns that arose as a result of the higher value of overseas investments from the weaker £-Sterling perspective.