In 2016 geopolitics, change was the dominant constant and could continue in 2017 with more significant world events scheduled to occur with outcomes the capital markets will have to digest. The surprise outcomes of the UK Brexit vote, the Italian referendum, and the US presidential election were proof points regarding the global prevalence of populism. The potential impacts of other international elections in 2017 begs the question, will their outcomes sway us to change course?
Given how the year started, perhaps we should have known 2016 was going to be the year of the unexpected.
Equity market performance in January and February was historically poor, causing many to anticipate a challenging year ahead. The pace of global growth—China’s in particular—was the primary cause for the equity market’s decline. Anxiety over the struggles of China’s two-speed economy, in which the service sector grew faster than manufacturing, proved to be overblown as the gap between them narrowed over the year. Although this remains a challenge, China has adequate reserves to mitigate potential future difficulties. And as severe as the decline was, the equity markets virtually recovered the losses in March.
Markets turned their attention to the Brexit referendum in spring and summer. The UK’s stunning decision on June 23 to leave Europe caught markets off guard, resulting in a sharp selloff. The S&P 500 lost over 5 percent during the next two trading days, but it swiftly sprang back. The benchmark index recovered all losses and hit a new yearly high on July 8, two weeks after the referendum.
The Brexit result foreshadowed the surprise outcomes of the Italian referendum and the US presidential election. Like former UK Prime Minister David Cameron, Italian Prime Minister Matteo Renzi’s future was tied to December’s referendum on constitutional reform. Nearly 60 percent of voters rejected the amendment, forcing Renzi to resign. Donald Trump’s startling election as the 45th president of the US further reflected a surge in populism in the developed world.
The domestic equity market climbed in the last two months of 2016, leading global equities after trailing emerging markets for most of the year. While equities fared well, bonds sold off dramatically during the fourth quarter. Rising inflation expectations caused an increase in bond market yields prior to the US election, only accelerating after the results were known. Despite the increase, bond yields remain near historical lows—long bond yields, in particular, are still below 2014 levels.
We see the potential for more geopolitical shifts in 2017, with these notable events scheduled to occur in Asia and Europe as well as continued uncertainty over Brexit and President Trump’s administration’s initiatives.
March 26—Hong Kong Elections
The Special Administrative Region (SAR) of China is a vital economic hub in Asia. Hong Kong elections often come with controversy because of Beijing’s past efforts to sway the outcome.
If pro-democracy activism occurs during the election for a new chief executive (head of the SAR government), mainland China might attempt to influence the vote, especially if authorities clamp down on dissent.
April 23—French Presidential Election
France will have a new president, since unpopular incumbent François Hollande isn’t running for reelection. Whoever’s chosen as the new head of the Socialist Party faces a strong challenge from the right-wing Republican candidate, former Prime Minister François Fillon.
The far-right Front National will also be closely watched. Many observers expect leader Marine Le Pen to advance in a final run-off vote, but fall at the final hurdle. Nevertheless, given the outcomes of Brexit and the US election, an upset wouldn’t be a total surprise.
May 19—Iranian Presidential Election
Iran’s relationship with the West remains testy, despite the nuclear deal reached in 2015. Tensions could rise during and after Iran’s presidential election.
The re-election of incumbent Hassan Rouhani suggests Tehran will attempt to further refine the nuclear pact. Conservative opponents who question the deal’s economic benefits to Iran will provide stern resistance to Rouhani.
October—German Parliamentary Elections
Chancellor Angela Merkel, Europe’s most powerful leader, faces a tough fight to secure another term. With the rise of nationalism in other European countries, Merkel’s acceptance of Middle Eastern refugees could stir the German people to elect a new chancellor come October.
October–November—National Congress of the Communist Party of China
The National Congress will select party leaders for the next five years. Although the outcome might not provide immediate insight, new party leaders will have significant influence on the direction of the world’s second largest economy and, consequently, the rest of the world.
UNITED KINGDOM and UNITED STATES
Capital markets will also contend with the effects of the Brexit negotiations and the first 100 days of the Donald Trump presidency. While the new administration hasn’t lacked for press coverage, uncertainty remains about how it will lead the country. Domestic equity markets have made strong gains on the expectation of individual and corporate tax reductions. The prospect of reinvigorated economic growth through inflationary policies, deregulation, and infrastructure spending also brightens the domestic outlook.
