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27/01/2017

CIO Blog: Tails of the Unexpected

What could 2017 have in store for us?

The exquisite unpredictability of markets was on full parade in 2016, and investors are still breathless. Very few believed populist anger would lead to “Brexit” or “President” Trump, or that a crashing oil market would be rescued by a deal underpinned by Saudis’ altruism towards Iran. Indeed, markets are replete with occurrences that make mockeries of expectation. Here are some unlikely – but eminently feasible – scenarios that markets are not pricing-in for 2017.

1.   Anno Trumpini: Post-Trump expectations of US growth fall flat, but Europe is a champion.

In the aftermath of the US election, global investors appear convinced that huge US infrastructure spending and slashed taxes will bring about President Trump’s “guaranteed” annual economic growth of 3.5% and stoke inflation. However, there are strong reasons why this may not happen. That level of growth has not been hit in the US for over a decade and wildly pumping fiscal stimulus into the economy will do nothing to address fundamentally poor demographics – made worse by immigration curbs – or slowing productivity. It will certainly not help underemployed people get the high-paying jobs for which they don’t have the skills. There could also be some major negative shock, perhaps of the President’s own making – a scandal causing him to rapidly lose his mandate to govern, perhaps? The Federal Reserve may well spend another year being much less active than it sets out to be.  

Conversely, expectations are for the euro zone to meander along, growing well under 2%, a little better than recent years, but still deep in a rut. However, conditions on the ground would suggest a breakout year for the euro zone is possible. Unemployment has finally fallen below 10%, an important milestone in Continental the region’s recovery. Economic confidence is at multi-year highs. Inflation has leapt to 1.1%, despite deflation seeming imminent just months ago. Yet this recovery may finally give the Germans enough reason to force the European Central Bank to tighten monetary policy by reducing quantitative easing and raising rates. The euro zone powerhouse is doing fabulously well economically and wants all this stimulus to end before it causes it to overheat.

2.   Not so hard: Brexit negotiations go fabulously well.

The prevailing consensus is Brexit will take longer, and be tougher, than expected. Britain’s ambassador to the EU, Sir Ivan Rogers, has unexpectedly and abruptly resigned, just a few months before the UK is expected to start formal Brexit negotiations. The vast majority of economists at the end of 2016 still believe Brexit will harm the UK’s longer-term economic prospects. The British pound is taking the brunt of the political uncertainty, beginning 2017 at multi-decade lows.

Of course, the majority of pundits could well be wrong… again. Europe has huge incentives to treat the UK well in negotiations and many thorny issues may well be resolved this year. The UK is Europe's "investment banker": the City provides 75% of foreign exchange trading and hedging products for the EU, and supports half of all lending. Moreover, the UK exports £26 billion of financial services to the EU and imports just £3 billion. A sharp break in that liquidity and capacity support could be detrimental to financial stability in the EU. On the other hand, the UK could easily find alternative suppliers of chemicals and wine. This gives the UK more leverage than many believe.

3.     Bone China: The long-awaited implosion happens this year.

China remains stable, unbelievably so. Fears of an economic implosion rocked markets early last year, but, remarkably, the country grew at an annualised rate of 6.7% in the first three quarters, bang in the centre of its stated target of between 6.5% and 7%. Guess what? The Chinese Vice Finance Minister states he is confident his country grew at an annual rate of 6.7% in the fourth quarter of 2016 too. Even if these figures are real, authorities were forced to rely once again on leverage-driven infrastructure spending to prevent a short-term crisis. Banks were also encouraged to lend to the private sector, but much of this ended up in housing: prices in first-tier cities such as Shanghai were up by 30% in 2016.

The Chinese yuan is at an eight-year low versus the US dollar, down more than 6% in 2016, and the country’s foreign currency reserves continue falling: just two years ago, reserves were $4 trillion; they are $3.1 trillion now. These are signs that all is not well on the inside. Many experts expect a day of reckoning to come at some point. It may well be this year.

Investment implications

Pollsters, political prognosticators, financial forecasters and average punters will be wrong about many of their expectations for 2017. Even if they are right, there is no way to know how markets will react. In 2016, no one saw Brexit or a Republican clean sweep. Even if they had, rationale investors would have shorted risk assets, been long on safe havens or held cash to ride out the ensuing volatility. They would have been wrong. Equities? Up. US dollar? Stronger. Government bonds? Sold off. Gold? Fell hard from an intraday peak. The VIX? Way down. Lesson: trying to divine the future is impossible; it may also be useless.

We encourage our clients to take three important tenets to heart, no matter what the year brings.

First, be optimistic. There are lots of causes for concern in the current macro environment. We are in the midst of an unprecedented paradigm shift due to populist political pressures. If that were not enough, another tremendous transition is taking place in global monetary policy. Uncertain times often present ripe conditions to invest. Over the past five years alone – the euro zone crisis, the US debt shutdown and downgrade, the slowdown in Chinese growth, and lately Brexit and Trump – the global equity market is up 56.6 per cent (or 11.4 per cent per year). It is when everything looks rosy that one should be cautious. That is when risk is often at its highest.

Second, be selective. Nearly a decade on from the financial crisis, global economic growth is still insipid despite the colossal efforts of central banks around the world to stoke growth. These efforts, while largely fruitless in their primary cause, continue to underpin equity and bond markets. However, at least in the US, this unprecedented monetary support is coming to an end; other central banks will eventually follow as well.

Therefore, the “rising tide” of liquidity-driven asset price increases will no longer “lift all boats”. Furthermore, valuations across a number of asset classes and sub-asset classes are no longer cheap, led by the second longest equity bull market in history, and the continuation of a three-decade strong bond bull run. From this stage, we must be ready to accept a lower return for each level of risk than we have historically received. Not too long ago, cash in a savings account yielded 5%. Today, equities may well struggle to achieve that. Still, opportunities are ever-present and when they arise, one should maximise them: increasing dispersion in market returns simply means that investors should be more careful and discerning than in the recent past.

Finally, be disciplined. We live in a world where events unfold very quickly and markets can move with staggering speed. It is easy to want to react. Often, that emotional impulse is wrong. A disciplined and robust investment process that seeks to evaluate long-term fundamentals rather than focus on short-term movements is key to navigating uncertainty. It is critical to eschew the “noise” that inevitably surrounds periods of great change. By focusing on indelible drivers of long-term asset returns – such as valuation, momentum and sentiment – short-term movement and uncertainty can be prudently managed.

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