EDITORIAL: SHIFTING GEARS
In a nutshell
- The last three decades have witnessed a profound transformation in global commerce
- In this context, political and popular scepticism about the benefits of free trade has risen – a crisis triggered by a build-up in debt
- The world is faced with a shift from over-reliance on monetary stimulus to a renewed focus on fiscal policy
- Here we will endeavour to determine how best to position portfolios for this gear-change
After almost a decade of easy monetary policy and fiscal austerity, budgets are becoming more growth-supportive and we expect the global economy to be stronger in 2017 than this year. The United States (US) should remain the fastest-growing economy in the developed world, while the eurozone will again register above-potential gross domestic product (GDP) growth. Emerging economies will be hit by fears of rising protectionism but we believe that healthy domestic demand will help mitigate that risk.
The impact of oil price falls on inflation will diminish, narrowing the gap between headline and core inflation in developed economies. Price rises in the US will also be fostered by rising wages while sterling weakness means that the United Kingdom (UK) should see a bout of imported inflation. However, inflation rates in the eurozone and Japan will remain well below target next year.
We expect the US Federal Reserve (Fed) to quicken the pace of interest rate hikes in 2017 although key rates will remain well below the long-term equilibrium. Monetary policy in Europe and Japan will stay extremely accommodative, while many emerging world central banks have room to ease policy further.
Despite its rich valuation, the US dollar is likely to remain strong next year as the market adjusts to the post-election shift in the policy mix. Recent weakness in many emerging currencies means that they are undervalued with respect to their improving fundamentals – this will offer selective opportunities in 2017.
The pick-up in inflation expectations in the US and the UK will put upward pressure on long-dated bond yields but upside will be limited by the continuing asset purchase programmes run by the European Central Bank (ECB) and the Bank of Japan (BoJ). Corporate bond spreads will offer a measure of protection against rising yields. Emerging market bonds still offer an attractive yield pick-up but there will be no tightening in spreads before we get greater clarity on President-elect Trump’s policy priorities.
Stronger global growth will help corporate profits continue the recovery initiated in Q3 2016. However, US earnings growth will be constrained by rising wages and financing costs while valuations are still demanding. We expect the eurozone to do better in 2017 – profit margins have more room for improvement and balance sheets are in better shape, while multiples are less stretched.
Mr Trump’s promise of fewer restrictions on US oil drillers should mitigate the impact of any cut in the Organisation of Petroleum Exporting Countries’ (OPEC) output, meaning that global supply is likely to continue to outstrip demand, keeping a cap on oil prices. Gold is likely to remain pressured by dollar strength next year.
The shifting gears in the policy mix will bring new opportunities but also new risks for investors. More expansionary fiscal policy would boost growth but valuations could be pressured by rising interest rates and dollar strength. In this context, broad diversification across assets and long-term themes remains advisable.
2016 has witnessed a number of major upsets on the political front, ranging from the United Kingdom’s decision to quit the European Union to the surprise elevation of Donald Trump to his first elected office. It is perhaps no coincidence that what appears to be a rejection of the established political order has occurred almost a decade after the Great Recession.
The last three decades have witnessed a profound transformation in global commerce as multi-lateral trade agreements under the aegis of the World Trade Organisation (WTO) have enabled companies to build international supply chains. This trend only accelerated after China’s accession to the WTO in 2001.
As companies began to offshore manufacturing capacity, the number of jobs in Western factories continued to decline, feeding fears that jobs had been “lost” to China or elsewhere. More efficient supply chains also helped reduce prices of many goods, contributing to downward pressure on producer and consumer prices. In turn, falling inflation meant modest wage increases for workers which fuelled fears of a decline in living standards, most keenly in those communities which had suffered factory closures.
In this context, political and popular scepticism about the benefits of free trade has risen, leading to a gradual rejection of the previous decades’ easing of trade restrictions. Since 2008, barriers to commerce have been raised again and global trade volumes have slumped well below pre-crisis levels. And in turn, this slowing of trade flows has contributed to weaker economic growth in the aftermath of the global financial crisis of 2007-2009.
This crisis was triggered by a build-up in debt, in particular sub-prime mortgage lending in the United States. It became global when it emerged that the international financial system was highly exposed to this risk. And the scale of the ensuing downturn in activity was such that it was judged that highly unconventional monetary policies were necessary to restore growth. First, interest rates were cut to negligible or even negative levels. Then, central banks expanded their balance sheets to purchase financial assets (e.g. government bonds), with the aim of lowering yields across different maturities and encouraging banks and investors to seek higher returns elsewhere.
As a result, the unconventional monetary policies conducted over the last decade have benefited owners of financial assets. The inflation that was targeted by central bankers has shown up in bond prices rather than in those of goods and services, at least until very recently. The growth stimulus that was sought has reflected in equity prices – the S&P index of large-cap US stocks has increased by 230% since its March 2009 low – rather than in an acceleration in productivity or gross domestic product (GDP) growth.
This in turn has fed a divisive rhetoric that “Wall Street” has been given preference to “Main Street” – that is, that financial intermediaries have benefited more than entrepreneurs and their workers. In addition, the rise in security prices has diminished the returns available on deposits or on fixed income instruments. This means that savers – for example, those building assets to fund a pension plan – have been penalised. As yields decline, more capital must be deployed to guarantee the same level of investment income.
In addition, greater commercial and economic integration across borders has encouraged greater international mobility of labour. In the European Union for example, to the population flows driven by freedom of movement for workers has been added the influx of refugees fleeing trouble spots in the Middle East and in Africa. Given the above-mentioned factors, it is not surprising that many voters have felt threatened.
This framework can help us understand the two unexpected electoral results we mentioned above. “Lost jobs”, “falling living standards” and “uncontrolled immigration” have proved powerful arguments for change.
One of the changes underway is a shift from over-reliance on monetary stimulus to a renewed focus on fiscal policy. While the build-up in debt in recent years constrains most governments’ ability to make radical changes, the change in emphasis is welcome.
In summary, we are witnessing a shift in priorities with potentially important implications for investors. In this report, we will endeavour to determine how best to position portfolios for this gear-change.
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