Putting 2017 into Perspective
In 2016 we got many things right. China didn’t collapse. Brazil rallied hugely. The US Dollar went up. Bonds sold off. Emerging Market currencies sold off, except for the Russian Ruble.
We were on the wrong side of Brexit, but still managed to take advantage of a falling GBP.
We hoped that Trump wouldn’t win the US elections as that would change many dynamics. But he did win and some changes will happen and on many others even his administration will be constrained.
These are our thoughts on what 2017 may have in store for us:
We are probably more than ¾ of the way in the US Dollar rally. Infrastructure spending under Trump will push up US rates and US Inflation more significantly compared with European Rates and European Inflation. But the weaker EUR, GBP, JPY and weaker EM currencies will feed inflation all over the world.
With a strong US Dollar, the US trade deficit is likely to widen further. But that could be checked if new tariffs are introduced on imported goods. Any tariffs will only increase domestic prices, in which case wages have to go up if consumption is to be maintained. Inflation in the end is a recipe not only for higher rates, but lower stock markets and ultimately a weaker currency.
At this stage of the US economic cycle any constraints on the labor force is going to be inflationary.
The UK has serious challenges. The nation converted a single issue on emigration into a national disaster by voting to leave the EU. The Brexit Vote was a perfect example of democracy working imperfectly. It dived the nation into rich and poor, old and young, nationalistic and cosmopolitan, educated and deprived of education, north and south, racist and multi-cultural. Now the country is lost and in a semi wilderness and by the day becoming insignificant.
It is still possible that the British establishment will see sense and go for a very soft Brexit. In this case GBP will rise a little bit. Brexit will kill the dynamism of a nation that thrives in diversity and international trade and leadership. Basically, none of the Brexit supporters are respected in Europe. They will have a hard time agreeing on anything.
Irrespective and as a result great trading opportunities will continue around GBP in 2017.
There is a camp that says Europe doesn’t work. Structurally there are countries in Europe that are different phases of development. Europe has done a great deal to bring fiscal discipline to Spain, Italy, Portugal, Ireland, Greece. Before the Single Currency and convergence, these economies were in a big mess. Through association with Europe, Sweden, Norway, Denmark have all flourished. Germany was always going to be the biggest economy in Europe after reunification and is probably the best run also given its size. Austria and the Netherlands not far behind. France was always going to take time to reform.
The politics of corruption and north south divide persist in Spain and Italy. The challenges are still there. But on the whole Europe is doing just fine.
The weakness of the EUR reflects the problems of Europe. The same weakness is the competitive advantage that will see Europe grow faster, particularly on the heels of a resurgent America.
We see very little downside to the EUR from current levels of 1.04.
If the Union does start to crumble, one assumes that countries such as Greece and Spain will go back to their own currencies. The EUR with Germany at its core will rise very significantly. Perhaps buying USD 2 for each EUR.
JPY has already weakened from 101 to 117.50 vs USD. It could weaken more to above 120. We see a range between 114 to 125 in 2017. Weaker JPY will mean high yields on JGBs and in time higher short term rates. Japanese inflation will hit 2%+ over the next 2 years. But domestic demand is not going to rise as the demographic trends are all negative. High inflation will be harder to sustain. JPY will then once again head towards 100, but not in 2017.
JPY will rise if Trump starts to declare that China and Japan are currency manipulators.
Most commodity currencies should do well over the next few years. Infrastructure spending globally should increase. AUD, CAD, BRL, ZAR should all recover.
AUD at 0.70 and CAD at above 1.35 makes these economies very competitive.
Long term trend for oil is stable. Around $45-65 seems like a god range given the impacts of renewable energy, shale etc.
Trump’s proposal for Corporate Tax Rate Reduction to 15%
Tax reductions always come with reduced spending on public services or benefits. Europe will have to follow suite and rejig tax and spending priorities in order not to give advantage to the United States. Of course should American companies start to invest more at home, this could be a welcome opportunity for other economies to have less competition.
In general corporates are extremely cash rich. It is not for lack of funds that they are investing less in America. The American consumer is peaking. The markets are elsewhere. To empower the American consumer doesn’t need corporate tax cuts. It requires individual tax rates to decline and more spend on education and training.
This is a more difficult call. If US 10-year heads towards 4% yield, markets should be lower. But if growth rates do pick up to double the current rates, then if not accompanied by much higher inflation, stocks could rise more. The upside will be checked either by runaway inflation pressures or limits to growth set by shortages of skilled workers.
Any serious signs of a trade wars will cause a Wall Street crash.
Driven by domestic demand and better conditions for trade due to lower currencies, EM should do better in 2017. America may heal its relationship with Russia and if the relationship with China is not disrupted then things will settle. Geopolitical risks are the highest along the US/Chinese axis.
Middle East may become less stable under Trump administration.
As always these are just guiding thoughts. One can imagine that the Trump administration will be far more extremist. America will start to flex its muscle in new ways and become more threatening on other fronts such as lack of perspective on Climate Change.
Climate Change remains the biggest medium term threat. Markets may start to discount that threat much sooner than anyone anticipates.
In the end one can only monitor emerging risks, measure and manage.