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Asset Allocation: The big picture

While 2016 was a year of tumultuous political change, there is familiar look to the year-end consensus economic forecasts for 2017: slightly higher growth and inflation as well as slightly tighter monetary policy from the Federal Reserve. For the past two years, however, those predicted benign outlooks have morphed into economic disappointments and false dawns. 

But 2017 could be different. Bond markets, led by US Treasuries, have already begun to price in economic reflation, as inflation expectations have risen across the world. More sharply rising prices are not just the result of base effects, which historically will also help future expectations, but also the prospect of more fiscal easing in Japan, Europe, the US and probably China too. The unexpected deal on production cuts from the Organization of the Petroleum Exporting Countries also pushed oil prices higher, adding to this reflationary mix.

For the US there are additional forces at work. Although it has experienced slow economic growth for several years, recession risks have ebbed. With unemployment falling to its lowest levels since 2007, the US output gap is closing. It remains to be seen just how much of President-elect Donald Trump’s pre-election talk will translate into policy, but the risks seem clearly skewed towards becoming more pro-growth.  

The anti-establishment vote is getting louder, at least judging by the magnitude of the turnout as well as the strength of the ‘no’ vote in Italy’s referendum. It would appear that a transition government will take charge through 2017 at least. Such a move would allay fears of potential institutional chaos, but the pressing needs of Italy’s beleaguered banks are not going away and delaying action is dangerous.

Italy’s banking woes are worrying enough, but the depth of animosity towards the establishment in Europe is ominous for the EU. 

Many of its leaders face their respective electorates over the coming months. Italy may choose to break important EU rules and come to the rescue of Monte Paschi Di Siena Bank, for example, to calm its disgruntled electorate. 

Might that be the trigger for other governments to follow suit? 

Bonds

With so many government bond yields bumping on the lower bound, market participants have almost got used to bond sell-offs that are sharp and often dramatic. These included the rapid yield rise and steepening of the US yield curve after the 8 November election. 

Although there is less of a consensus that reflation is yet the theme for the EU or Japan, many are wondering whether the yield lows seen in the summer of 2016 will be visited again. Could this be the end of the 30-year bull market in bonds?

There seems to be a wider range of forecasts both for economic data and for what the central banks may get up to for the coming year. 

Some are more reluctant than others to embrace a global reflationary theme. That the US Fed will continue raising is broadly accepted. By how much is still debated, not least because the leap in rates and the stronger dollar together represent a meaningful tightening of financial conditions in the US.

The European Central Bank (ECB) is unlikely to raise rates in 2017. Although there have been economic improvements, perhaps most notably in Spain, many countries have missed out on the good news. The already higher borrowing costs that have followed the US election will not have been welcomed. 

Fed Chair Janet Yellen’s job has most likely got harder with Trump rather than Hillary Clinton as the next president. 

And ECB President Mario Draghi’s job in 2017 was always going to be a delicate balancing act with its purchasing programme coming to an end. Economic activity is stronger but the ECB will be wary of triggering its version of the taper tantrum. 

The validity of quantitative easing (QE) is also under increasing scrutiny and, with embattled politicians everywhere, so too is the independence of central banks.

Currencies

Since mid-2015, the Chinese currency has depreciated against the dollar and this downward trend may go further in 2017. 

The volume of capital outflows from China, large at the start of 2016, ebbed over the course of the year as Chinese corporates paid down their overseas debts. But over the last few months of 2016 there appeared to be a pick-up in the pace of outflows.

Last year was one of leadership transition in China. Historically, policymakers have endeavoured to maintain firm economic growth in the run-up to the National Congress meetings (held in November). It is therefore probable that uncomfortable economic reforms may be further delayed. Instead more infrastructure investment will be favoured, adding to already high Chinese corporate indebtedness. 

dollar renminbi exchange rate 2015 16

As China grows so too does its already large influence on the rest of Asia. While the dollar retains its place as the most influential currency for emerging markets, the correlation between Asian currencies and the Chinese renminbi has increased since the financial crisis and looks set to carry on rising. 

The International Monetary Fund (IMF) describes China’s influence on regional markets as on a par with Japan’s. But the IMF suggests that links between China and Asian through trade and direct finance mean that China will soon overtake Japan in this context.

Emerging market currencies had already weakened over the third quarter of 2016, and then fell lower in the aftermath of the US election.

With forecasts for the dollar being revised higher across the board, confidence in the ability of the Chinese authorities to manage capital outflows will be critical. 

For emerging market currencies these could be dangerous times. They are already buffeted by global events but they could find themselves swept along in their huge neighbour’s storm.

Focus: Inflation breaks even

Even without considering some of the potentially inflationary policies Trump may introduce, there were signs that the period of low and falling inflation expectations was ending. There has been a sizeable upward movement of inflation breakevens.

Headline inflation in the developed markets ought to read higher in 2017, primarily as a result of base effects, in particular the rise of the oil price after the declines at the start of 2016. Some of this shift will probably feed through to future inflation expectations.

There seems to be mounting evidence of rising inflationary trends in the US from a variety of sources. These include the closing of the output gap, an economy at close to full employment, potentially looser fiscal policy, and oil price stability. However, a similarly positive inflation outlook for Europe is less obvious. 

Global inflation has started to rise, but there can be no denying that European economies lag quite far behind the US, and that output gaps in Europe remain much wider too. Additionally, a lot of the reflationary impetus is US specific. It is hinged on the probability of President-elect Trump following through with his election promises. The Federal Open Market Committee (FOMC) has also noted that a ‘small’ inflation overshoot could be beneficial after such a long drawn out period of below par economic activity.

Over 2016, US and European 10-year breakevens traded closely together, both in the absence of significantly diverging inflation news and then more recently when news and data outlooks took different paths. The rise in European inflation breakevens looks less compelling and may well be overdone.

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