Daniel Ben-Ami outlines key factors likely to have an impact on investment performance in the coming year
At a glance
•The excitement about political developments is obscuring the importance of investment fundamentals.
•Corporate earnings are likely to be particularly important in the year ahead.
•Both inflationary and deflationary forces look set to have an impact next year.
•Markets look particularly fragile at present.
It is perhaps too easy for investors to become obsessed with politics. The often larger-than-life characters involved and the intense passions aroused can create a morbid fascination in the subject. But it should not be forgotten that investment returns depend largely on more mundane factors such as corporate earnings, inflation rates and central bank policies.
That is not to deny any role for politics. From an intrinsic perspective – leaving aside any considerations of economic or financial impact – it is important to consider the best way to govern societies. There is also no denying that political changes can have substantial effects on economics and the investment world. That is why several subsequent articles in this section consider different aspects of recent political developments.
However, the focus of this opening piece is unashamedly on investment basics. If the fundamentals are not in order, then, whatever the composition of government, returns are likely to be poor in the long term. A strong corporate sector is also likely to be more resilient in the event that unwelcome political shocks do emerge. “Political risk is secondary,” says Marc Renaud the founder and CEO of Mandarine Gestion, an independent French asset management company based in Paris. “Europe has had problems before but it has weathered them.”
There is considerable room for debate about the most important investment trends but there are four identified as key by experts interviewed by IPE.
• Corporate earnings look set to be more important than ever. It is all too easy to forget that, particularly from an equity perspective, the main determinant of investment performance is corporate earnings. Since equities are essentially claims on future earnings streams, the stronger a firm’s potential earnings the better its shares are likely to perform.
One reason why it is easy to disregard this truism is that there is a significant caveat. Although it is true on a fundamental level, with all other things being equal, there are factors that can modify the dynamic. Under some circumstances, often peculiar ones, equity prices can rise even when earnings growth is weak or even non-existent. That has certainly been the case recently. Many stock market indices are trading close to all-time highs despite corporates being caught in what analysts sometimes refer to as an earnings recession.
That helps to explain why corporate results will probably merit even more attention than normal in 2017. Andrew Milligan, the head of global strategy at Standard Life Investments, says: “The corporate earnings cycle is something I would particularly urge people to pay attention to in 2017”. He adds that he will be watching to see whether the earnings recession ends in 2017 and, if so, how it does so.
This is in contrast to recent years where equity prices have tended to rise as a result of multiple expansion (figure 1). That is the phenomenon where the price/earnings (P/E) ratio (multiple) rises without help from earnings.
There is room to debate why share prices have risen in this environment but it is often attributed to quantitative easing (QE) and ultra-low interest rates. Bill Priest, the CEO of Epoch Investment Partners in New York, says: “What did that? It was basically the effect of QE. It led to a huge re-rating of financial assets.” In his view, cheap credit has helped to push up equities to levels they would probably not have reached otherwise.
The catch is that this situation cannot continue forever. If corporates do not show sufficient potential for growth, their share prices are likely to fall at some point. It is also the case that QE will eventually reach a point where it will be reduced. The US Federal Reserve has come closest to this situation of all the main central banks with its announcement in October 2014 that it was about to cease purchases of longer-term Treasury securities and agency mortgage-backed securities. However, the Fed’s balance sheet, has remained stable since that time at about $4.5trn (€4.1trn) of total assets (figure 2). Although it has not engaged in a programme of new bond purchases since then, it has not started to claw back its existing holdings either.
Nevertheless, the scope for further multiple expansion, perhaps most particularly in the US, looks limited. That is why Priest talks of “the end of the big re-rating”. He goes on to say: “We are entering the period of the end of the great re-rating since the global financial crisis. Multiple expansion is behind us. It is over”.
Although conditions are different, in the developing world, too, there is likely to be a strong focus on corporate earnings. William Palmer, co-head of the emerging and frontier equities team at Barings, says that next year “it’s going to be all about corporate earnings delivery in emerging markets”. In his view: “The key call now for investors is whether we can see a recovery in corporate earnings.”
There is a touch of irony in this situation, since investors have traditionally seen emerging markets as more prone to political risk than developed ones. But this year the balance was decidedly different. “A lot of geopolitical risk in 2016 took place outside of emerging markets,” says Palmer. In his view, the emerging world benefitted to a degree from trouble in the developed world. “Many investors sold some of their exposure to UK and Europe and invested elsewhere,” he says.
In any event, investors in both developed and emerging markets are likely to watch corporate earnings particularly closely in 2017.
• Watch the battle between inflation and deflation. Next year could see both inflation and deflation becoming a factor in different markets. The impact could also be positive or negative, depending on circumstances.
Dario Perkins, the chief European economist at Lombard Street Research, said in a recent teleconference: “The inflation backdrop is gradually turning a bit more inflationary now.” Indeed, inflation is already picking up, albeit from a particularly low base, in the euro-zone and the UK.
