Chief Investment Officer
Bank of Singapore
Member of OCBC Wealth Panel
THEMES FOR 2017
As we start the journey that will be 2017, it is pertinent to recap the year in review. What worked, what is still relevant, and what needs be discarded?
The hunt for yield theme was emphasised often in 2016, and will likely make a number of appearances in 2017 too. By the end of the year government bonds were reeling from the combined effect of a tightening US economy, the expectation that Trumpenomics would provide an inflationary stimulus and the surprising jump in the oil price. Nonetheless, credit assets have had a stellar run, delivering returns close to 15 per cent for the year.
An additional theme that remains valid for longer term investors include the focus on stocks that have a strong tilt to innovation, or where there is a long-term strategic advantage. Both these were themes that received good support in 2016, and will remain valid given their focus on longer-term value. In addition there is the fact that with China at risk of a trade war with the US, stocks with a smaller exposure to trade will be better off.
Themes for the start of 2017
In very broad terms, we have sliced the new Trump world into three main scenarios: First, the one where everything good happens, but none of the more questionable policies get enacted. Second, our base case pictures a world much akin to the one we have now, where U.S. policy gets stuck in a quagmire between the White House, Senate and House and no sudden jolts hit the market from fiscal policy realignment. Third, we think about the landscape where nothing particularly sensible happens, but where all that is negative for markets happens to transpire.
However, we urge clients to think rather about what looks more certain in a world where many, many outcomes are now feasible compared to only a short time ago. Here are our key themes:
Theme: Expect more volatility. Compared to the last number of years, we should anticipate a greater degree of market volatility in 2017. A far greater number of policy outcomes are possible this year, as Mr Trump looks to introduce policy changes that had not been contemplated before. This alone is probably enough to spur market swings. Keep in mind furthermore the possibility of disruptions and surprises in Europe (politics) and China (credit), and the scope for some interesting developments should be obvious. Portfolio diversification is critical for this year.
Theme: Rates on the rise as reflation replaces deflation: Even before the ascent of Mr Trump we had commented that measures of inflation expectations were on the rise in the United States. The sudden addition of fiscal stimulus to the picture would add more spice to the broth than the US bond market might be able to handle. Not only that, we view the “Fed on hold” status quo as shattered. The Fed will hike in December of 2016, and quite likely two more times in 2017 at least. More will be in store in 2018 if the mix of aggressive fiscal stimulus ignites inflation in the US economy which is already approaching full capacity.
To position for a rise in rates, shorten duration. This is the first set of moves in what may be a longer rate rise cycle than we foresaw previously. Look to stay protected by not extending duration beyond benchmark at most. Our preference would be to be shorten even more than that: floating rate exposure, or fixed out to five years or so but not longer.
Theme: Credit looks better than government, but trim exposure after outsized gains in 2016. Interestingly, we find that the outlook for credit assets remains positive, but further gains after this year’s bonanza will be difficult to achieve. Our best strategy is to stay with higher-yielding paper in the expectation that the default outlook is still benign enough. High grade bonds may in fact carry too much interest rate risk.
Theme: US equities the winners despite stretched valuation. In poor outcomes for the market, a global trade war trips up the expansion plans of emerging economies, especially in Asia. In a positive scenario, US stocks are boosted by a fiscal spurt, deregulation and extra money into infrastructure. Either way, US stocks do better than Asia and EM.
Theme: We expect a strong dollar versus EM currencies. It is often the case that EM carry trades come under pressure when US rates are expected to rise. This time around appears to be no exception. Across markets in Asia, Latin America and Africa, EM currencies have been punished to a greater or lesser extent and the dollar has rallied. We think this trend is likely to persist.
Finally, we urge a cautious stance going into 2017: underweight risk assets, overweight cash. The key to the position is more to be able to take advantage of the opportunities that will almost surely come along. For example, US healthcare and financial stocks are beneficiaries of a more relaxed regulatory stance. Financials in addition stand to gain from a steeper yield curve as long rates rise faster than the Fed moves rates on the short end.
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