Stock markets emerged unscathed from the shock of the EU referendum result and the election of Donald Trump, but will investors be so sanguine in 2017?
We have sounded a rather cautious tone recently and we shall strike a few of those chords again here. However, in our efforts to herald an air of providence, we do not want to give the impression that we expect the music to stop playing entirely.
There is always a risk of ‘correction’ with financial markets – jargon for a fall of 10%. These corrections are often explainable and good fundamental analysis can help us to gauge their likelihood. At other times, however, there is little explanation beyond there being ‘more sellers than buyers’. The point is that the possibility of a correction should not deter new money from entering the market or existing money from remaining invested. Tactical holdings of cash may from time-to-time help investors to stay within their risk tolerances and deliver superior risk-adjusted returns. But over the long run, being in the market is what counts. Looking at over 100 years of data, the probability that UK equities outperform cash over two consecutive years is just 68%, but there is a 91% probability that they beat cash over 10 years.
The only deterrent should be an elevated chance of a ‘bear market’ – a 25% fall – which have historically had much more persistent impacts on portfolio wealth. So, while we believe that the likelihood of a correction is higher than usual – that investors’ optimism is at odds with a realistic appraisal of the range of possible outcomes over the next six to 12 months – we wish to emphasise that we assign a relatively low probability to a bear market in 2017. We may be cautious, but we still want to invest. To borrow from Keynes, if the facts change we reserve the right to change our minds – but the starting point is positive. Aside from 19871, bear markets coincide with recession. Encouragingly, our global leading economic indicator suggests a strong finish to 2016 and a strong first half for 2017. Similarly, the probability of a recession occurring in the US in the first half of 2017, as implied by a range of indicators with a long track record, is very low indeed.
Reasons to be cheerful
Two of the biggest sources of consternation in 2016 are waning as we enter 2017. The corporate profit recession in America ended in the third quarter. And as we have pointed out before, it only really affected the natural resource sectors; excluding these, the earnings per share of US companies are growing at over 10% per annum.
The two sharpest downturns in global equity markets over the last two years have been triggered by large changes in China’s exchange rate and resultant kneejerk concerns about its economy. Our research suggests that the bulk of the Chinese slowdown is behind us and that the economy has already slowed to the pace at which we estimate it will remain for the next decade. In our assessment, the real rate of growth belying the official figures – which are put together in just three weeks after quarter end and always on target! – troughed at the end of 2015 and has remained broadly stable since. We expect policy to tighten in early 2017 to rein in some excess, but we do not foresee another marked deceleration.
While global growth is likely to remain low, we have entered a new phase in which the growth rates of developed and emerging economies are accelerating together. Between 2010 and 2013, both decelerated after the initial rebound from the financial crisis; between 2013 and mid-2016, developed economies accelerated mildly, but emerging economies continued to decelerate.
Despite this positive context, however, there is much uncertainty about 2017: the Trump presidency, Brexit, Italian banks, commodity prices and a string of significant elections in the eurozone in which parties running anti-EU tickets have a real chance of success, putting at risk the confidence investors have in an economy still being weaned off life support. The Dutch start us off in March; France goes to the polls in April and May; Italy may follow suit at some point if the new interim government struggles to rule; and Germany votes in September and October.
All of these issues have the potential to undermine economic confidence. This alone means that the spread of likely outcomes for the business cycle is wider than usual. The risks that they pose to the global economy, while serious, are unlikely to result in recession in 2017, but they could easily undermine market confidence. Unsurprisingly, there is a strong correlation between economic uncertainty and the rate at which investors discount future earnings into today’s share prices. In other words, as investors become less certain about the direction of the business cycle, they become less certain about future corporate earnings and so discount them more heavily. It is surprising then that the rate at which they are currently discounting earnings has fallen sharply over the last two months, in spite of what’s happened in Washington and Rome. Put more technically, the ‘equity risk premium’ implied by current market levels has fallen to one of the lowest levels we have observed over the last five years.
