Please note the disclaimer at the end of this Blog.
2016 produced its fair share of surprises, not the least of which is that the political surprises ushered in surprisingly strong returns in equity markets (at least from the viewpoint of a sterling investor) when the received wisdom had been that Brexit and the Trump election would be “risk off” events. Bond markets flew on to ever more fantastic valuations in the summer (on the assumption that central banks would have to press harder on the monetary accelerator to counter a feared post-Brexit growth shock) but came down to earth with a bump after the US election, as the idea dawned that a significant shift in the economic policy zeitgeist had occurred.
The period since the global financial crisis in 2008 had been characterised by cuts in interest rates (to make the debt mountain manageable) and central bank purchases of government bonds, to provide liquidity to the financial sector and encourage investors to buy riskier assets. The hope was that a lower cost of capital would encourage companies to expand and that the wealth effect resulting from higher investment market values would boost demand in the economy.
This had considerable success as a palliative in the aftermath of the banking crisis but less so in encouraging convalescence and a fuller recovery. Interest rates were so low that they came to be seen as indicating an underlying problem, particularly when the phenomenon of negative interest rates appeared. It was hard to believe that long term real returns of less than zero were normal or reassuring. Investors saving for a particular level of retirement income may have been tempted to save more, not less, as a result of vestigial returns on deposits.
As unconventional monetary policy ran out of road, it prompted debate whether fiscal policy, which had been tightened to curtail expanded deficits after 2008, should instead take advantage of minimal borrowing costs to boost demand in the economy, hoping to break out of the anaemic growth rates seen since 2008.
Mathematically, the previous mix of prodigal monetary policy and Teutonic fiscal discipline could have worked in theory, given time. However, a policy of reducing demand from government sources, hoping to offset it by ever-lower interest rates had mixed and generally dispiriting results. Official intervention in capital markets boosted financial markets while being an accessory to the zombification of the economy, given the dulling of incentives to improve productivity. The resulting low growth, low inflation world increased the effective burden of debt, while creating social tensions between those who had gained from inflation in asset prices and those who lost out from globalisation’s squeeze on real wages. Electorates in western democracies appear to have lost patience with the stalactitic pace of economic progress and voted for populists promising a different approach.
The populist approach has positive aspects to it (lower taxes, more spending, more jobs) but also negative baggage (protectionism, entailing barriers to free movement in goods, capital and people), while shelving the issue of how to fund the increased government deficits. The hope is that nominal growth in the economy will accelerate, improving social cohesion and reducing the relative significance of government debt levels.
The policy may succeed, or be an improvement on recent history. If lower taxes and a focus on growth as the objective of government policy rekindle animal spirits, it is possible that consumers will be more confident and companies more willing to invest, potentially boosting productivity after its curious weakness in the past 10 years. There are two principal risks, one structural the other cyclical. The structural risk is that ill-considered protectionist measures if adopted by the incoming US administration might negate the boost to growth from lower taxes and higher government spending. It would be sorrowful if the world, having avoided a repeat of the 1930s by shunning tariffs and protectionism, now experimented with them. The cyclical risk is that a major US reflation (whether tax cuts or increased spending), coming at a time of near-full employment could simply cause higher inflation.
Although the social media side of the Trump candidacy and transition introduces elements of unpredictability in economic and foreign policy, it would be a mistake to dismiss the significance of the shift in US policy, or its chances of success. Lower personal taxes are likely to boost demand, lower corporate taxes could significantly boost 2017 earnings and higher infrastructure spending could benefit commodity producers as well as unskilled employment and wage levels. However, the resulting mix looks more inflationary than the status quo, wherein lies a risk.
If the economy starts to behave more like it did in previous economic cycles, the Fed could tighten more than expected. Raising the base level of interest rates will reintroduce valuation discipline to financial markets, producing different winners and losers in the corporate world from those applying in a low-growth environment when predictability trumped cyclicality. If a more normal cycle takes over, lowly valued companies which benefit from faster growth could respond better in the short-term than more predictable companies already trading at high valuations. There have already been some signs of this shift in preferences during 2016.
Although the policy shift in the US has been most in focus, Japan and Canada have also introduced fiscal stimulus during the past year, with announcements more recently from both China and Taiwan. The UK has stretched out the timescale over which it aims to close the budget deficit, retaining fiscal flexibility in case the economy hits a Brexit air-pocket. Similar pressures are in place in Europe but so far Germany has maintained that European fiscal rules must be adhered to. This orthodoxy is likely to come under pressure in the heavily election-laden year of 2017.
Faced with an economic backdrop of improving economic growth, with reduced emphasis on the interests of bondholders, what are investors to do? Here are SIX resolutions for 2017:
- Stay Active. 2016 was a torrid year for active managers, partly because they tend to avoid ultra-cyclical single theme sectors such as resources, which recovered strongly during the year and partly because of the change in policy paradigm during the year. When macro factors dominate, stock pickers can take time to react but if new themes are taking hold there should be ample valuation anomalies for active managers to exploit.
- Be value conscious. Equity market valuations are higher than their historical averages, partly because of depressed earnings in some sectors and partly owing to the valuation turbo-drive from low interest rates. There are few windfalls from index levels so selectivity is required between and within markets.
- Don’t assume or over-react. Despite the risk of political surprises (from the process of negotiating a UK exit from the EU, the slew of European elections and the new Trump administration – in all cases “known unknowns”) the lesson from 2016 was that prejudged responses could miss the message from incoming news. For example, Brexit has undoubtedly made forecasting the UK economy harder but the fall in sterling has boosted the corporate sector’s earnings potential. More generally, events in 2017 could increase short-term volatility but the end result will be driven by economic developments. As has often been said, in the short term the markets are voting machines but in the long term they are weighing machines. Although higher growth and higher inflation both seem possible, technology, debt levels and abundant supply are secular depressants on inflation, while any fiscal package will take time to agree and implement, so the boost to growth may be gradual.
- Tied down by Bonds. Ian Fleming would not recognise some of the Bond movies and investors can be forgiven for thinking about over whether a bond which charges you interest (rather than paying you) is an asset or a liability (or perhaps a temporary umbrella).
- Independence of mind. We don’t live in a post-factual world just post-truthful news sources. The truth will come back into fashion when those who rely on untruths are tripped up. There is no substitute for making one’s own mind up (with advice where required) as there is usually a crescendo of buying interest at market tops and sell recommendations near the trough. Be fearful when others are greedy and greedy only when others are fearful.
- Be realistic. I am an optimist by nature. Ever since the first mudskipper or newt emerged from a primordial billabong and took the air (analogously the birth of active management) it has paid to back progress. Adaptability is as necessary in investment as in the evolution of the pentadactyl limb that we share with “Landcrawler 1.0” and 2017 will be no different in throwing marbles beneath investors’ feet. The other reality check is valuations. Equity valuations appear high but rational, given low returns elsewhere, while government bond yields appear to offer low investment value but with the timing of normalisation imponderable. Expecting bumper returns from equities from this level is not rational but corporate earnings appear set to improve - much depends on the interaction between this growth and valuation constraints as interest rates rise. With long-term UK government bonds yielding less than the Bank of England’s inflation target, it is hard to see how returns (before tax) can do any better than inflation and easy to see how they might do worse.
2017, the Year of the Rooster, appears a year to approach with interest and some optimism. Let us hope our leaders approach it with open minds, not simply open mouths.
1st January 2017
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