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.