Download Investing in 2017

UBS Asset Management
November 2016
Investing in 2017
Protection, politics, populism
Introduction
"In this world, global institutions will need to
make way for more regional ones."
2016 may very well go down as the year in
which governments, particularly those in
developed economies, came to the realisation
that they failed in their duty to ensure the
benefits of growth are spread evenly across
their electorates. Instead of focussing on
ensuring the long term productive capacity of
the economy, governments for too long were
focussed on austerity. The over-reliance on
monetary policy as the sole tool to address the
post-financial crisis malaise propelled the trend
in rising income and wealth inequalities within
economies even further.
As a result of this neglect, potential growth
rates have fallen. Ironically, while governments
around the world have realised that they have
left voters behind in their efforts to lift postcrisis economic growth, they have become
powerless to do anything about it. The fragile
state of many coalition governments that are
made up of parties at extreme ends of the
political spectrum has depleted political capital.
The exception to this is the US where the
Republicans control both Congress and
the White House. There is still considerable
uncertainty surrounding the extent to which
Congress will support the more extreme
policies of President-elect Trump, however.
With little political capital remaining,
governments are increasingly tilting toward
protectionist policies as an easy solution. This
tilt was given a substantial push following the
outcome of the US presidential election.
In this world, global institutions will need
to make way for more regional ones. Trade
agreements will become more preferential.
Multi-national corporations will shrink and
cross-border political collaboration will be more
difficult to achieve outside of the region.
In 2017, multi-asset investors will need to
re-price risk to reflect national differences
between sovereigns and between regions.
From a strategic perspective, this will likely
benefit developed markets more than emerging
markets. Within emerging markets, however,
the fundamentally more sound Asia region
will benefit over the less sound Latin America.
Between asset classes, more expansionary
fiscal policy and more protectionist trade policy
suggests bond yields will be pressured higher.
This may not be to the detriment of equities,
however, if growth supports earnings expansion.
Tracey McNaughton
Head of Investment Strategy
3
The Great Fed Debate
Nearly ten years on from the financial crisis and after unprecedented amounts of
monetary stimulus, economies around the world are still struggling to generate
sustainable growth. A realisation is dawning within central banks and among
government authorities that economies are hamstrung by structural challenges that
cannot be addressed with cyclical tools alone. Just how much downward pressure
these structural issues are having on growth is the subject of much debate.
A great debate is currently taking place inside the US
Federal Reserve. The issue: just how expansionary is
the current setting of monetary policy? This seems a
simple enough question to answer, especially since
those trying to answer it are the ones setting monetary
policy. The problem is the line in the sand that delineates
expansionary from contractionary policy is firstly, not
directly observable and secondly, may have moved in
recent years. With the Fed now in tightening mode,
knowing where you are in relation to a neutral policy
setting is pretty important, especially given how low
the starting point is. There is little room for error to the
downside if policy is tightened too much or too quickly.
Recovery of sorts
It is clear there has been a recovery in global growth
since the 2008 financial crisis. However, the recovery has
been disappointing. Using data from the International
Monetary Fund (IMF), in the last three years world
growth has averaged less than 3 percent. This is below
what would be considered trend growth of 3.5 percent.
The real median wage earned by men in the US is lower
today than it was in 1969.
This comes despite unprecedented levels of monetary
accommodation. There have been no fewer than 670
interest rate cuts globally since the 2008 financial crisis.
This equates to around one rate cut every three working
days. Interest rates have been pushed to record lows.
Around 489 million people now live in countries where
the official interest rate is negative. In addition, the major
central banks have expanded their balance sheets by over
$US12 trillion.
As a result, asset prices have surged – the world stock
market capitalisation has increased from $25.5 trillion
in March 2009 to $65.4 trillion today1. Non-financial
corporate profits in the US have increased by 72 percent
since the financial crisis trough. At the same time, US
household net worth has increased by $33.7 trillion.
Despite the expansiveness of the stimulus, the US
economy is experiencing its weakest recovery in the postWorld War II era (chart 1). The average rate of growth
in GDP during the current expansion has been just 2.1
percent. This compares with the average of the previous
ten expansions since 1949 of 4.7 percent. Despite ranking
the fourth longest expansion, the economy has only
managed to increase in size by a total of just 15.5 percent,
compared to an average of 24.9 percent over the past
expansions (chart 2).
Has monetary policy lost its potency?