This is especially the case in the US. Investors appear to be giving Donald Trump the benefit of the doubt by placing more emphasis on the positive impact of his proposed fiscal stimulus measures than on any damaging trade policies. As we wrote in our post-election Investment Update, no one yet knows exactly which policies Mr Trump will pursue or be able to achieve during his first year in office. Nevertheless, investors have so far responded positively rather than discounting underlying earnings more heavily in response to the uncertainty, as we might have expected. Oxford Economics suggests financial markets are pricing in a fiscal stimulus equivalent to 1% of GDP for every year of Mr Trump’s term.
At current levels, there is not much of a risk premium in equity markets to compensate investors for the risk of disappointment. Sentiment gauges have moved to bullish extremes. The ratio of put (sell) options to call (buy) options on US stocks has fallen to one of the lowest levels ever recorded and the bullishness registered by surveys of retail investors has risen to a two-and-a-half-year high. These are usually good ‘contrarian indicators’.
This week, the Federal Reserve raised US interest rates as expected, but indicated that they may rise faster than expected next year (even before any infrastructure programme for which Mr Trump can get Congressional approval). Such ‘new news’ also has the capacity to spook investors.
Beware of the bond bears
Many pundits are starting the new year with calls that a great bond bear market has finally begun. Since July, yields have been rising, but again we see a wide spread of likely outcomes from here. It is worth reviewing what drives sovereign bond yields. They can be broken out into three elements: a growth component, inflation expectations and the term premium. Since September, the growth component has actually fallen. To believe that it will rebound significantly, one has to have a confidence in Mr Trump’s policies that we cannot muster.
Inflation expectations have driven yields higher since September, but these are very sensitive to currencies and the oil price, the direction of which is notoriously difficult to call over the short term with any certainty. Inflation is likely to trend higher in the US, and temporarily reach 3% in the UK by the end of 2017 due to the pound’s decline after the referendum. Yet there remains enough economic slack in much of the world to limit how high it could climb next year. Many commentators are writing about a reflationary shift from monetary to fiscal stimulus, but recent policy documents suggest that this is unlikely outside the US.
That leaves us with the term premium, which has been a constant driving force since July. The term premium reflects supply and demand and is thereby the component on which quantitative easing (QE) acts. As investors expect less QE (i.e. less central bank demand relative to supply), the term premium rises. As the eurozone is responsible for the bulk of new QE, gauges of the region’s economic health have best explained changes in the term premium. In other words, as the eurozone economy improves, investors expect less QE in the future and so the term premium rises. The global nature of sovereign bond markets means that QE in one region still acts on another’s term premium. Therefore, to have the utmost confidence in rising term premia, you need utmost confidence in the eurozone recovery –not easy in a politically charged year.
Oil prices – further rises in 2017?
Oil prices are ending 2016 on a high after OPEC and non-OPEC nations agreed production cuts equating to around 2.25% of global supply. Yet we are somewhat circumspect about the discipline of OPEC members as well as the cartel’s ability to influence the market after the US shale revolution. We place a low probability on oil prices continuing their steep ascent. We note that the price of oil for delivery in two years’ time has only risen by 5% since the OPEC meeting – in stark contrast to the 20% rise in the price for immediate delivery – suggesting that market participants share our circumspection.
Even when we exclude Iraq, the remaining OPEC members have rarely adhered to their respective quotas over the last few years. Saudi Arabia may have the enormous foreign exchange reserves to withstand low prices but most other members don’t have such strong buffers. Ill-discipline is likely to continue as members try to replenish their vaults. The House of Saud plans to float the state’s production company, Saudi Aramco, for around $2tn, and the cynic could postulate that once that has transacted, it will be less committed to supporting the oil price.
Furthermore, US shale oil producers have worked hard to improve efficiency. Estimates of the price they require to get a barrel out of the ground without losing money are now just $30-40. Investment to expand US production capacity also looks set to resume. Some 5,000 wells are drilled, but non-operational; the number of operational rigs has increased by over 50% since July.
Seasons greetings! And best wishes for a happy and healthy new year.
1The October 1987 stock market crash (‘Black Monday’): interestingly, despite this bear market, the FTSE 100 still finished the year higher.