Despite a number of potentially destabilising political events, the pace of global economic expansion picked up in the second half of 2016. According to the International Monetary Fund (IMF), the global economy expanded by 3.1% in 2016 and will grow by 3.4% in 2017.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the economic and political outlook for 2017.
Of the major developed nations, growth will be driven by the US economy, which is expected to grow 2.2%. The Eurozone is expected to expand at a more modest 1.5% and, although there are concerns about the housing market and the build-up of debt in China, its economy is forecast to grow by over 6%.
% Gross Domestic Product (‘GDP’) growth forecasts for 2017
Source: IMF, World Economic Outlook Database, October 2016
However, we expect 2017 to be challenging politically. Brexit discussions will continue, and there are a number of European elections this year that will test investors' nerves.
Across the globe, voters are sending a clear message to their respective governments that they are not happy with the status quo. Much of this anger can be traced back to the weak recovery in the aftermath of the financial crisis, one of the slowest ever recorded. In particular the squeezed middle, blue-collar workers from Michigan to Sunderland are using their democratic right to demand change.
As unpalatable as his views and opinions may be, Trump’s victory could be a game changer for economic policy. In a return to Reagan-like, Keynesian-style economics, he has promised to cut taxes, reduce regulation, spend big on rebuilding America’s ageing infrastructure and create jobs. This clearly hit a nerve with voters.
Although it is unclear how these policies will be funded, expansionary policies have the potential to extend and prolong the current economic cycle that was at risk of running out of steam. This could prompt a significant change in policy direction for other governments in the coming years to appease their electorate. Governments can currently borrow at record low interest rates and politicians may find the path of least resistance is to loosen the purse strings.
A more worrying trend emerging is the reversal of globalisation and the introduction of protectionist policies. For most of the past 30 years, globalisation was considered a positive force. It facilitated many people in developing nations to exit poverty, but many in the developed world have failed to see the benefits and feel left behind. How closed the global economy becomes in the years ahead remains to be seen. The last period of protectionist policies in the 1930s did little to improve global prosperity and did not end well. This is something that needs to be monitored closely in the years ahead.
A key feature of the economic and investment landscape in 2017 will be diverging monetary policy. Having raised rates just once in 2016, the US Federal Reserve (Fed) is expected to raise rates 2-3 times in 2017. A key difference this year is that we expect inflation to pick up as rising wage pressures and increased oil and commodity prices push prices higher. This is something we have not seen for several years.
In contrast, the European Central Bank (ECB) and the Bank of Japan (BoJ) are expected to keep monetary policy accommodative to help support flagging growth in their respective economies. The ECB has signalled that it may taper its Quantitative Easing (QE) programme at the end of the year.
Europe will enter the political fray in 2017. Like the Italian constitutional referendum, elections in France, Germany and the Netherlands will be viewed as votes on the future of the Eurozone. As much as they can be trusted, the latest opinion polls show Angela Merkel in the lead in Germany, but she is facing a backlash due to her open door policy on migrants. In France, François Fillon has a lead in the polls over right-wing Marie Le Pen, but again we must question the ability of pollsters to predict election outcomes.
Against this backdrop, we expect a pick-up in global growth in 2017. Figure 3 shows our economic and business cyclical indicator which looks to assess turning points in the business cycle. It suggests that although things have improved considerably since the financial crisis in 2008/9, conditions today are not consistent with those present in the lead up to the last four major recessions. This gives us confidence that in the absence of an exogenous shock, the likelihood of a recession is still relatively low. This also suggests that it is a good time to stay invested, although investors should factor in lower potential returns going forward than they achieved during the early stage of the cycle.
Note: Recessions and Bear Markets defined by the NBER. Recessions overlap Bear Markets for the purpose of this chart.
Source: Bloomberg, Davy and National Bureau of Economic Research (NBER)
Taking this into consideration, we assign probabilities to different economic scenarios occurring in 2017 (see Figure 4). These range from a depression, which would be a repeat of the 2008 financial crisis (5%), to a more normal recession (15%), to our base case of a modest expansion (60%), to a strong recovery (20%).
In the end, 2016 turned out to be ‘ok’ from an investment perspective, but it was year that most investors will be glad to see the back of. No sooner had the year began than investors were put on the back foot as the combination of an interest rate hike in the US and a global growth scare, led by China, pushed markets lower.
In the six weeks to mid-February, global equities were down as much as 12.5% in local currency terms, and European equites almost 15%.
Investors had to endure more erratic swings throughout the year, particularly around Brexit, but equity markets did eventually finish the year in positive territory as Trump's victory and his promises of less regulation, lower taxes and increased government spending helped push markets higher.
In fact, following the US election equities enjoyed a very strong fourth quarter, and global equities finished the year up 7% in local currency terms (8.5% in euro terms).
In a contrast of fortune, the other main asset class, government bonds, started the year well but materially underperformed equities, as the yields on sovereign bonds ended the year relatively flat after the US Federal Reserve raised rates for only the second time in 10 years in December.
It was not a uniform picture globally with European, Irish and Japanese markets lagging behind. The EURO STOXX 300 ended the year up 1.5%, and the Japanese Nikkei index finished up 0.4%. The ISEQ was lower for the year, down 4% as shares such as Bank of Ireland (down 31%) weighed on performance.
Regionally, gains were led by the UK and the US which were up 14% and 9.5% respectively. UK equities benefited from the collapse in sterling following the Brexit vote, which was scant consolation for euro-denominated investors as the pound's 16% drop against the euro offset the FTSE 100 gains.
In the US, small and mid-cap stocks – which are most exposed to the domestic US recovery – did well with the Russell 2000 up 20%. The US technology sector also had a good year, up 10%. Our portfolios have had exposure to both these sectors for several years.