The concept of secular stagnation was first put forward
by economist Alvin Hansen in the 1930s but was given
1
Data as at 31/10/16 from Bloomberg
Chart 1: Average annual change in GDP,
by expansion (%)
Chart 2: Length of expansions since 1949 (years)
8
12
7
10
6
8
5
6
4
4
3
2
2
1
Source: US Commerce Department, at 31 October 2016
Q2 2009 – Q2 2016
Q4 2001 – Q4 2007
Q1 1991 – Q1 2001
Q4 1982 – Q3 1990
Q3 1980 – Q3 1981
Q1 1975 – Q1 1980
Q4 1970 – Q4 1973
Q1 1961 – Q4 1969
Q2 1958 – Q2 1960
Q2 1954 – Q3 1957
Q2 2009 – Q2 2016
Q4 2001 – Q4 2007
Q1 1991 – Q1 2001
Q4 1982 – Q3 1990
Q3 1980 – Q3 1981
Q1 1975 – Q1 1980
Q4 1970 – Q4 1973
Q1 1961 – Q4 1969
Q2 1958 – Q2 1960
Q2 1954 – Q3 1957
Q4 1949 – Q2 1953
Source: US Commerce Department, at 31 October 2016
4
Q4 1949 – Q2 1953
0
0
prominence by Lawrence Summers in a speech at the IMF
in 2013 as a reason for why the post-crisis US recovery
has been weaker than its predecessors. The concept
of secular stagnation rests on the idea that there is
structurally too much saving in the system and too little
investment. The imbalance puts downward pressure on
real interest rates.
A further three years on from when Summers first gave
his speech, and with the recovery still stuck in the slow
lane, the hypothesis that this is more than a cyclical
problem that requires more than a cyclical solution is
even more compelling.
If the US, Europe and Japan are indeed stuck in a period
of secular stagnation, as argued by Summers, the malaise
cannot be fixed by record low interest rates alone.
Government fiscal policy and structural reform needs to
become part of the fix.
The US Federal Reserve has now recognised that the
decline in the neutral rate, the interest rate that is neither
stimulative nor restrictive for the economy, is something
that is more than a temporary reaction to the financial
crisis. Ageing populations, slower productivity growth
and a reluctance around the world for business to invest
have propelled many developed economies into a state of
secular stagnation.
The implication of this structurally lower growth state
is a lower neutral interest rate. Currently, the Federal
Reserve’s estimate of this neutral interest rate is 2.875
percent (chart 3). While this rate has steadily been revised
lower it is still a long way from the markets 1.5 percent
estimate. There is still a clear disconnect between the
market and the Fed.
Chart 3: Fed policy makers' median longer-run Fed
Funds rate projection
Prior to the financial crisis. it could be argued that the
neutral rate was closer to around 5 percent made up of
2.0 percent inflation and 3.0 percent potential growth
(made up of 1.5 percent population growth and 1.5
percent productivity growth).
Today, it can easily be argued that all three components
are lower. The Fed‘s estimate of around 3 percent can be
seen to be a combination of 1 percent inflation and
2 percent potential growth. This is consistent with a
recent Fed paper that suggested potential growth had
fallen by around 1.25 percentage points2.
Why is it so important to know where the
neutral rate is?
First, because the effective operation of monetary
policy hinges on it. If the neutral rate is too low, it is
very difficult to get to a monetary policy setting that is
considered expansionary. This is why nominal rates have
had to go negative in Japan, Europe, Sweden Switzerland
and Denmark and why there is now $13 trillion worth of
bonds that have a negative yield.
Second, a lower neutral rate means that each Fed
tightening will pack a much greater punch than in the
past. It would suggest that monetary policy is not as
expansionary as we thought and so the path back to
neutral will be short with the need to raise interest
rates less urgent. Fed Chair Janet Yellen accepts this
saying in the press conference following the September
Federal Open Market Committee (FOMC) meeting
that the current stance of monetary policy is “only
modestly accommodative”. On the flipside, it also means
unconventional monetary policy is likely to be needed
again at the next downturn since this tightening cycle is
likely to be modest.
Time to get fiscal
Market discussion has now turned to the effectiveness of
monetary policy. Monetary policy can boost asset prices
but it can do very little to boost an economy’s potential
growth rate (and by inference lift the neutral interest
rate). For this we need the government to step in with
structural reform and productivity-lifting fiscal policy.
4.35
4.15
3.95
3.75
As the next article will discuss, if we are to address what
truly ails the global economy, that is a structural excess of
saving over investment, then the central bank cannot be
the only game in town.
