"Every generation needs a new revolution." - Thomas Jefferson
Global uncertainties regarding the political landscape in the US, Europe and some Emerging Economies, together with the ongoing China's structural economic reforms can warrant too much uncertainty for investors leading to spikes in volatility and increase in asset class correlation.
Given the political events of the last few months, we see significant pockets of opportunities, as well as looming risks. In the US, the new administration of president elect Donald Trump, is promising an increase in infrastructure spending, a massive tax reduction, substantial deregulation especially in the financial industry, and a reassessment or reshuffling, if not a suspension of current trade agreements. These fiscal actions, although threatening to destabilize the status quo of economic policies from past administrations, might reignite US consumer optimism and business stale outlook on a macro scale. Two major economic implications stand up at first sight from the political rhetoric expressed. The first is an increase in fiscal deficits, with major consequences in inflation and the long rates, and consequently the FED response, affecting also the short end of the curve. The second is a large reallocation of income and spending from the government spending, thereby reassigning resources between industries.
Cyclical companies will definitely benefit from the latest effect, among which industrial and consumer discretionary firms might overperform. Other sectors such as financial and healthcare might also advance relative to the market given looming deregulation efforts.
The bond market rout following the US presidential election clearly signal higher fiscal deficits leading to a reflation phase and consequently a gradual but steepening of the yield curve. This eventually will be followed by a tightening of the short end when the FED moves to increase the FED funds rate.
Even though this brings unintended negative consequences to the banking sector balance sheets in the short term, it will provide some relief to pension funds and other long term institutional funds like insurance desperate for some help from the market.
Look for a cautious and gradual decrease in allocation to the long term government sector for conservative portfolios. Ten year yields can sell off well above 3% in 2017, especially if the FED keeps on a waiting mode on lifting FED funds at a higher clip. Consider slowly increasing government back money market and newly created Prime funds. Also, consider increasing allocation to TIPS as well.
Additionally, we are underweighting agency debt due primarily on higher ultra-long yields but also but also on lower prepayment speeds and higher rate volatility.
U.S. Treasury bond yield change breakdown, 2013 vs. 2016
Investment grades have also been hit significantly with the longer curve sell off. However, this sector can also benefit from slow spread compression in the coming months from increase in optimism in the US economy.
High yield bonds might benefit relatively well from the higher yields, if the increase comes from growth in the cyclical sectors, as spread compression due to a pick-up in economic activity and slower default rate growth start to kick in.
As with government debt, consider decreasing allocation to the IG sector if the US labor market starts heating up in the first quarter of 2017. However, consider increasing your allocation to shorter term high yield debt, maybe in the 5-7years range, in energy, industrial and mid-market sectors.
Since the US elections, emerging markets in general have been on a wild ride. The space saw a significant sell off in the first few weeks across the board, due mainly to fears on global trade, only to be partially offset in the subsequent weeks by rebound, largely accredited to higher growth and inflation expatiations.
Even though EM typically tends to have low correlation with developed markets in the long run, effects are highly correlated in the short run. Given the latest currency market corrections, we see many EM equity assets becoming attractive, especially in the exporting sectors and those economies with heavy dependence to China’s growth. Contrarily, countries with large exposure to the US growth, might eventually become weaker.
The US dollar has, for the most part, been front and center of the major market development this year. EURUSD and GBPUSD have been weakened by the Brexit events in June, but have lately stabilized and even rebounded to some extent, reflecting the uncertainty of the burocratic and effective long term effects the exit strategy might indeed imply. Additional pressures on EURUSD comes from other peripheral economies that are posing more immediate challenges to the Union, especially on the fiscal front, weakening the common area currency further. Expect more of this theme coming next year, implying more volatility and a EURUDS breaching the parity level.
We expect currencies of oil producing countries to stabilize on OPEC and non OPEC country oil supply cut agreements. Similarly, agricultural producer currencies might also gain some support given China economic domestic stimulus. Expect most EM currencies to trend down, mainly on the USD strength and increasing domestic deficits and lose monetary policy (USDRBL, USDBRL, USDMEX, USDINR, USDIDR, USDKRW). Also we see USDCHY strengthening as a response to a more acute crackdown by the government on the outflow and the domestic shadow lending market.
Energy markets, in particular wti/brent oil, are poised to get a support from OPEC and non OPEC producing countries in the first half of 2017. Key to this support is the non OPEC countries committing to their pledge in due time and form. Nonetheless, we still see significant pressure from non conventional production to counterbalance the lower supply. A key factor in forging the trend is global demand, especially from China and Europe. In both cases, we see this demand as muted for the first half of 2017. With these premises, we view WTI on the 45-55 range for the first half of 2017.
USD strength will play unfavorably in the precious metal space in the short term, pulling Gold on even double digit losses. We see this effect stabilizing and gaining further upward momentum once inflation expectations overcome global growth in the second half of 2017.
The industrial metal space will become the major beneficiary of the fiscal policies of the incoming US government administration. However we don’t expect a pickup in growth in China, making this sector grow only in the single digits.
Similarly, we expect agricultural commodities to trade range bound to slightly lower given muted appetite from China and further global trade contraction.
Given our expectations of lower correlation between asset classes, we expect sectors to perform differently. Higher interest rates pose headwinds in Real Estate, however CMBS might play out better in the next few quarters given low duration and higher growth expectations.
Private Equity will be aided by higher M&A activity in consolidating industries and Hedge Fund long/short strategies might benefit on higher market performance dispersions across sectors and industries.
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