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WorldDecember 1 2016

2017: a journey into the unknown

The biggest shocks of 2016 were political rather than financial, and politics will continue to keep financial markets on their toes in 2017 as monetary policy gives way to fiscal stimulus. The long-term effect of a Trump presidency, however, is anyone’s guess, writes Edward Russell-Walling.
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Trump and Putin

Politics looms larger than usual over today’s markets. There has been not one but two ‘black swans’ in 2016, and both were served up by voters rather than investors. The UK's Brexit vote and the election of US president-to-be Donald Trump ­– ‘Brump’, as some have rather inelegantly labelled this joint phenomenon – raise more questions than answers right now, though some expect a Trump administration to spur US growth.

The inward-looking result of the UK’s Brexit referendum was generally acknowledged as a downside risk for the global economy, and had forecasters scaling down their already subdued expectations for 2016. The Organisation for Economic Co-operation and Development (OECD) trimmed its world growth forecast for 2016 to 2.9%, down from 2015’s 3.1% and well below the long-run average of about 3.75%.

This reflects a continued pattern of slower trade growth since 2012, with depressed demand following the financial crisis, the domino effects of slowdown in China, falling productivity growth and eurozone weakness. The OECD does not expect things will dramatically improve in 2017, predicting a modest improvement in world growth to 3.2%.

Slow going

The OECD says the US economy will grow by 1.4% in 2016 and 2.1% next year, while Canada is forecast to increase gross domestic product (GDP) growth from 1.2% to 2.1%. It does not foresee economic acceleration in many other economies, however. It forecasts falls from 6.5% to 6.2% in China, 1.5% to 1.4% in the euro area, 1.8% to 1.5% in Germany and 1.8% to 1% in the UK. Growth is predicted to remain flat in France, at 1.3%, and in Italy, at 0.8%.

India is one of the few bright spots, where the OECD estimate is for 7.4% in 2016, rising to 7.5% in 2017. Japan should inch up from 0.6% to 0.7%, while Brazil should reduce its rate of contraction from -3.3% to -0.3%.

The UK’s departure from the EU will be a drawn-out process, and its real economic effects will not be apparent for some time. By contrast, the Trump effect on the world’s biggest economy will begin to manifest itself on January 20, when the president-elect takes office. Today, however, there is still a great deal of uncertainty over the extent to which Mr Trump’s actions will reflect his campaign rhetoric.

In trade he has been unequivocally protectionist, promising to impose import tariffs on China and Mexico, renegotiate or withdraw from trade deals and pursue China over currency manipulation and unfair trade practices. This would support domestic growth but do little to lift world trade out of the doldrums.

Will Mr Trump go that far? “We assume punitive but not prohibitive tariffs, and proportional responses by targeted countries that would avoid public trade wars,” says Barclays in its latest Global Outlook Overview, entitled Turning Point. It calculates that the resulting economic drag should be more than offset by economic stimulus.

Hard sums

Mr Trump has pledged to cut government spending, while touting a substantial infrastructure package and higher spending on defence. Indeed, if all his policies were adopted, they would increase the federal debt by $5300bn over 10 years, to 105% of GDP, according to the non-partisan Committee for a Responsible Federal Budget.

Paul Ashworth, chief North American economist at research firm Capital Economics, believes that Mr Trump’s fiscal policies are vague and do not add up. And he is sceptical about Mr Trump’s pledge to push US GDP growth to 4%.

“A lot of the slowdown over the past decade across the developed world has had more to do with the ageing of the baby boom generation,” Mr Ashworth observes. “Mr Trump might try something to get productivity growth going but it isn’t clear what he can do. On economic growth, I suspect his promises are going to be unfulfilled.”

There are, however, some promising sides to the president-elect’s tax plans, he says. These include simplifying the tax code, taxing business income at 15% and taxing repatriated corporate profits currently held abroad at the alluring rate of 10%. “That money would return to the US, where it would encourage domestic investment,” says Mr Ashworth.

Fiscal expansion

Bankers at Crédit Suisse believe that the new president’s policies, particularly on fiscal expansion, will be key to economic developments in the year ahead. “He is one of the only leaders elected since 2008 to strongly advocate fiscal expansion,” says Christopher Tuffey, Crédit Suisse's Europe, the Middle East and Africa (EMEA) head of debt syndicate. “Everyone else has been pursuing austerity and debt reduction.”

The US economy is expected to expand as a result, Mr Tuffey says, adding that this could have an impact on the global economy. He notes that rates have already risen globally, and the dollar has been strengthening. “Ten-year US government bonds could get to 2.75% by mid-year, and will probably trade around a range of 2.5% to 3%,” he predicts.