3.55
3.35
3.15
2.95
Source: US Federal Reserve, at 31 October 2016
Jun 16
Sep 16
Dec 15
Mar 16
Jun 15
Sep 15
Dec 14
Mar 15
Jun 14
Sep 14
Dec 13
Mar 14
Jun 13
Sep 13
Dec 12
Mar 13
Jun 12
Sep 12
Mar 12
2.75
2 “Understanding the new normal: The role of demographics”, Gagnon, et al 2016.
5
Central banking, no longer
the only game in town
Economies around the world are stuck on a structurally lower growth
path. Ageing populations, weak investment spending, and shrinking
workforces are putting downward pressure on the potential growth
rates of both developed and emerging economies. Having spent too
much of the past decade in balance sheet repair mode, governments
must now focus on addressing the longer-term structural issues that are
inhibiting the productive capacity of their economies.
The chorus of voices calling for government
policy to step in and give central banks a
hand in fixing the global economy is getting
louder. Until now, the solution to lifting
global growth post the financial crisis has
been to ease monetary policy through both
conventional and unconventional means.
Governments meanwhile have for the most
part been focussed on repairing their crisisbattered balance sheets. It is now apparent
this combination is not only not working, it is
actually making the situation worse.
Fiscal austerity is depleting economies of their
productive capacity, sending potential growth
rates lower, increasing debt-to-GDP ratios, and
making the task of creating an expansionary
monetary policy even harder.
Chart 4: Deteriorating global infrastructure quality
(1–7 score, 7 = best)
6.8
Productivity growth has declined around
the world. The need for new infrastructure
has failed to keep pace with the growth
in emerging markets while developed
market economies have failed to keep pace
with the deterioration in the quality of its
infrastructure (chart 4). In the US, non-farm
business productivity growth has averaged
just 0.9 percent per annum during the current
expansion, less than half the average from the
previous cycle.
Weak productivity growth, driven by underinvestment in both capital and labour, coupled
with slowing population growth and declining
worker-to-retiree ratios, translates into more
stress on social safety nets and hence higher
fiscal deficits. From a monetary perspective,
it puts downward pressure on the neutral
interest rate (the interest rate that is neither
expansionary nor contractionary for an
economy) and therefore impedes the effective
operation of monetary policy.
6.6
6.4
6.2
6.0
5.8
5.6
5.4
5.2
5.0
Germany
Japan
US
2006-07
UK
2014-15
Source: IMF, Bank of America Merrill Lynch, at 31 October 2016
6
Three broad determinants of a country’s
potential growth are population, productivity,
and participation in the labour force. Increasing
any or all of these factors will have a positive
effect in lifting the potential growth rate of an
economy. The ability of monetary policy to have
any effect over any of these factors is limited.
Monetary policy operates with just one tool
that being the price of capital via its influence
over the level of interest rates.
Korea
It is clear, in order to raise the potential
growth rate of an economy, government
support is needed. Specifically this may include
measures such as infrastructure investment,
investments in research and development,
programs designed to improve the skill set of
the workforce, reforms designed to increase
the size of the workforce including policies
designed to encourage skilled migration,
incentives to make self-employment easier and
policies to reduce the barriers to workforce
entry or re-entry for females and older workers.
The evidence
Fiscal policy will likely be positive for developed
economy growth next year for the first time
since 2010 (chart 5). Japan and Canada have
already announced stimulus programs. Japan’s
Government announced a supplementary
budget worth ¥28.1 trillion within which ¥4.7
trillion (0.9 percent of GDP) is new spending.
The Canadian Government has pledged C$60
billion of new infrastructure spending over the
next decade, double the previously planned
amount. The focus for the spending is on public
transport, housing and water systems.
The UK has indicated it would slow down
the pace of fiscal tightening as a result of the
expected impact on growth from the Brexit
decision in June. The May Government, by
setting up a new Economy and Industrial
Strategy Cabinet Committee, has signalled
a desire to combine fiscal easing with a new
industrial strategy aimed at investing in the
economy’s long-term growth potential.
In the US, President elect Trump has proposed
tax cuts, infrastructure, defence and health
spending.
There is no coordinated fiscal push in Europe,
rather a fiscal fillip is happening more by
circumstance than by design. The refugee
inflow, the rise in border security, and the
rise in terror-related activity will require a
considerable lift in government spending. In
the fourth quarter of 2015, the fiscal impulse
on growth was the largest since 2010. For the
most part, the program of fiscal austerity in
Europe is now over.