After a very poor 2015 when emerging markets (EM) dropped 8%, EM fared better as commodity prices recovered. But even here, the majority of returns were driven by just a few segments of the market. Digging a little deeper, the majority of gains were driven by Russia (+27%) and Brazil (+39%), two nations which clearly have some problems. China for example was down 11%.
The prospect of rising interest rates and inflation is at the forefront of investors’ minds. With governments once again looking to loosen the purse strings, risk appetite has improved as we start the New Year.
Higher interest rates and reflationary policies are typically good for real assets like equities, but rising interest rates and higher inflation are typically bad for bonds. That said, with so much potential political risk in 2017, periodic flights to safety should keep bond prices from falling too much. Bond yields could become attractive once again in comparison to cash deposits.
So overall we think investors should maintain a well-diversified approach to investing and pick out specific opportunities as they present themselves.
See a list of our top investment opportunities for 2017.
Cross-asset and regional performance (price returns in local currency for 2016)
The United States (US) economy continues to show signs of steady improvement. Unemployment now stands at just 4.6% which is consistent with full levels of employment. Inflation pressure is starting to build, with wages rising 3.1% in the year to November.
The American economy is now entering its eighth year of recovery since the global financial crisis. Over the past 12 months there has been further improvement in the parts of the economy that matter most: unemployment is back under 5%, over 150,000 jobs are being created each month, and there are tentative signs that wages are beginning to pick up, which in turn is helping to boost consumer and business confidence.
Of course one of the most remarkable developments in the US over the last year was Trump’s victory in the US presidential election. He campaigned with a slogan of ‘Make America great again’ and promised to implement more expansionary government policies.
These include large-scale infrastructure programmes, tax cuts for business and households and there are also plans to announce a tax holiday for US multinationals to bring their $2 trillion in cash back home from overseas. These policies should be good for growth, but could be bad for the US debt situation, with total debt to GDP still above 70% of Gross Domestic Product (GDP).
Faced with more government spending and higher oil prices, the Federal Reserve (Fed) will be mindful not to let inflation pressures build up. The Fed undertook its second rate hike in December, and is expected to make another 2-3 rate hikes over the next 12 months.
Overall the US economy is forecast to expand by 2.2% in 2017.
Europe faces a number of important elections in 2017. France, Germany and the Netherlands will all go to the ballot boxes. After the Brexit referendum result, it is likely that these will be seen as votes on the future of the Eurozone.
The euro area once again finds itself at a critical juncture. Following Brexit and the rejection of the Italian referendum on constitutional reform, French and German elections this year will bring the question about the future of the Eurozone back into focus.
As we start the year, the polls have pro-European candidates in front but the accuracy of pollsters has to be called into question given recent election results.
Overall, the European economy has been performing better than many expected, but growth still remains weak, particularly in southern European nations. European leaders will push for greater integration in the coming years, including greater consistency in fiscal policy among member states.
The European banking sector remains a potential threat with several large Italian banks needing to raise capital to boost their longer term funding requirements.
One important difference between today and the darkest days of the debt crisis is that Europe now has a lender of last resort. Mario Draghi and the European Central Bank (ECB) have committed to extend Quantitative Easing until the end of 2017, and have signalled that they will do more should conditions warrant further action.
Overall the Eurozone is expected to grow by 1.5%.
So far the Brexit result has not had the impact that many predicted it would have on the UK economy. That said, Brexit has not happened yet, and the only real impact we have seen is a 15-20% devaluation of the pound which has helped support the economy.
We expect to see more clarity on the terms of the Brexit agreement by the middle of the year. Theresa May’s initial suggestion that the UK could pursue a hard Brexit has been softened somewhat. But any negotiations are likely to be hard fought and may not be concluded satisfactorily within the two-year timeframe.
Europe remains Britain’s largest trading partner with over 40% of exports going to the continent. As long as uncertainty persists about the terms of the exit, the economy will remain under pressure.
A weaker pound will help to cushion the fallout but companies are likely to hold back on investment and hiring due to uncertainty about the future trading relationship with the EU. Already several large banks have said they will move their operations overseas if Britain cannot secure EU passporting rights.
Households will start to feel further strain in the coming months as inflation is starting to creep up with price increases in everything from household appliances to groceries shortly after the referendum result. Both residential and commercial property prices are coming under pressure which could also knock consumer and business confidence.
Overall, the economic outlook remains clouded for the UK in 2017, and our economists forecast growth to be just 0.2% for the year.
A persistent risk to the global economy over the last number of years has been the risk of a hard landing in China. So far predictions of a collapse have failed to materialise, but there are worrying signs that the build-up in debt is becoming unsustainable.
The most pressing issue as we start the New Year is increasing evidence of a property bubble forming in China. This is most stark in Tier 1 cities - such as Shenzhen, Shanghai and Beijing - where new home prices rose almost 30% in the first eight months of 2016.
The rapid rise in prices has in part been fuelled by easing lending requirements by the People’s Bank of China and the lifting of restrictions on developers raising money for new projects. Understandably policymakers have become concerned that the property market is overheating and may take action to cool the market.
Authorities are likely to do all in their power to keep growth above 6%. These include the recently launched large-scale infrastructure programme, the ‘One Belt, One Road’ initiative. Rising incomes and urbanisation should support consumption in the coming years.
Most agree, however, that for China to avoid a sharp correction down the road a process of deleveraging and structural reform must be undertaken sooner rather than later.
Something to watch closely is China’s relationship with the United States. Any protectionist policies from the Trump administration could be detrimental to China’s growth prospects and need to be watched closely.
Growth is forecast to slow marginally in 2017 but remain above 6%.