The Federal Reserve may raise rates in December and two, perhaps three times in 2017, and rising rates will feed into inflation. US consumer price index inflation was 1.6% in the year to October. It will rise to 2.8% next year, according to Barclays, which is forecasting 2017 inflation of 1.1% in the euro area and 0.3% in Japan.

Expectations of higher rates, coupled with promises from the Trump camp to loosen bank regulation and “dismantle” the Dodd-Frank Act, have seen US bank share prices stage their biggest recovery rally since 2009. Questioned about Dodd-Frank, Federal Reserve chairman Janet Yellen told a Congressional committee recently that she would not “want to see the clock turned back” on improvements put in place since the financial crisis.

The China question

If all eyes are on the US at this juncture, they have never strayed far from the world’s other pivotal economy, China. While there was much concern over Chinese growth at the start of 2016, official stimulus has since steadied the economy, though at the cost of substantial credit expansion.

Indeed, China’s failure to blow up was one of the key features of 2016. “China stops and starts,” says Bilal Hafeez, Nomura’s head of EMEA fixed-income research. “Markets expected it to be a big negative story this year, but in fact it has stabilised quite well. It has been dealing with debt overload and overcapacity and will be under more pressure economically in 2017.”

A stable Chinese economy is good news for emerging markets, even as the authorities try to increase domestic consumption. And if the US creates a vacancy in world and regional trade leadership, China fully intends to fill it. Chinese president Xi Jinping has responded to Mr Trump’s protectionism by saying China will be even more welcoming to foreign business and more committed to globalisation. 

“China will not shut the door to the outside world but will open it even wider,” Mr Xi told the Asia-Pacific Economic Co-operation summit in Peru in November. He then invited Latin American countries to join China’s One Belt One Road project, recreating the Silk Road trade route to Europe. With outgoing US president Barack Obama’s Trans-Pacific Partnership – which included Japan and 10 other countries but excluded China – now apparently dead in the water, China has been pushing its rival Regional Comprehensive Economic Partnership. That too has been attracting interest from South America.

Europe elects

In Europe, 'Brump' has focused attention even more sharply on a slew of important votes due in 2017. Will they too reflect a less globalist, more nationalist, right-wing mood among voters? Could Eurosceptic populism lead to more Brexits?

First up is December’s constitutional referendum in Italy, where prime minister Matteo Renzi has pledged to resign if his reforms are rejected. Many think that his promise is simply inviting trouble. What is certain is that, if he is obliged to honour it, this would play into the hands of the Eurosceptic Five Star Movement opposition party.

In March, the Netherlands votes for a new government. Its anti-immigration Party for Freedom, currently leading in opinion polls, has called for a referendum on leaving the EU. April and May see presidential elections in France, where the Front National is demanding ‘Frexit’. German elections due later in the year raise more uncertainty than for many years, with the outside possibility of success for the right-wing Eurosceptic Alternative for Deutschland (AfD) party. Now that Angela Merkel has finally declared she will seek a fourth term as chancellor, markets will hope that AfD’s chances are further reduced.

Lower volumes

A Eurosceptic outcome in any of these votes would unsettle international financial markets, particularly in the case of France or Germany.

“We don’t know what their policies will be, so there will probably be more volatility,” says Jean-Marc Mercier, global co-head of debt capital markets (DCM) at HSBC. Volatility makes clients more inclined to turn to the professionals for help, he adds.

Another sign of more volatility ahead is the diverging behaviour of central banks. “For the past year or two they have all been aligned, but that’s changing,” says Mr Mercier. “The Fed may hike, but we don’t know whether the European Central Bank will add to quantitative easing. We expect so, but this will all make for more volatility.”

Though markets proved resilient to Brump, they have had a mixed year. Volumes for year-to-date 2016 are down compared with year-to-date 2015 for equity capital markets, mergers and acquisitions and initial primary offers, according to figures from Thomson Reuters. However, low rates and investor appetite for bonds at any price (at least until now) have kept DCM activity significantly ahead of 2015.

That polarity may be reversed in 2017. Crédit Suisse's head of EMEA DCM, Sandeep Agarwal, notes that, while fiscal expansion would increase the borrowing of the US government, any repatriation of corporate funds would have the opposite effect. “That would lead to some stock buybacks or deleveraging in the US corporate sector,” he says. “With the raising of rates, deleveraging would be a good trade, so issuance volumes could go down rather than up.”

Regulation is likely to drive a lot of financial institutions group (FIG) issuance in 2017, as banks meet their total loss-absorbing capital and minimum requirement for own funds and eligible liabilities obligations. However, this is unlikely to boost FIG volumes overall as it will merely be replacing existing senior issuance.