Elections are looming in France, Germany,
Netherlands and Hungary next year and
possibly Italy. This will no doubt add impetus to
the fiscal impulse next year. Already Germany
has announced a €264 billion infrastructure
package to be spent on roads, railways, roads
and waterways by 2030.
In addition, there is likely to be a more
concerted push on investing the €315 billion
currently earmarked in the centrally coordinated
infrastructure fund called the Juncker Plan.
Among emerging economies, fiscal dynamics
are more varied. Fiscal policy is expansionary in
Asia, especially in China, South Korea and India,
but contractionary in Latin America and other
commodity producing countries like Russia and
South Africa where the fall in commodity prices
has severely impaired fiscal balance sheets.
While some steps have been made by some
governments toward lifting the productive
potential of their economies, more needs to
be done. The longer it takes to realise this, the
longer the period of low growth, low returns
and low interest rates will be with us.
Importantly, the longer it takes governments to
realise change is necessary, the more difficult
it will become to implement that change.
As the next article will show, electorates
around the world are becoming increasingly
disenfranchised with their governments and so
are gravitating toward minority or fringe parties.
The end result is weakened mandates and a
depletion in the political capital needed to drive
structural change and reform.
Chart 5: Fiscal contribution or subtraction to growth
2.0
1.5
Projections
1.0
0.5
0.0
-0.5
In July the European Commission elected not
to punish Spain and Portugal for breaching
their deficit-reduction targets. Even in Germany
the government is becoming less austere.
The Finance Minister Wolfgang Schauble has
promised more than $2 billion worth of tax
cuts and increased child benefits in 2017 and
$7 billion of tax cuts in 2018.
-1.0
-1.5
-2.0
-2.5
2010
2011
2012
Japan
2013
Europe
2014
US
2015
2016
2017
UK
Source: JP Morgan, at 31 October 2016
7
Unconventional monetary
policy meets unconventional
politics
Ironically, just as governments around the world are coming to the realisation that
large portions of their populous have been left behind as a result of rising income
and wealth inequality, the political capital needed to do anything about it has been
depleted. Voters around the world are increasingly turning to non-mainstream parties
who promote a more nationalistic agenda. With so many disparate parties winning
support, the formation of a stable, effective government has become more difficult.
Globalisation, free trade, large scale immigration
programs, and free market ideologies in general have
produced the most rapid progress in living standards
that the world has ever seen. Millions have been raised
out of poverty. Life expectancy has increased as new
technologies are shared. Wealth has been created at a
scale that our ancestors could not have imagined. And
yet, a growing number of citizens in Europe, North
America, and the Middle East blame globalisation for
unemployment, rising inequality and terrorism.
The evidence
There is little disagreement that globalisation in general
has been a benefit across countries. The share of the
global population defined as “poor” — those making less
than $2 per day — have fallen since 2001 by nearly half,
to 15 percent (chart 6). Overall, the world has become
“wealthier” in the 10 years between 2001 and 2011.
Notably, those in the middle-income bracket making
between $10 and $20 per day have nearly doubled their
global presence, from 7 to 13 percent. Indeed, according
to IMF data, global inequality has declined consistently
since 1990.
Chart 6: Global population by income group
60%
56%
50%
50%
40%
30%
20%
29%
15%
13%
10%
7%
7%
9%
6%
7%
0%
Poor
Low Income
2001
Middle Income
2011
Source: World Bank, at 31 October 2016
8
Upper-Middle
Income
High Income
So why the discontent?
While inequality has fallen across countries, within
countries it has increased. In particular, income inequality
has risen dramatically since the 2008 financial crisis. The
top 1 percent of earners in the US for example have
received 95 percent of the growth in income since the
crisis. This is compared to an average of 54 percent for
1979–2007. In 34 of the 83 countries monitored by the
IMF, income gaps had widened since 2008, with incomes
of the richest 60 percent rising more quickly than those of
the poorest 40 percent.
This trend highlights two important risks that come
with globalisation. The first relates to spill-over effects
of a globalised world onto other countries which can be
both positive as well as negative. The second is the risk
that certain industries get left behind by globalisation.
Since 2008, these two risks have come to the fore
in accentuating the widening in income and wealth
inequality within economies.
The over-reliance on monetary policy as a result of
global deflation trends has boosted the wealth levels
of asset owners (physical and financial) but has done
little to boost aggregate demand in the real economy.