Rising commodity prices, particularly crude oil, are a contributory factor to the rise in inflation (figure 3). It also looks like modest wage rises could also add to inflationary pressure. Diminishing slack in the labour market, particularly in Germany, is playing a part in this trend.
Perkins even sees the possibility of an inflation surprise in Europe next year. That could lead to a rise in bond yields of perhaps 100 or even 150bps.
However, Yu-Ming Wang, the global chief investment officer at Nikko Asset Management in Tokyo, argues that Europe is becoming mired in Japanese-style deflation. “We think Europe is going down the path of Japan over the past two decades,” he says.
In contrast, he sees the inflationary trend in Japan itself as positive. In his view, it could mark the end of a malaise that has plagued the country since the late 1990s. In 1998 the economist Paul Krugman, later to win a Nobel prize, revived the notion of a liquidity trap to explain Japan’s plight. The basic idea was simple. Consumers were reluctant to buy goods today when they could buy them more cheaply tomorrow. Ever since then, at least in the view of many Keynesian-inclined economists, it has been caught in this dilemma.
Wang sees a revival of inflation as positive for Japanese equities. “Japan is becoming increasingly successful,” he says. “And 2017 could be the pivot year, where deflation begins to become a bit of a memory.” He points out that the country looks like it is making progress towards meeting the central bank’s 2% inflation target.
While he views the inflationary trend in Japan as positive, he sees a deflationary trend in China that could have a global impact. “If China’s currency weakened it would basically be exporting deflation to the rest of the world,” he says. “So we are watching the renminbi very closely because that is the key currency to watch about the financial condition, whether it is loosening or tightening”.
“[A new emphasis on fiscal policy] would be a game changer and it would mean there would be a boost to the economy”
• Monitor the divergence between different central banks. Parallel to the battle over inflation, is a possible divergence between central banks. The Fed was widely expected to increase rates during the year. In contrast, others may put rates on hold or even reduce them. In the ECB’s case, it is trying to decide what to do with its QE programme.
It certainly looks like the Fed hopes to raise rates if it can. Payson Swaffield, the chief income investment officer at Eaton Vance Management in Boston, says: “The Fed would like to take us off that Novocain [a brand of painkiller] to some extent if they can do that.”
Renaud of Mandarine Gestion is less confident. “I hope [US Fed chair] Janet Yellen will raise rates but I’m not certain she will,” he says.
Payson Swaffield also points out that, although the federal funds rate is low, other measures of short-term interest rates are already rising “Libor has moved up as if there had been about two rate hikes,” he says (figure 4).
He says that October’s money market reform led to many US investors withdrawing cash from money market funds. This added to funding pressure on banks and was, in turn, translated into a higher LIBOR rate. In his view, the shift is likely to be permanent.
In any event, the divergence over monetary policy between the US and the rest could easily spill over into a battle in the fixed-income markets. For that reason, Milligan argues it will be a key arena, important to watch. “What can happen to global bond yields if the world’s most important economy is pulling one way and everyone else in the tug of war is pulling in the other?”.
A final point to bear in mind in this respect is that monetary policy does not act in isolation. With concerns about central bank intervention becoming less effective – ‘running out of ammunition’ being the favoured metaphor – it is possible there will be a new emphasis on fiscal policy.
In the European context, this could mean governments implementing a fiscal stimulus. Fiona Frick, the CEO of Unigestion, a Geneva-based investment boutique, says “that would be a game-changer and it would mean there would be a boost to the economy”. That could then alter the path of interest rates.
However, such a shift to fiscal stimulus is far from a foregone conclusion. While some in Europe favour such a move, there are others, most notably in Germany, who remain in favour of austerity.
• Be wary of market fragility. It looks like a reasonable bet to many that the markets will experience substantial volatility next year. The form this will take is open to question.
Professor Peter Meier, the head of the Centre for Asset Management at the Zurich University of Applied Sciences, says: “I think the probability that we will have disruptions is getting higher and higher.” In his view, the uncertainty over the direction of interest rates leaves the market vulnerable to tail risks. “There is this flood of money and nobody has a clue how it will be unwound,” he says.
James Wood-Collins, the CEO of Record Currency Management, says: “If we see something unexpected happen, the market responds in significant leaps.” He gives, as an example, the sterling ‘flash crash’ in October, where the currency fell by 6% in a couple of minutes. “The way the FX market responds to events is something investors need to be more mindful of,” he says.
This is a trend that was evident in other markets too. Frick points to “decreasing liquidity in the bond space and even in the equity space”. She attributes a large part of the problem to tighter regulation, which has led banks to become more reluctant to take risks. “This kind of liquidity crash will become more and more common in the bond, equity and FX markets,” she says.
This prediction takes us back exactly a year ago, when the introduction to IPE’s Outlook 2016 raised the possibility of bond market liquidity drying up this year (‘Will liquidity dry up in 2016?’, IPE December 2015). Although a total liquidity drought did not transpire in fixed income there were instances of liquidity shortages in several markets.
No outcome can be certain in an uncertain world but it looks like an eventful year lies ahead.
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