One area of DCM that should experience an uplift is emerging market issuance. Low oil prices have been squeezing budgets in the Middle East and other oil-dependent countries. Many of them have sold bonds to finance their deficits: witness this year’s mammoth $17.5bn issue from Saudi Arabia, the largest ever from an emerging market. That trend is likely to continue in 2017.

Russia revival?

With Mr Trump in the White House, it becomes more likely that sanctions on Russia will be rolled back. This would open the door to pent-up bond supply from Russia and the Commonwealth of Independent States.

The so-called ‘Trump tantrum’ saw investors sell off emerging markets bonds and currencies, fearing they would be hurt by protectionism. Not everyone agreed with that conclusion. “First, it does not take into account the current poor state of the US economy, which is unlikely to be US dollar positive and will take time to fix,” observed investment adviser CrossBorder Capital in a recent note. “Second, it ignores the impact of China, which matters far more for emerging markets than the US.”

Overall, Mr Agarwal predicts that global DCM issuance volumes will be flat in 2017. “If oil prices remain low and if some sanctions are rolled back under Mr Trump’s presidency, volumes should be better in emerging markets,” he says. “But they are likely to be flat to marginally up in FIG and corporate.”

Inflationary cycle

Bond yields remain low by historical standards, even after the recent Trump-induced sell-off, and are likely to rise in the year ahead. “We have seen the end of the 35-year bull market in bonds,” says Ewen Cameron Watt, senior director of BlackRock Investment Institute. “Now we’re moving into a slightly more inflationary cycle, with slowly rising interest rates for the first time in a long period.”

Equities in the US at least should be supported by the new administration’s policies, notably those affecting corporate taxation. Barclays calculates that a 15% corporate tax rate would raise S&P 500 earnings by 10%. Non-US equities may have a tougher time as they wrestle with higher bond yields, higher inflation and a stronger dollar.

Equity flows have already been moving out of Europe, where the political risks have become too difficult to understand for US investors. “It’s a very challenging backdrop, and some investors are sticking to what they know better,” says Richard Evans, Barclays head of equities EMEA. “Money is also coming out of actively managed funds and going into passive investment strategies."

Because everything has been so macro-driven, being a stock picker has been tough for the past few years, according to Mr Evans. Now, however, more local drivers of asset movements have been prevailing, such as the Brexit vote and the US election result, and recent data shows these shifts have been stabilising. Barclays has been advocating a greater rotation out of low volatility or ‘bond proxy’ stocks, which have become too expensive, into value stocks, and out of staples into more cyclical shares.

Mr Trump’s growth policies should be good news for mergers and acquisitions in the US, though some think that his protectionism might depress inbound acquisitions by non-US companies. “It could affect sentiment,” says one banker. “You don't want to be told ‘no’, so you don't even try.”

After a grim few years, commodities have fared better in 2016, and should continue to do so in 2017. Supply and demand fundamentals are improving, and Chinese stimulus has already helped to lift copper and iron ore prices. Mr Trump’s plans and a broader shift away from monetary towards fiscal policy should do more in the future. Direct investment in commodities via indices and exchange-traded funds has picked up for the first time since 2012.

Gulf power

Mr Trump wants to make it easier to frack, end the ‘war’ on coal and dismantle the Clean Air Act. He also wants to reimpose sanctions on Iran. “If that happened, it would be likely to take 1 million barrels of oil per day out of the market,” says Kevin Norrish, Barclays head of commodities research.

“With President Obama, Iran has been in the ascendancy in the Middle East, while the Saudis feel they are not being listened to. So, depending on the way he approaches Iran, Mr Trump could affect the power balance in the region and, at the same time, move the market from surplus to deficit.”

That would be more extreme than most are expecting, and the US Energy Information Administration anticipates only a small rise in Brent crude to an average $51 a barrel in 2017, after averaging about $48 in the fourth quarter of 2016. The World Bank recently raised its own 2017 forecast by $2 to $55.

In its latest Global Credit Conditions Report, Moody’s predicts commodities in general will command higher average prices in 2017, though with limited upside. It forecasts G20 global growth of about 3% in 2017 compared with 2.6% in 2016, with steady growth in advanced economies and recovery in a number of emerging markets.

The ratings agency adds, however, that the risks to its outlook are skewed to the downside. “In terms of negative surprises, the growing risk of a re-pricing of assets, or a loss of confidence in the ability of China to manage its deleveraging and rebalancing process stand out,” Moody’s maintains. “Positive surprises are less likely.”

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