Meanwhile, government policy to address the hollowing
out of industries as a result of globalisation has been
notably absent. In the post-financial crisis world,
governments have been more focussed on reducing
debt levels than on providing investment in re-training,
education and industry vocational programs.
As a result, income and wealth inequality within countries
has increased as has support for anti-establishment
political parties whose policies are based more on
nationalism, populism, and demagogy. The antithesis of
what globalisation represents. Support for these nonmainstream parties has meant coalition and minority
governments are on the rise around the world.
In some countries, elections have failed to produce a
result at all. A national election in Spain in December
last year failed to give any party a majority. A second
election held in June this year produced the same result.
An agreement to form a coalition government was only
resolved in October of this year, some 10 months after
the first election.
Similarly, recent elections in Iceland left no party with an
outright majority and at the time of writing no coalition
government had been formed.
In May 2016, Europe came within 31,000 votes of
electing its first far-right head of state since 1945 when
the Freedom Party of Austria, founded in the 1950s by
ex-Nazis, lost the election by the smallest of margins. The
result was declared invalid by the constitutional court
after faults in postal ballot procedures. A new election is
set for 4 December 2016.
The far-right Sweden Democrats took 13 percent of
the vote in elections in 2014. The resulting minority
government under the Social Democrats collapsed after
just two months. Formal coalitions between the two
biggest parties now rule in Germany, the Netherlands,
Finland, and Ireland, among other countries.
In 1955, 96 percent of the British electorate voted
Conservative or Labor. Last year, barely two-thirds voted
for either. The same trends are evident in Australia. In
1975, 95 percent of the vote went to the Coalition or to
Labor. In 2013, one-quarter of the electorate voted for
minority parties.
The issue is that coalition governments are increasingly
reliant on the support of a number of different minor
parties that at times can sit at opposite ends of the
political spectrum. This makes such a government
unstable, fragile, and ineffective.
Europe is by far where the greatest amount of political
risk lies next year. Since the UK vote to exit the European
Union in June, anti-establishment parties in France,
Germany, the Netherlands, Italy and Austria have called
for referendums on EU membership.
The Italian constitutional referendum on 4 December
2016 threatens to turn into a political crisis with Prime
Minister Renzi threatening to step down on a “no” vote
to change the constitution to make it easier to pass
legislation. Italy’s anti-establishment Five-Star Movement,
advocating for a referendum on EU membership, is
currently polling at 30 percent.
National elections are coming up next year in France
(May/June), Germany (September), the Netherlands and
Hungary. In all four, far-right, non-mainstream, political
parties are growing in popularity.
In France, President Hollande suffers from the worst
approval rating of any president in modern French history.
Marine Le Pen’s National Front Party is currently polling
27 percent of the vote.
In Germany, the Alternative for Germany Party won 25
percent of the vote in state elections in March.
The three mainstream parties in the Netherlands are set
to win just 40 percent of the vote at the next election,
roughly what any one of them might have gotten
previously. The Party for Freedom, currently leading in the
polls, wants a referendum on EU membership.
In Hungary, the far-right Jobbik party is the second
strongest party with 21 percent of the vote.
2017 will be a defining year for global politics. The
concerns of electorates in many countries who feel left
behind by the solutions put forward to address weakened
post-crisis economic growth are reflected in the rapidly
growing support for political parties that advocate
increased trade barriers, reductions in immigration, and
greater national control over the marketplace.
9
Rise in protectionism
What was a tentative tilt away from globalisation has now been given a significant
push following the election of Donald Trump as President of the United States. Political
culture is contextual. The euphoric benefits of globalisation as China ascended onto
the world stage some 15 years ago have given way to the ugly truth for those left
behind by governments who failed to re-train, re-educate, and reform affected
industries. This political new normal will require investors to re-price the sovereign
risk they take.
From an economic perspective globalisation
is the great equaliser, at least across countries
if not within. Allowing the free flow of labour
and capital means price differentials are bid
away, resources are more efficiently distributed
and overall welfare is lifted. A move away from
globalisation means this equaliser will not work
as efficiently.
Globalisation does appear to be slowing. In
the 60 years before the financial crisis, trade
typically expanded at twice the rate of output
or GDP. Between 1960 and 2015, world trade
increased at an average annual rate of 6.6
percent, while output grew at an average
annual rate of 3.5 percent. Between 2008
and 2015, however, average annual growth of
world trade slipped to 3.4 percent in real terms,
while world output grew at 2.4 percent.
