16th December 2016
Luca Paolini, chief strategist Pictet Asset Management suggests an interesting ride for markets next year.
“Rising inflation and tightening monetary policy will prove tough for bonds in 2017, while cyclically-sensitive equity sectors should benefit from improving economic growth.”
“We like Japanese equities on both on valuation and fundamental bases. Selected emerging markets could also do well. Inflation-linked bonds are starting to look attractive again, while high yield bonds, particularly US, merit greater caution.”
“Investors will need to buckle up in 2017. Political turmoil, rising inflation and tighter financing conditions look set to rub up against improving economic growth and rising corporate earnings. That adds up to a challenging environment for equities but potentially a pretty grim one for bonds and bond-like dividend-paying stocks.
“The winners in the current climate should include cyclical shares as well as traditional hedges against volatility and inflation, such as gold, the VIX and inflation-linked bonds.
“Within the developed world, we have upgraded our growth forecast for the US economy. Trump’s corporate tax plans, infrastructure spending and encouraging multinationals to repatriate foreign earnings could add up to 1 percentage point to GDP growth in the next two years – although the final policy mix is likely to be watered down.
“A recession in the next 12-18 months now looks more remote, as long as private investment spending rises at a faster rate than GDP.”
“Bad news for equities includes tightening liquidity conditions, potential political upheaval and the return of wage inflation. The risk of protectionism is extremely difficult to price but even a low-intensity trade war stoked by the new US administration can do long-term damage to equities.
“History also suggests caution. US presidential first terms have traditionally been the worst for equity markets. Election years, in contrast, have been some of the best. Good news comes in the form of an expected acceleration in corporate earnings growth.
“A move by the US administration to cut regulation and corporate taxes could offer further support. If all Trump’s mooted tax cuts were actually implemented they could boost valuations by 7-10 per cent.
“However, US stocks are very expensive versus Japanese and European peers so further notable outperformance is unlikely.”
“While European equities could present an attractive medium term investment opportunity, there are good reasons why they look cheap.
“In Europe more than elsewhere, domestic institutions, such as insurers, are restricted in their ability to sell bonds and buy equities. That means the impetus for a market rebound will need to come from foreign investors – unlikely while there are still uncertainties over ECB policy and forthcoming European elections.
“By the second half of 2017, these risks may well have cleared, paving the way for a reversal in the extremely negative sentiment and thus for a market rally.”
“Japan, on the other hand, is worth buying now – not just because it is cheap but also because of its positive economic prospects. Although trade curbs are a risk in Japan, exporters should win out as global growth improves. Japan also historically benefits from a global reflation scenario. Some of the best opportunities can be found in Japanese financials as the improving economic outlook bodes well for credit demand.”
Emerging market equities
“We are bullish on the long-term outlook for emerging markets due to attractive valuations, structural reforms, a recovery in commodity prices and healthy investment flows. The recent sell-off highlights the vulnerability of this asset class to trade concerns, a surging dollar and tighter financial conditions.
“EM stocks should outperform next year on improving fundamentals and we would look to selectively add to our exposure there. Regionally, emerging Europe and Asia look the cheapest.”
“Cyclical stocks are generally well-positioned for the coming year, despite their recent rally. Capex related stocks should perform particularly well as corporations step up investment. Financials shares, meanwhile, are set to benefit the most from global reflation due to their cheap valuations and their tendency to respond positively to a steeper yield curve.”
“For bonds, rising inflation and tightening monetary policy are more unequivocally negative than for other asset classes.
“In the developed world, those forces are strongest in the US, where inflation is on track to top 2 per cent for the first time since 2014. Trump’s policies are likely to prompt greater monetary policy tightening than previously expected, in turn leading to higher US government bond yields and a steeper yield curve.
“We see bond yields moving higher in 2017, especially in Europe where the risk of tighter central bank policy is underappreciated. European bonds also look very expensive compared to their US counterparts.
“Having benefited from the 2016 rally in US high yield bonds, we have now turned neutral on this asset class. Debt ratios for non-financial companies are at historic peaks and excess spreads, after accounting for defaults, are still quite tight.
“EM local currency debt is a notable bright spot. As well as offering some of the highest yields in mainstream fixed income, EM corporate bonds tend to have shorter durations, making them less vulnerable to interest rate hikes. The opportunity is far from risk free, however – possible threats to performance include a stronger US dollar and Trump’s protectionist stance on global trade. We prefer Latin America due to encouraging signs of progress on structural reform as well as the region’s exposure to commodities and energy, whose prices should rise.”
“The US dollar is likely to strengthen in the coming months due to stronger US growth and more rate hikes than are currently priced in. Overall, we expect a very volatile, range-bound performance. Sterling, meanwhile, looks cheap following the steep depreciation since Brexit. The exchange rate is now consistent with fairly dire economic growth. Weak growth may materialise eventually as Britain progresses with the EU exit, but in the short term the UK economy and assets are more likely to exceed expectations, presenting potentially attractive investment opportunities.”