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What an extraordinary year 2016 was. Over a 12-month period in which British citizens voted to exit the European Union and American citizens voted in Donald Trump as Commander-in-Chief, who would have imagined that global equity markets would in many cases be trading at, or near to, all- time-highs.
But as we look to rule off 2016 we thought it would be useful to cast our thoughts towards next year and look at what some of the key investment themes are likely to be. To best achieve this we have drawn upon parts of commentary by strategist Bernard Doyle who is responsible for managing our Global Themes Fund.
Theme 1: More growth = more inflation
Whatever else is going on in the world, the growth backdrop remains critical. In that respect, 2017 should provide a relatively supportive foundation. We expect global growth in the mid 3%’s next year, which will represent a pick-up from 2016. This would take us back to the pace of growth seen in 2013-2015, with one important distinction: less reliance on China. Back in 2013 China was growing at almost 8%, providing a crutch for weak growth in the US and Europe. In 2017 we expect Chinese growth to slow to a little over 6%, but the slack is being taken up by the advanced economies, particularly the US. So while global growth in aggregate is printing the same number, the balance and therefore the quality, is superior.
Donald Trump’s victory in the US Presidential election presents another twist to the growth dynamic: substantial fiscal easing. Markets have already moved quickly to anticipate the impact of tax cuts and infrastructure spending in the US. The President-elect’s first speech of substance promised to “rebuild our highways, bridges, tunnels, airports, schools, hospitals”, which fuelled enthusiasm for anything with a shovel attached. Caterpillar rallied substantially since Election Day. Others have cautioned that the Republican Party will prove a handbrake on Trump’s ambitions to loosen the purse-strings. We see validity in both arguments, but generally believe that renewed fiscal easing is the real deal.
Any acceleration though in US growth comes at a time when the US economy is running out of spare capacity. The unemployment rate has dropped to 4.6%, the lowest level in a decade. Similarly employee job hunting activity has risen, with voluntary “quits” at levels we have not seen since pre- GFC. This quit rate is a reliable indicator of future wage growth. Inflation is making a comeback.
We are not only seeing this in the US labour market. In September, Chinese producer prices ceased falling for the first time in 4 years. Commodity prices stopped falling in the first half of the year and in some cases have rebounded dramatically. Oil prices have roughly doubled since a low of $27 per barrel in January.
The prospect of rising inflation comes against a backdrop of still modest interest rate expectations. Market pricing implies the Federal Reserve (Fed) will hike rates barely twice in 2017. Whilst we see this as a plausible scenario, we think it at least as likely the Fed moves three times in calendar 2017.
Theme 2: Rising earnings meet rising interest rates
The link from growth, to inflation, to interest rates is integral to the life-cycle of an equity market. The current US bull market began in February 2009, and is now almost 8 years old. This is second only to the 1990’s episode that culminated in the Tech bubble and subsequent crash. However, by magnitude, the current bull phase is middling versus history.
So what kills a bull? A simple snapshot of prior bull markets is revealing. This shows unemployment at cyclically low levels, a median of 5.0%, which in turn is driving up wage growth and inflation (median 3.7%). The combination of low unemployment and elevated inflation inevitably leads to rising interest rates, which eventually undermines equities abilities to sustain gains.
Against this backdrop, 2017 presents some challenges. Unemployment is already at levels that are generating a pick-up in wage inflation. As this translates to generalised inflation, we will see the Fed’s attitude to growth change from cheerleader to referee. It is this transition that is most dangerous to equities, and it could take place over 2017.
So is it time to underweight equities? We would argue that there are good reasons not to take this position yet, including:
1. It takes time for the Fed’s attitude to change. The first few rate hikes are more about reversing prior easing rather than slowing the economy. On average, there has been a 25 month period between the first hike and the market peak. The first hike was 12 months ago.
2. Importantly, earnings are making a comeback. We expect close to ~10% US earnings growth in 2017, something that has been absent in the past 2 years. Other markets such as Japan, the Euro Area and India are also enjoying better prospects for earnings recovery.
Theme 3: A political pivot right, but watch Italy
If there was one political message from 2016, it was not to underestimate the mood for change. In Brexit and the US election, polls and analysis, which generally leans on past voting patterns, were wrong-footed at the ballot box. With that in mind, investors are justifiably viewing the political calendar with trepidation. National elections in France and Germany stand out as potential existential threats to the future of the Euro. Italy, with the recent resignation of Prime Minister Matteo Renzi, with attendant pressure for fresh elections, is also a concern.
New Zealand: the elusive soft landing
New Zealand’s new Prime Minister Bill English will inherit an economy in enviable shape. GDP growth has averaged around 3% for the past 3 years. Our growth is underpinned by the three L’s: Leisure, Lattes and Land:
Leisure (tourism) is our biggest export and has been growing at a double digit rate all year. On the ground surveys in China show a desire amongst residents of Tier 3 and 4 cities to visit this country.
Lattes (dairy) our second most important export has come back from the brink this year. Whole milk powder prices were 30% below the 5 year average as at June, they are now 20% above.
Land (immigration) most controversially, immigration continues to be a significant driver of population growth. Natural increase (births less deaths) in New Zealand is around 30,000 per annum. Net immigration is comfortably more than double that, which supercharges the New Zealand housing cycle.
The challenges the new Prime Minister faces are twofold. Firstly, improve the quality of growth. Impressive GDP numbers driven by rampant population growth mask a housing crisis, debt build-up and infrastructure bottlenecks. New Zealand needs a comprehensive population policy.
Australia: shock and ore
The turnaround in Australia’s key export, iron ore, puts our 80% dairy recovery to shame. Since this time last year, Iron Ore prices have risen 120%. Some question the sustainability of the resources turnaround, but it comes at a time when the Australian economy was looking on the improve anyway.
The mining turnaround has multiple benefits for the economy:
Directly through the reactivation of idled mine capacity, fresh capital spending and job creation.
Indirectly through improved Government accounts from taxes and mining royalties. This may in turn feed through to a stronger outlook for Government infrastructure spending. The threat of a sovereign ratings downgrade for Australia also lessens with improved mining sector receipts.
The pick-up in the mining sector is well timed, as the Australian building cycle looks set to fade, led by a decline in residential apartment construction activity. However we don’t expect the downturn here to be enough to stop Australia growing at around 3% per annum over the next two years. This will embolden the RBA to begin a tightening policy by early 2018, at the latest in our opinion.
The environment that Bernard describes above is an exciting one for investors. Ultimately we would expect financial market volatility to remain a characteristic for 2017, but this is a productive setting for us at Devon given the fundamental approach that we take when considering investments on behalf of our clients. Stock picking is the foundation of our firm and we take the responsibility of managing your money very seriously.
We have a number of changes occurring within our business next year with Managing Director Mel Firmin stepping back from an operational role but remaining on the Board as a Director and Shareholder. Slade Robertson will be assuming the role of Managing Director and the portfolio management responsibilities for the Alpha and Diversified Income strategies will shift to Nick Dravitzki. Next year we also anticipate the addition of at least one new investment analyst to the team.
We would all like to thank you for your support during 2016 and we wish you all a wonderful and safe time over the holiday period.
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