The IMF believes part of the reason for
the decline in global trade is the rise in
protectionism driven in turn by a popular
uprising against income and wealth inequality.
Globalisation does cost jobs, at least in the initial
phase when unproductive domestic industries
make way for imports produced by more
productive industries offshore. Most economists
would argue, however, that the benefits of
globalisation are not in the number of jobs it
creates but in the rise in productivity it produces.
Higher productivity and cheaper imports lifts
living standards and helps to keep inflation and
therefore interest rates in check. Broader job
creation is a secondary benefit that comes about
indirectly via faster economic growth.
10
It is true the benefits of globalisation are not
spread evenly within a country. Middle-class
wages in the US stopped rising more than 30
years ago. It is here where government policy
has a role to play in ensuring those most
adversely affected by globalisation are not
left behind.
In the decades leading up to the financial crisis,
the rising tide of strong economic growth
globally lifted all boats, obscuring the rise in
inequality within countries. After the financial
crisis, when the tide was no longer rising, or
rose less fast, the relative differences between
income and wealth cohorts within countries
become more obvious.
Some governments have responded to the
political pressure posed by this inequality
by raising trade barriers or imposing trade
restrictions. According to the Global Trade
Alert (GTA), 2015 saw a 40 percent rise in
protectionist activity, the worst outcome
since the global financial crisis3. According to
GTA, 50 to 100 protectionist measures were
implemented around the world in the first four
months of each year between 2010 and 2015.
In 2016, the total exceeded 150.
Protectionism is about shutting out an economy
from international competition. The agriculture
industry is one of the most heavily protected
industries in the world reflecting the particular
place of agriculture in the political economy of
most countries. Food security has become a
major political issue.
3 Global Trade Alert Annual Report, 2016.
The tendency to protect agriculture more
than manufacturing is more prevalent among
developed economies. Rich countries tax their
agricultural imports on average 6.7 times more
than manufacturing4.
Interestingly, Japan is at least as bad as the
EU when it comes to subsidised farming. The
average Japanese farmer, for example, is 66
years old and tills 1.9 hectares of land. In 2010,
Japanese farmers added 4.6 trillion yen in value
to the economy but consumed 4.6 trillion yen
in subsidies, meaning the net benefit to the
economy was zero.
Protecting an industry hardly equates to an
efficient use of an economy’s resources. The
UK’s new Conservative Prime Minister, Theresa
May, appears to be signalling an end to Britain’s
free-market economic liberalism of the past. As
a way of responding to the will of the people
following the Brexit result, May is implementing
an interventionist industry policy to promote
certain industries the government deems to
have value. In a nod toward a more protectionist
stance, May is also introducing a new system to
vet foreign investment deals into the UK.
Governments are notoriously bad at asset
allocation. Political bias and the election
cycle too often get in the way. This is
one of the reasons why many developed
market central banks are independent of
the government (although the UK was late
to this party asserting the independence of
the Bank of England as recently as 1997).
This independence may come under strain
in a world where government plays a more
interventionist role in the economy as appears
to be the case in the UK under Theresa May.
Not only are trade barriers rising, but the
number of free trade deals being successfully
negotiated is falling (chart 7). The fate of the
most ambitious arrangements, the Trans-Pacific
Partnership (agreed, though not ratified)
and the Transatlantic Trade and Investment
Partnership (very far from agreed), remains
quite uncertain. The Trans-Pacific Partnership
has been six years in the making and potentially
ties together 40 percent of the world‘s
economy and eliminating 18,000 tariffs. The
election of Donald Trump as the new President
of the United States leaves the fate of this deal
seriously in doubt.
largely because it required the agreement to be
ratified by all 28 EU parliaments. The difficulty
in getting all 28 EU parliaments to agree raises
questions about the ability of Europe to fulfil
one of its fundamental objectives – to break
down trade barriers.
Emerging markets are most affected by trade.
Emerging market economies within the G20
have around 27 percent of their GDP exposed
to exports. Since peaking in 2009, the growth
differential between emerging and developed
markets has been narrowing. Part of the reason
for this is the slowdown in global trade.
The implication for investors of a less open
global trade environment is that sovereign
risk must take into account more idiosyncratic
risk. In a globalised world, inefficiencies are
bid away and global collaboration supports
the broader good. In a less globalised world,
inefficiencies remain and national interests
are put first. This must be priced by financial
markets accordingly.
