2016 will be remembered for political upsets, with the UK vote to leave the European Union and the election of Donald Trump highlighting voter dissatisfaction with mainstream politicians and parties. For investors, it will probably also go down as the year when global deflation fears came to an end, long-term interest rates finally started to rise, and central banks stopped being the “only game in town”.
Faster reflation and reduced emphasis on monetary policy would both tend to increase the returns of equities relative to bonds in the future, and to point investors in the direction of cyclical assets over more defensive ones. Within fixed income, it would also tend to argue against holding long-dated bonds. But the structural and supply-side factors that are constraining global investment and productivity growth, and pushing up the relative demand for safe assets, have not gone away. These structural constraints, coupled with the fact that the US is much further along the reflationary road than other parts of the developed world, suggest the search for both income and new forms of “safety” will continue to be crucial for investors.
Politics and policy are likely to dominate headlines again in 2017, with Brexit negotiations due to start and key elections in Europe. But for investors, we would argue that the real economy will continue to be the most important factor-especially supply-side dynamics in the US, the resilience of the eurozone and UK recoveries in the face of uncertainty, and the pace and extent of any further appreciation in the dollar.
Overall, we believe the eurozone will struggle to outperform other developed markets at the index level, but the point about financials again underscores the importance of selectivity and active management. The main Japanese stock index could fare better, if investors retain confidence in the BoJ’s new policy of targeting the 10-year bond yield and the yen continues to weaken against the dollar.
We would expect the US to continue to outperform in 2017, especially the small cap sector, which is theoretically less affected by a stronger dollar and could benefit more than most from corporate tax cuts. However, investors will need to be alert to important sectoral shifts if the reflation theme continues to gain steam. The UK, with its large cap bias and exposure to the rest of the world, has done better than many in 2016, but for non-UK based investors the benefit was more than offset by the falling value of the pound. Though UK equities look reasonably well supported at current valuations, they are clearly less attractive than they were at the start of the year. We will be looking to see whether earnings momentum can continue to improve in 2017,though within the equity market the relative shift back from mid and small cap equities to the larger businesses probably has further to run.
Emerging markets are probably the toughest call for investors in 2017, having seen a dramatic recovery in investor sentiment in the first half of 2016, which was halted in its tracks by the outcome of the US election. Other than a major negative shock from China, which we do not see on the immediate horizon, the greatest risk for emerging market assets today is either an early US recession or, more likely, a further upward lurch in the dollar and/or relapse in commodity markets.
At the end of 2016, there were signs of renewed dollar strength, but little sign of another collapse in commodity prices. We do not discount either possibility, but-as mentioned above-the current account and currency adjustments we have seen in emerging economies since 2013 mean they are much less vulnerable to these downside risks than they were before. Emerging market assets also have the unique advantage-in the current environment-of being risk assets that are still reasonably attractively priced. Overall, we believe it is too soon to give up on the emerging market (EM) recovery, though the prospects for higher global rates should make investors more confident in EM equities than EM bonds.
By Stephanie Flanders, Chief Market Strategist for the UK and Europe, JP Morgan Asset Management
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