Corporate Taxes and Deregulation
Corporate tax reduction is the biggest tailwind for domestic equity markets. At 35 percent, the United States has the highest national statutory corporate tax rate in the developed world. With Congress under Republican control, some form of corporate tax reduction in the future is highly likely.
Domestic equities should increase earnings per share as the lower tax burden falls directly to bottom-line profit—and recent equity markets have thrust ahead on that possibility. Some full-year estimates for 2017 project S&P earnings will be 6.9 percent higher than the 2016 year-end close on the benchmark index.
It’s much harder to quantify the financial impact of Trump’s plans for deregulation and infrastructure spending, which are still ambiguous. Deregulation should benefit corporate earnings in the short term, since compliance with stricter regulations is expensive. The long-term question is how to strike the right regulatory balance to expand earnings while avoiding the unbridled greed that led to the 2008 financial crisis.
Bonds and the Global Markets
Bonds face the prospect of three interest rate hikes from the Federal Open Market Committee in 2017, along with higher inflation expectations. On the surface, bonds don’t appear to be promising investments in 2017, but we believe their demise is farfetched.
Inflation is set to rise but will still remain well below its long-term average. We estimate a peak of 2.5 percent this year on the headline Consumer Price Index. The global need for income remains extremely elevated. We forecast this will keep yields on the 10-year US Treasury note below the historically low 3 percent threshold.
The US dollar is the favored, most consistently demanded reserve for global trade. US Treasury yields remain higher than most of the developed world, despite being perceived as having higher credit quality than every other sovereign nation. When yields on US debt rise, increased demand for US paper holds them at relatively muted levels. We don’t believe there’s as much risk as the market perceives.
We favor European equity, despite the challenges of political and economic uncertainty. Deflationary pressures, weak economic growth, and mounting political risks all weigh on the European economy’s outlook. Negative interest rates—although rising—still have an adverse impact on the banking sector and corporate earnings, which are growing slower than expected.
However, select European companies are overcoming regional challenges. The depreciation of the euro and the pound sterling has been a tailwind for exporters, especially luxury retailers. Health care companies with innovative therapies are also faring well. Viewing European equity strictly from comparing its valuations to US equity paints an attractive long-term picture.
Emerging markets (EM) face an established and significant headwind in the strengthening US dollar. Conventional wisdom implies the dollar will strengthen as the Federal Reserve increases interest rates, negatively impacting EM investments. While that paradigm has held true, the effect appears to be diminishing.
Many EM nations are in much better fiscal and monetary shape than in the past, and several EM currencies are stronger, thanks to improved conditions. Commodity prices are stabilized and interest rates remain low. Emerging markets bounced back in 2016 after a tough stretch, and in the long term, EM nations’ prospects are bright.
Ten-year forecasts for developing nations project nearly 1 billion new people in the middle class and higher, meaning EM economies could account for approximately half of total global consumption. It’s not hyperbolic to suggest this demographic trend will dramatically transform the world’s economy.
Growth and Spending
Even though 2017 presents a world in transition, from an investment standpoint we’re optimistic. US consumerism is strengthening and with consumption comprising 70 percent of gross domestic product this should lead to increased growth. A fiscal infrastructure spending package under the Trump administration could improve prospects for the US economy. The US equity market appears overvalued across several sectors, but if earnings expand, the market may not be as expensive as it currently appears. Despite the slow pace of global growth, the United States and some emerging markets remain bright spots.
With its future in question, the European Union faces a challenging environment characterized by low growth and high unemployment. Yet many companies are rising above regional headwinds, and European equity valuations appear relatively compelling.
The growth of China’s economy continues, albeit at a slower pace than recent years. Aggressive stimulus and a healthier property market are supportive and expansionary. Many emerging markets that began rebounding in 2016 still have momentum, supported by higher commodities prices and China’s turnaround.
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We don’t see a financial meltdown on the horizon. While it’s easy to get distracted with the coming year’s uncertainty, we think investors should stay the course and keep their portfolios balanced. Even as the current outlook is very positive, being ready for the long term should always be a top priority. To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams wealth advisor.