This can be seen in how the UK pound has
reacted to the Brexit decision. If the UK is going
to become less integrated into the EU, then its
sovereign risk must be priced accordingly. Given
the UK has the second highest current account
deficit in the G20, this implies either a higher risk
premium for its bonds and or a weaker currency.
For investors, we are now in a far more volatile,
uncertain environment. The shift in political
ideology (away from globalisation) that is now
shared by the leaders of the US and UK, means
a re-pricing of risk premiums to reflect national
differences. For discerning investors, this may
present opportunities. At the very least, we
may now be reverting to a world where risk is
more appropriately priced.
Chart 7: Number of free trade agreements – by year of
signature
45
40
35
30
25
20
15
10
4 “A picture of tariff protection across the world in
2004”, Houssein Boumellassa, David Laborde, Cristina
Mitaritonna
5
0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
The trade deal between the European Union
(EU) and Canada was seven years in the making
Source: IMF, at 31 October 2016
11
Economic outlook
for 2017
For the most part, economic growth and inflation appear to have past their lows.
Moves to support growth with more accommodative fiscal policy, as well as monetary
policy, will be positive for global growth in 2017. With less excess capacity in the
system than at any stage since the global financial crisis, deflation fears will make way
for rising inflation pressures in 2017.
13
Australia
The Australian economy is on track to record its
world record-breaking 26th year of uninterrupted
growth in 2017. Overall, growth will be supported by
accommodative monetary policy with interest rates
expected to remain unchanged at 1.5% through most
of next year. Growth will be reasonably broad-based
with consumer spending supported by further gains
in employment and an expected decline in what is by
historical standards a high saving rate. A partial recovery
in commodity prices, particularly coal and iron ore, will
provide a lift in the terms of trade and support income
growth. The pipeline of residential construction work will
provide another key source of support next year while
state and federal government budgets imply ongoing
growth in public investment.
Chart 8: Australia GDP and CPI
The Australian dollar remains over-valued relative to
commodity prices and is likely to experience some
downward pressure in 2017 as the US dollar strengthens
and rates there rise. A weaker dollar will improve the
competitiveness of our export sector and will assist
domestic industries such as tourism, education and
financial services. Offsetting this to some extent is the
expectation that the Trans Pacific Partnership agreement
will not be ratified under a Trump Presidency.
Source: Bloomberg, at 31 October 2016
14
5
Bloomberg
forecast
4
3
2
1
0
06
07
08
09
10
11
GDP (yoy%)
12
13
CPI (yoy%)
14
15
16
17
China
Economic growth in China is expected to edge down
slightly in 2017. Large-scale infrastructure spending will
only partly make up for slowing business investment as
overcapacity is being worked off in several industries
including coal and steel. The property market is cooling,
but housing inventories remain sizeable. Consumption
is projected to stay buoyant. The reduction in excess
capacity will ease the downward pressure on producer
prices, but consumer price inflation will remain low.
Corporations need to deleverage as slowing growth
heightens credit risks. Fiscal policy is being eased
significantly, potentially crowding out of private
investment and building up imbalances.
The pace of structural reforms will continue to influence
short-term outcomes, the challenge being to keep up
sufficient momentum to reduce imbalances while avoiding
overly abrupt adjustments that might trigger a crisis. The
potential implications of a Trump Presidency for China
mainly centre around trade and political relations. Trump
said he would name China a currency manipulator on day
one of his Presidency raising the risk of a currency war. A
rise in US protectionism and trade tariffs on China that
materially affect Chinese exports and hence growth, can
expect to be met with an increase in fiscal policy support
from the Chinese government.
Chart 9: China GDP and CPI
16
Bloomberg
forecast
14
12
10
8
6
4
2
0
(2)
06
07
08
09
10
11
GDP (yoy%)
12
13
CPI (yoy%)
14
15
16
17
Source: Bloomberg, at 31 October 2016
15
Japan
Growth in Japan is expected to remain muted in 2017
despite low unemployment, ultra-loose monetary policy
and government fiscal stimulus measures. The impact of
the consumption tax hike planned for 2017 will weigh on
consumer spending, and the slower growth outlook for
China (which accounts for a quarter of Japan's exports)
and other Asian countries will impact exports as will any
further strengthening in the yen. Japan's trade prospects
will likely take a further hit if, as expected under the
new US President, the Trans Pacific Partnership falls over.
Offsetting this to some extent is record-high corporate
profits supporting business investment and employment.
Despite the tightness of the labour market, labour
shortages have risen to their highest levels in 25 years,
wage gains have been frustratingly slow to materialise.
