The Investment Outlook for 2017
by George Hatjoullis
When I started work in 1974 we had a political risk department. The main concern was about nationalist governments sequestering corporate assets or defaulting on debt for political reasons. Many multinationals might consider reintroducing such groups which I gather have gone into decline during the era of globalisation. Political tumult is the theme of 2017 (and beyond). The rise of populism and its main vehicle for expression, nationalism, will create economic and investment risks that only those of us that have retired will fully appreciate. Ironically it is my generation that are responsible for this resurgence of political risk. Maybe we missed it.
Trump is a big unknown. The quintessential populist, no one really knows what he will do. He brings a risk of protectionism not seen in the post-war period. Will he be able to deliver? His power is more limited than people grasp. His party control both houses but he does not represent his party any more than Corbyn represents the current parliamentary Labour Party. Not everything he says will turn into action. It may be he achieves very little. His election has thrown Russia into the spotlight. It is no longer the pariah. Populist parties in the west seem to like Putin. Indeed they seem to be modelling themselves on his regime. The first to Putin-ize politics is Erdogan. If he gets his constitutional changes, Turkey will become Russia’s (not so) mini-me. Turkey is on the brink of economic and political chaos so we can see how this is working out. The fact that Putin sounds remarkably like a rude word is several languages seems apt.
Russia may be in the political ascendancy. It has annexed the Crimea and de facto parts of the Ukraine, at the cost of only some economic sanctions. It has sustained the Assad regime in Syria with impunity. The recent rise in oil and commodity prices has offset much of the economic damage inflicted by sanctions. It stands to benefit from a Trump boom if one emerges. It is well placed to weather protectionist forces. It has what others want; raw materials. Russia investments have done well in 2016 despite the sanctions. In part this is a correction to the initial down draft. However, it seems this correction may have legs and Russia emerges as an interesting place to invest. Moreover, improved relations with populist leaders in the west may reduce political risks for corporations operating in Russia.
The Russian theme continues with the Brexit fiasco. The UK departure from the EU greatly weakens the EU and this serves Russia’s interests. The Leave camp is most pro-Russian. Similar pro-Russian outcomes are possible in the many elections Europe will see in 2017. The EU as an institution is now faced with existential problems and its capacity to deal with outside threats is much diminished. Russia is the main beneficiary.
In the east, the great power, China, has been going through its own growing pains. It has built a supply chain throughout the world which has political as well as economic significance. The immediate focus however is the China seas and Taiwan. It has a one-China policy which basically amounts to reincorporating Taiwan. It has a military focus which basically amounts to making the China seas its sphere. This creates some potential for conflict with Japan and the USA. Having a bull in a China shop as US President (pun intended) may not help much.
The great ‘ism’ of our time is Islamism. It is the concern uniting western populists with Russian populists. It has destabilised the middle east and is separating traditional allies (Turkey, Saudi Arabia) from the west and, ironically, bringing traditional enemies (Iran) back into the fold. Islamism is sunni phenomenon it seems. It does not matter if Islam poses a real threat to the west and Russia. It is perceived and/or presented as such by populists (like Trump and Putin) and the rest follows.
It would be astonishing if this concoction of risks does not raise volatility, implied and actual, in 2017. A rise in implied can only occur if these risks are perceived and priced but it may take an actual shock event to change the financial market mindset. There is no way of knowing what might do this or the timing, so I am not being very helpful. It is however worth being aware that the conditions for a discontinuity exist and that shock events in 2017 may lead to state changes rather than a return to steady state. In layperson language, 2016 has been a buy-the-dip environment, much as expected. In 2017 the dip may be the beginning of a new trend so no rush!
On economic policy we should see an end to falling rates and tentative signs of rises. This is not because the underlying deflationary pressure has abated but because low rates have ceased to be effective. Measured inflation and inflation expectations have risen and will continue to do so but the process may just be corrective. Low rates have become a problem in that they may be boosting the savings rate rather than aggregate spending at these levels. Fiscal policy has come back into fashion with government spending deficits once again acceptable. The end of the insane policy of austerity is the silver lining in the dark cloud of populism. Holding long duration bonds in 2017 may not be the best idea though cash may come back into fashion.
Equity and property assets are not immune to rising interest rates and steeper yield curves. Property assets are particularly vulnerable. Equities have more scope to offset such valuation adjustments through earnings growth but unless GDP growth is strong enough to float all boats it will pay to be selective. It may be best to look carefully at sectors and individual stocks. Those using index funds would be well advised to look at the components of the indices that they are tracking. The only sector that should do unambiguously well is the financial sector. It stands to gain from steeper yield curves, higher rates, and end to provision for fines and penalties. The recovery has begun but there is still plenty of upside. Corporations that have been held back because of pension deficits should also do better. Bond proxy stocks such as utilities may suffer though individual stocks may have offsetting advantages. Beyond this it is difficult to generalise other than to say that indices may diverge because of composition. Not all boats will float.
Currencies have had a large impact on equity indices yet again. UK investors in ‘domestic’ indices benefited from the high weight in stocks earning foreign currency (and from investing in unhedged overseas indices). The path of sterling in 2017 may be volatile but the end point may not much different from the start. Sterling discounted the expected loss of competitiveness more or less instantly and it is unlikely the Brexit negotiations will be completed in 2017. Brexit may provide considerable noise but not much investment light in 2017.
Beyond what I have said above I would advise against going into 2017 with strong convictions. It is an unusually dangerous year.