Year Ahead 2017

Where are we in the business cycle?


(1) Year 2016 in review

Without any doubt the previous twelve months were the year of surprises from many perspectives. Despite its pre-season odds of 5000/1 Leicester won the Premier League, however there were some solid examples from the investing markets as well. (i) Britain’s decision to leave the EU and the election of Donald Trump as the president of US caused unexpected movements on the market in both directions. (ii) Many called into question the reliability of the pollsters because these events were considered as underdog outcomes based on the surveys. (iii) And the Chinese economy didn’t turned into recession (this was one of the key risk factors of market forecasts) in 2016.


Historical performance of MSCI World index (source:Yahoo Finance)

As per IMF data, global economy is ecpected to grow by above 3% in 2016 and in 2017 as well. Not a surpise, increasing consumption was fuelled by real wage growth. In general global equity markets were oscillating in a range for almost three years from now (with US outperforming rest of the world).

The top FX story was the strenghtening dollar in 2016.

The extremely lazy global monetary policies pushed down mainly every debt related metrics, which was favourable for borrowers (the improved credit conditions are underlined by falling credit spreads; era of “easy money” with gradually increasing debt levels), on the other hand even nominal returns were hard to achieve on the fixed income markets. Practically real assets and equities were able to generate some noteable returns; the increased demand in these asset classes resulted in significantly increased valuations (US equity market, real estate prices in developed cities).

Additionally the investors could have learnt again last year that uncertanties in connections with politics and elections can have greater impact on the markets. This risk factor can be as significant as “simple” market risks we they are familiar with.

What will happen in 2017? Although we strive for one-handed answers, our current investment universe might not allow it. In the next section I will summarize my thougths on the key themes.

(2) Key investment themes

(2.1) US monetary policy

Majority of the investors already priced in the effects of Fed’s “gradual” rate hiking policy. Undoubtedly the recent US macro figures are supportive: in H2 inflation increased moderately and GDP data confirmed economic growth. The monetary tightening is expected to result in – finally – remarkable US yields and further appreciating dollar in 2017.


Historical US Treasury yields for different maturities (source: US Treasury)

The key question for the next decades whether this momentum might be new inflection point of US historical yield graph and a new upward trend could start. And why is this important? Because the increasing US bond price curve was one of the most important fundamentum of the last three decades from investors’ perspective.

Additionally the yield curve became more steepener, which – together with the stimulative fiscal regime (see next section) – is supportive for economic growth.


Long – short term US yield differences (source: US Treasury)

(2.2) Fiscal support

This would be quite a new policy item on the post 2008 developed markets. Based on Trump’s announcements tax cuts and increased spendings in infrastructure and defence segments are expected in the US. An additional potential impact which could put an upward pressure on inflation and growth (causing further monetary tighthening). In Europe such magnitude of fiscal easing seems to be less certain.

(2.3) Eurozone monetary policy

Most probably ECB will change the QE and will follow the FED in central rate hike (at least back to positive territory) – with a certain time lag. It would be very hard to imagine that Eurozone could do the opposite strategy compared to US on long term. Very intersesting to see the significant differences between the two yield curves for all maturities.


US and Eurozone yield curves on 30 December 2016 (source: ECB, US Treasury)

(2.4) End of deflanatory threats

Based on OECD forecasts the expected inflation rates for US, Eurozone and OECD countries are 1.9%, 1.2% and 1.8% respectively. The relatvely long era of disinflation seems to over.

(2.5) Special risk factors might completely reshape forecasts

  • European elections: The Eurozone election calendar seems to be very complex in 2017 (the Netherlands, France, Germany). Similar to pre-Brexit odds the base case for investors might be the “no surprise” outcome, however increased level of volatility is expected.
  • Equity valuations: compared to historical limits, this asset class is definitely not cheap. Additionally the stricter monetary policies are not necessarily supporting equites.
  • Real estate bubbles: extreme price levels already in central cities of developed world.
  • Current stage of the business cycle: In the theory the increasing level of inflation and the stricter monetary policy could be the early indicators for an upcoming economic slowdown (mid or long term). It is worth to mention that the current business cycle is 7 years old already.
  • Chinese growth related considerations similarly to 2016 forecasts. FX reserves are in a declining trend and CNY depreciated significantly against the dollar.