Chart 10: Japan GDP and CPI
6
Bloomberg
forecast
4
2
0
(2)
(4)
(6)
06
07
08
09
10
11
GDP (yoy%)
12
Source: Bloomberg, at 31 October 2016
More than three years have passed since the Bank of
Japan introduced the surprisingly aggressive monetary
policy of quantitative and qualitative monetary easing.
The introduction of negative interest rates in February
2016 reaffirmed the Bank's commitment to its 2%
inflation target. Despite this, core inflation is expected to
remain close to zero.
16
13
CPI (yoy%)
14
15
16
17
US
Growth remains on a moderate trajectory sustained
by mutually-reinforcing gains in employment, income
and household spending. Business investment has been
lacklustre, in part due to the decline in drilling and mining
investment due to the low oil price.
The policy environment will be supportive next year.
The clean sweep outcome of the US election, with the
Republicans not only retaining control of Congress but
also winning the White House, is positive for economic
growth. Assuming he has the backing of his own party
on most measures, President Trump's policies of higher
infrastructure spending, lower corporate taxes, and higher
defence spending will lift GDP growth. Lower corporate
taxes may also give a boost to business investment
spending. The negative consequence of this policy stance
is higher budget deficits and higher inflation.
Chart 11: US GDP and CPI
4
Bloomberg
forecast
3
2
1
0
(1)
(2)
(3)
06
07
08
09
10
11
GDP (yoy%)
12
13
14
15
16
17
CPI (yoy%)
Source: Bloomberg, at 31 October 2016
The policy shift away from free trade is likely to have
a neutral effect on net exports as higher tariffs on
imports are likely to be met with a retaliatory move of
higher tariffs on US exports. The end result is likely to be
higher inflation and therefore higher interest rates and a
higher US dollar. A more protected economy, however,
will support employment growth in import-competing
industries.
17
Europe
The ongoing moderate recovery in Europe is expected to
continue in 2017 albeit at a slightly lower pace. Sustained
monetary stimulus and low oil prices will support
domestic demand, but the slowdown in emerging
market economies will weigh on exports. The decline in
unemployment should also continue at a modest pace,
but differences across euro area countries will persist.
Continued cyclical slack and some second-round effects
from cheaper energy will hold inflation under the ECB’s
target of just below 2%. Monetary policy should remain
accommodative through most of the year while fiscal
policy is projected to be slightly expansionary.
A busy political calendar is coming up for Europe in 2017
with national elections scheduled for France, Germany,
the Netherlands and Hungary. Europe will also be
negotiating the exit of the UK from the Union. The farright movement that is already polling strongly in Austria,
France, Italy, Hungary, and Poland would have received a
fillip from the outcome of the US Presidential election. As
a result, we see the greatest risk for Europe being a rise in
anti-union sentiment next year.
18
Chart 12: EU GDP and CPI
4
Bloomberg
forecast
3
2
1
0
(1)
(2)
(3)
(4)
(5)
06
07
08
09
10
11
GDP (yoy%)
12
13
CPI (yoy%)
Source: Bloomberg, at 31 October 2016
14
15
16
17
UK
The outlook for the UK economy hinges on the Brexit
negotiations. The near 20% fall in the pound over the
past year reflects a growing realisation that the UK’s
long-run growth potential has deteriorated since the 23
June referendum result. While the lower currency will put
upward pressure on inflation, it is unlikely to give much
of a boost to exports given the limited pass-through of
a cheaper currency by UK exporters to foreign buyers.
The upside to this is that UK exporters will benefit from
higher margins. The net export impact on GDP will still
be positive as consumers substitute away from the higher
priced imports.
Consumers are likely to feel the pinch from the squeeze
on real incomes as a result of higher inflation. Heighten
business uncertainty resulting from Brexit may also hinder
business investment spending. Despite this, a recession
will likely be avoided in the UK next year as any weakness
from will be offset by the wealth effects from a strong
housing market and more accommodative fiscal policy
with plans to step up public investment spending. While
interest rates have been cut and quantitative easing has
expanded post-Brexit, any further monetary easing is
likely constrained by the rise in inflation pressure.
Chart 13: UK GDP and CPI
6
Bloomberg
forecast
4
2
0
(2)
(4)
(6)
06
07
08
09
10
11
GDP (yoy%)
12
13
14
15
16
17
CPI (yoy%)
Source: Bloomberg, at 31 October 2016
19
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