This excerpt, taken from Balentine’s 2017 Capital Markets Forecast, compares today's financial and political environment with that of early 2016 and considers how it may evolve over the remainder of 2017.
As 2017 dawned, there was a stark contrast from the environment the world experienced one year before. The beginning of 2016 saw
- Equity markets that had suddenly become more volatile the previous summer and showed signs of having peaked (a suspicion further reinforced by sharp, sudden declines in January and February of 2016).
- An oil price that was in the midst of another steep drawdown.
- A bottom in the price of gold as central banks stepped up their bets on increased monetary inﬂation through negative interest rates and increased “quantitative easing.”
- Polling ﬁgures in the United Kingdom (UK) which suggested that the “Remain” campaign had about a 10-point lead over “Leave” among those who had decided their vote on whether the UK should exit the European Union.
- A Donald Trump candidacy still relatively off the radar, having around only a 20% chance of winning the Republican nomination and around an 8% chance of winning the presidency.
In contrast, today
- Equity markets have made all-time highs across many global markets.
- The oil price bottomed in February, stabilized by mid-summer, and ended 2016 at the year’s highs.
- The gold price increased by 30% into the summer, then sold off on more hawkish rhetoric from the world’s central banks.
- The United Kingdom is making preparations to leave the EU, leading to similar voting sentiment elsewhere in Europe.
- The election of Donald Trump as president of the United States, which is perhaps the greatest upset in US political history.
What a difference a year makes.
Given 2016’s sharp turns in both the ﬁnancial markets and the political cycle, we believe the world is on the cusp of some important transitions. Globally, we see three prominent transitions that began in 2016 and will likely accelerate in 2017:
- A movement from globalism to populism
- A shift in emphasis from monetary policy to ﬁscal policy
- A change from low economic growth to inﬂation as the primary economic concern
- Additionally, the transition from increased regulation to deregulation is primarily domestic in nature but may slowly increase globally.
The most notable of these shifts is the political trend towards greater populism, because it is the main catalyst for the other transitions to unfold. The seeds of this voter outcry were sown long ago, as central bank policies in the wake of the burst internet and subsequent housing bubbles have done little to foster true economic resurgence, a burden which has been disproportionately borne by those on the lower end of the income spectrum. This populism has asserted itself quite vociferously around the world in the wake of the United Kingdom vote to exit the European Union. On the back of the “Brexit” vote, additional populist referendums in Europe have led to leadership resignations, third parties with prior insigniﬁcance obtaining more clout and credibility, and, most notably, the election of Donald Trump as president of the United States. We do not see this populism trend slowing anytime soon but rather accelerating in 2017 as additional countries come to the realization that the policies that have been in place this century are not delivering the economic results for which many had hoped.
So, how do we expect these new regimes will inﬂuence economic policy? Most notably, we expect ﬁscal policy (spending on infrastructure and lowering tax rates) to take over from monetary policy (artiﬁcially low interest rates). Monetary policy has reached its limits, as the unfavorable reaction to negative interest rates in Europe and Japan highlighted. We expect both tax reform and increased government spending. Tax reform will likely be at the individual and corporate levels and should reﬂect the effects of both lower rates and tax repatriation, in addition to the repudiation of onerous tax structures such as those in the European Union. Government spending is likely to be targeted toward investments which have been long deferred, such as infrastructure, rather than toward direct government transfer payments.
As monetary policy has reached the point of essentially “pushing on a string,” the ability of ﬁscal policy to stimulate demand should be the missing ingredient to the recovery.
This increased ﬁscal spending will likely lead to the next big shift, as concerns about deﬂation and economic stagnation will be overtaken by inﬂation concerns. As monetary policy has reached the point of essentially “pushing on a string,” the ability of ﬁscal policy to stimulate demand should be the missing ingredient to the recovery. That said, we do expect this transition to take some time. Fresh concerns about bloated government balance sheets behind increased government deﬁcits from looser ﬁscal policy will likely lead to much debate about the potential for higher inﬂation.
Lastly, rolling back domestic regulation where industries have been handcuffed—notably energy, healthcare, and banks—won’t be easy, either. Whether the beneﬁts of deregulation exceed the unintended consequences remains to be seen. But we expect this to expand worldwide as the shackling effect of economic, tax, and geopolitical regulation is challenged by the new populist governments.
As markets continue to defy many investors’ expectations, today’s high starting valuations likely imply that returns should be weak, in aggregate, over the next seven years.
The beginning of 2017 marked almost eight years into a domestic equity bull market that stagnated for a few years but has recently seen another leg up. Moreover, equity markets are showing signs of breaking out all over the globe despite many economic and geopolitical headwinds. As markets continue to defy many investors’ expectations, today’s high starting valuations likely imply that returns should be weak, in aggregate, over the next seven years. However, this does not mean there will not be pockets of opportunity or that equity markets cannot exhibit strength in spurts over the next seven years. Finding those opportunities will be more daunting than the bull market to date; it will require acumen in a regime change during which central banks are no longer supplying as much punch to the bowl.
Our Key Themes for 2017
- The course of achieving a sustained economic recovery will necessitate coordination and discipline that will take some time to effect. There is a particular prescription to unshackle the economy from the weak growth we have seen for almost a decade. However, these actions won’t come easily from governments that are feeling populist pressure to “rip off the Band-Aids” and establish reforms quickly and efﬁciently. As a result, the path to get there should encounter further turbulence in the near term.
- Interest rates will remain lower than normal as the economy gradually reﬂates. While the path of least resistance for interest rates is higher, rates should remain lower than history demonstrates in a rate-tightening cycle. Our observations have not changed much from one year ago. The difference now is that the rate hike cycle has begun in earnest; consequently, people are apt to extrapolate occurrences from prior cycles to the current cycle. This is not prudent given the continued meager growth we foresee.
- Manager Skill and Private Capital take on even more importance in strategy design as equity markets begin to experience decreased correlations and increased dispersion. More so than in the recent past, these building blocks will be key for strategies to achieve their long-term objectives as equity markets are not expected to be a one-way ride higher while ﬁxed income markets experience some turbulence as interest rates rise. The contributions from active management in both building blocks must be weighed against the trade-offs to determine the suitability for each investor.Our 2017 Capital Markets Forecast expands upon the following important assumptions underpinning these key themes:
- How does the rising tide of political populism shape the outlook for capital markets?
- Given the poor performance of active management during recent years, what skills are crucial for an active manager, and what do we seek when considering active management?
- What are the trade-offs in making portfolio decisions as clients look to balance their long-term ﬁnancial targets with risk tolerance, spending needs, and a desire for absolute returns?