(2.6) Asset allocation ideas

  • Due to the existing stimulative monetary policy and growing economy, European equities can outperform this year. Long position in the related instruments (Eurostoxx or other index derivatives) seems to be reasonable.
  • The US equity market can easily grow further, but the “gradually” restrictive monetary policy might put a downward pressure on it. Not necessarily a clear picture for US equities, but countinous monitoring of technically¬†oversold securities is proposed.
  • Do not have a clear opinion about gowth vs value stocks. In the light of potential slowdown in mid term, investor might turn to the value stocks.
  • Due the uncertainties related to Brexit, having no clear opinion on UK equities.
  • The strengthening dollar and the rising bond yields are not really supportive for emerging market equities. Isn’t a clear picture.
  • Bond funds might not overperform due to the downward pressure on bond instruments.
  • With really small bets certain emerging markets with recent shocks (i.e. Turkey) can be tapered. Remember on post-Brexit reactions or the Russian stock market opportunities, when investors could utilize the short term volatilities.
  • Corporates with outstanding USD debt obligation having no sufficient dollar income as natural hedge seem to face increasing debt service costs. Rather avoid of these assets.
  • On the FX side everybody’s favorite is the USD, but further upsides might be limited in case other regions will start to follow restricting monetary policies.

Arbitrage stories from a freshly liberalized market

What was the most important difference from investor’s point of view between our current age and the 1980’s and early 1990’s? Clearly the available level and quality of information. And if it is limited in general and not available to everyone in the same quality, this might trigger short term arbitrage opportunities. Especially in a country where first attributes of modern capital markets were just introduced. This post focuses on four colorful examples from different financial segments of a freshly liberalized economy, Hungary which stories could serve as a solid basis for educational purposes (what does arbitrage mean in real practice?) as well.


Triple deposit rates per month

First of all let’s see what was the most important ‘to do’ of an average rational Hungarian deposit owner. Actually running between 2 or 3 local offices of retail banks with the savings resulted in triple rates in a month for an individual. In order to understand the background, the owner of the deposit was entitled to receive the entire rate after the monthly period from OTP (Orszagos Takarekpenztar, the most significant player of the Hungarian banking market nowadays as well and the most freqently traded share on Budapest Stock Exchange) only if the money was on the bank account on the 26th of the given month, practically no other criteria was taken into consideration. Additionally other local institutions followed the same approach but their effective date was the last day of that month. Because Postabank employed daily deposit rates, it was beneficial to hold the savings at Postabank until the last days of the period and collecting the rates from other banks via transfering the money to them for 1 or 2 days. Transfering meant physical delivery and this explaines why extremely long qeues characterised the branch offices of Hungary that time. Due to their oldfashioned systems the banks could not change this picture significantly for many years.

Anomalies on the local fixed income market

Due to the lack of IPOs, commercial bank loans, foreign loans and notable state subsidies, local fixed income issuances were relatively popular and could serve a good basis for the Hungarians to start learning the basics of capitalism. On the other hand calculating the fair, non-arbitrage price of an interest bearing bond was practically impossible for many people. This offered a great arbitrage opportunity (often more than 5%) for a small qualified group and the cost of the transaction was practically the walking time between two offices…. Not surprisingly many university fresh graduates prolonged their career starting and HR interviews and entered into this relatively easy game.

The story of IBUSZ, the first stock on the market

The date of 21 June 1990 has historical importance in Hungary. This is the birthday of the Budapest Stock Exchange and the first trading day of IBUSZ in Budapest and Vienna. Right after the start the first bid was settled at HUF 5600 and the closing price of that day was HUF 8000. However it closed the year at HUF 4820, less than the initial issuance price. Taking into consideration the experiences of the Austrian-Hungarian Monarchy, the existence of parallel trading in two different locations offered great geographical arbitrage opportunities. Even after the deduction of trading costs the price of Budapest was significantly lower and past data explained significant correlation between the current price at Budapest and the yesterday quote of Vienna.

Playing with the swap points

In 1991 and 1992 the central bank of Hungary posted FX forward quotes on regular basis. Swap point was defined as the difference between spot and forward prices. Obviously the central bank updated its spot prices every day, however the swap points remained fixed in a particular period. Even a relatively small change in spot quotes violated the classic no arbitrage formula (forward price equals to the spot price inflated by the risk-free rate) according to which at initiation the value of the forward contract must be zero. Subject to positive or negative fluctuations in the actual market prices, spot purchase with future selling or immediate short position with forward selling were the appropriate market neutral strategies (at the costs of the central bank). Moreover usually the bank offered upward sloping curves, lower swap points for shorter maturities and higher for the longer end of the curve. In this case the beneficial trading strategy was forward purchase for the shorter maturity and forward selling for the longer period.

sources:, Tozsdesztori,