“Through the Looking Glass”
By Excel Investment Counsel Inc
We use the imagery of the “Looking Glass” from Alice in Wonderland as a symbol of our 2017 outlook.
In many aspects, 2017 will almost be a reversal or mirror image of the “new normal” we have experienced in the past several years post-2008. With monetary policy at its limits for major developed economies like the U.S. and Europe, there will now be a shift to fiscal spending and in the U.S., a normalization of monetary policy. The U.S. electorate voted in a highly controversial PEOTUS, in large part based on his promise of higher infrastructure investment and tax cuts. Reflation will replace deflation or “Japanification” as the word du jour. Populism has, and will likely continue to, drive political changes during elections, reversing decades of globalization and reducing the high level of policy (especially monetary) coordination among developed countries that we have seen post-2008. For now, fears of “secular stagnation” gives way to hopes for a cyclical recovery, particularly in business capital spending. In recent months, public companies are being rewarded by investors for actual or planned capital spending and investment, rather than being rewarded for returning capital by way of dividends and buybacks. Negative yielding bonds have finally been recognized by investors as an irrational investment, leading to a sharp sell-off in bonds during the last quarter of 2016.
Peering into 2017, here are the key investment themes we are focused on:
1. Reflation Will Be Capped… But Steeper Yield Curves Here to Stay
A sharp rally in commodity prices from multi-year lows have increased real-time inflation measures, producer price indexes (PPIs) and future inflation expectations are now reflected in steeper bond yield curves globally. A deeper dive into key macro indicators such as the recent China PPI numbers, show the majority of the upward pressure has come from higher commodity prices. Until we see sustained wage growth in the global economy, we believe that the broader deflationary impetus of an aging population in the largest economies will cap inflation. However, after years of flattening yield curves, we do anticipate a normalization to a steeper curve. With this in mind, we are selectively adding to financials.
From a fixed-income perspective, our team has reflected this view by overweighting USD-denominated emerging market bonds versus local currency emerging market bonds. Within the local currency holdings, the preference is for higher yielding countries such as Brazil, Russia and Indonesia where there is an attractive spread over U.S. Treasury rates to absorb any further rate hikes by the Federal Reserve.
2. Fiscal Policy Takes Centre Stage in 2017
After 8 years of quantitative easing (i.e. money printing), and interest rate cuts eventually resulting in more than US$10 trillion of developed country government bonds sporting negative yields, but with limited impact on stimulating economic activity, the baton has been passed to stimulatory fiscal policy. Whether in Canada, Colombia or Indonesia, there has been an increased focus on infrastructure spending. Even the European Central Bank (ECB) has changed its call for austerity into one for more fiscal spending. U.S. President-elect Donald Trump won on promises of tax cuts and infrastructure spending. Despite the optimism, we are cautious because the implementation of infrastructure programs often take longer than anticipated. However, we welcome the shift away from unorthodox monetary policies that clearly had reached its limits in effectiveness, other than impacting asset prices.
3. Populism Politics Reverses Globalization and Policy Coordination Among Major Developed Nations
A lackluster global economic recovery and still elevated unemployment or underemployment post-2008 has given rise to a populist movement, resulting in significant political shifts in recent elections. The two key election shifts in 2016 were the “yes” Brexit referendum and Trump winning the U.S. Presidential elections. In 2017, we will be watching the French and Germany elections very closely given the important implications for the sustainability of the Eurozone. Since Trump’s campaign focused a lot on trade and bringing jobs back to the U.S. manufacturing sector, we will also be scrutinizing U.S. trade policies to assess the potential impact on emerging market exporters.
We highlighted monetary policy divergence in our 2016 outlook. We expect continued monetary policy divergence in 2017, although as we discussed above, fiscal policy will be the focus this year. The U.S. Federal Reserve is expected to potentially hike interest rates three times this year. Conversely, the ECB maintained its low interest rates and extended its asset purchases from March, 2017 to December, 2017 but reduced the size of the program to €60 billion beginning March. We expect the various emerging market central banks will be taking different monetary paths this year as they attempt to finely balance the impact of multiple factors such as a stronger U.S. dollar, stronger commodity prices and higher inflation on domestic growth.
4. Commodity Prices Stabilizing at the “Sweet Spot” for Producers and Buyers
After a sharp and painful 18-month sell-off in commodity prices to a multi-year low, we have seen a strong rally since February, 2016 lows as global cyclical indicators showed slight improvement. Commodity prices have also benefited from supply curtailment, including steel capacity reduction in China and the agreement by Organization of the Petroleum Exporting Countries (OPEC) to cut production by 1.2 million barrels/day. Non-OPEC producers such as Russia have also agreed to trim oil production. This agreement comes after ultra-low oil prices severely hit government revenues and depleted foreign exchange reserves. We expect that commodity prices have found an equilibrium level. Our view is that oil will be range-bound between US$50-60/barrel because U.S. shale producers will start drilling to increase production thus capping further appreciation. Within this range, oil exporting countries such as Saudi Arabia, Russia and Colombia will benefit from higher revenues, while oil importing countries like India will still enjoy oil prices significantly lower than 2014 levels.
5. Emerging Market Value and Cyclicals Expected to Continue Outperforming
After several years of underperformance as investors focused on defensive growth businesses, value and cyclical businesses outperformed in 2016 on expectations that we are beginning to see a cyclical economic activity. We had been focused on investing in secular visible growth businesses, which are now trading at a premium multiple relative to cyclical businesses. Hence, we have reduced our growth holdings and repositioned in energy, materials and cyclical industrials. We anticipate value and cyclicals to outperform growth again in 2017.
6. Domestic Growth and Pro-Growth Reforms More Important Than Ever
We expect 2017 global economic growth to improve incrementally over 2016 with contribution from a better U.S. outlook and cyclical recoveries in countries like Argentina, Russia, Peru and Brazil. With the current strong populist impetus in major developed economies, countries will have to rely more on domestic growth drivers and implement pro-growth policies or reforms. Subsequently, we are overweight India for its strong domestic consumption and Brazil on expectations of an economic rebound. We have also been adding to Russia, Peru and Colombia as beneficiaries of better commodity prices. Peru and Colombia are also undergoing positive political changes. New Argentinian President Mauricio Macri’s sweeping economic reforms have already triggered a rerating in the country’s bonds and currency, with a positive impact on lowering inflation. We believe that after years of crisis, Argentina is in the early stages of economic recovery hence have been adding to Argentina.
We expect 2017 to be a positive year for investors based on our expectations of an improved global economic outlook and gradual normalization of global monetary policy. We believe investors should keep a long-term perspective and remain diversified with a meaningful allocation to the attractive yields of emerging market fixed-income and undervalued emerging market equities. We are at a point of inflection, where emerging markets stand to be major benefactors while still providing higher growth and greater yields compared to what is offered in traditional markets.
This document may make forward-looking statements and there are risks that actual results could differ materially from forecasts, projections or conclusions in the forward-looking statements. Certain material factors and assumptions were applied in drawing the conclusions or making the forecasts or projections in the forward-looking statements and you may find additional information about such material factors and assumptions and the material factors that could cause actual results to so differ from the sources provided.
The content in this document is for informational and illustrative purposes only and is not intended to provide specific financial, investment, or other advice to you, and should not be acted or relied upon in that regard without seeking the advice of a professional. Particular investment or trading strategies should be evaluated relative to each individual.