On Guard & On the Lookout

2016 was a challenging but surprisingly lucrative year in the markets. 2017 may hold more of the same, although we suspect the drivers of market action are poised to structurally shift globally, pushing volatility up and cross correlations down. With the shifts in central bank accommodation, the rise of populist politics, the increased likelihood of debt-financed fiscal policy and the final unwinding of the commodity supercycle, we think our stance of taking calculated, “high quality” risk is the right posture for 2017.
 
In practical terms, that means remaining with a 1) tilt toward equities and away from fixed income; 2) a bias toward U.S. markets within equities; 3) an underweight to non-U.S. markets and a skew toward smaller companies; 4) creative implementations of alternative exposures like flexible fixed income and convertible bonds; and 5) selective use of active managers especially in overseas markets and in domestic markets when we have a goal of having more concentrated and/or thematic exposure.
 
Some of the biggest risks on our radar for 2017 include:
 
1) The U.S. may become a malevolent hegemon.
 
Although it is early, it appears Trump may require foreign nations that want access to the dollar to pay more for that privilege. This may mean that if a nation wants to sell its products in the U.S., it will be required to build production facilities here. If it refuses, it may find itself facing barriers to trade. The Trump administration may also penalize domestic firms that offshore production through tariffs. Nations under America’s security umbrella may be forced to pay for those services, which could be in the form of minimum purchases of arms from American firms.
 
Most hegemons extracted some sort of tribute from the world for the global public goods they provided. The U.S. has been relatively munificent compared to other superpowers, and it would be politically popular to create conditions that support Americans by shifting some of the costs of hegemony to the rest of the world.
 
However, it should be noted that such a shift carries risks. At best, raising barriers to trade may lead to global mercantilism that portends even weaker global growth. At worst, it is a recipe for conflict as countries become more aggressive and independent in foreign policy. At very worst, it creates conditions for rearmament.
 
2) European Union disintegrates.
 
The past year delivered two electoral jolts from Europe, Brexit and the Italian referendum. The coming year promises similar uncertainty. There are three potentially important national elections in 2017.
 
Netherlands: The first election occurs in the Netherlands in March. Current polls put the Party for Freedom in the lead with a projected 34 seats out of 150. This is a right-wing populist, Euroskeptic, anti-immigrant party led by Geert Wilders. It isn’t clear whether he can form a government. Nearly all the other parties in the country dislike Wilders and he seems to prefer being in the opposition. However, if his party wins the largest share of seats, it will be difficult to create a government of minority parties. Thus, the Netherlands could face a situation of political instability even after the election.
 
France: The first round of elections will be held in late April. Assuming no candidate gains an outright majority (and that outcome isn’t expected), a runoff will be held in early May. Current opinion polls suggest that the center-right Republican candidate, François Fillon, is leading, with the National Front candidate, Marine Le Pen, in second. Both candidates are controversial. Fillon was PM in the Sarkozy administration. Politically, he is similar to supply-side American Republicans. He supports balanced budgets, tax cuts and fiscal restraint. Le Pen is a right-wing populist, Euroskeptic and anti-immigrant. In the past, when the National Front emerged from the first round to compete in the runoff, the rest of the establishment parties would unite around whatever establishment candidate was competing for the presidency. However, Fillon is considered radical by French standards and Le Pen could be considered more acceptable to left-wing voters. Although we would not expect a National Front victory, a Fillon-Le Pen election could lead to a populist government in France.
 
Germany: Although Chancellor Merkel has seen her popularity fall due to her support of immigration, her coalition of the center-left SDP and center-right CDU are currently polling with support of 44.5%. With Germany’s mixed proportional voting system, we would expect Merkel’s coalition to prevail, although with less power than the current arrangement. However, it should be noted that support for the mainstream parties has been declining. If France or the Netherlands produce populist outcomes, we could see a threat from The Left or Alternative for Germany, which are left-wing populist and right-wing populist parties, respectively.
 
Italy: Although the country doesn’t have scheduled elections in 2017, the recent failure of PM Renzi’s referendum on government restructuring has led to his resignation. If a new government cannot be formed, a no-confidence vote and snap elections are possible. There is a good chance populist parties will win and, if they do, the odds will increase significantly that Italy holds a referendum on exiting the Eurozone.
 
Even if the establishment parties maintain control, populist movements are forcing change. For example, Chancellor Merkel has recently called for bans on full-face veils usually worn by some Islamic women. In France, the most likely runoff will occur between non-traditional candidates. Mainstream parties are in retreat and thus policies that are less supportive of European unification should be expected. Combined with our expectations from President-elect Trump, the Europe Union may come undone this year.
 
3) Central banks grapple with their limits and rates run amok.
 
The U.S. Federal Reserve is likely to pursue a “dovish tightening,” raising rates to 1.5% in 2017 while leaving the federal funds rate below 2% through at least 2018. However, there is a risk that previously carefully controlled U.S. interest rate policy comes unhinged in the Trump era, as profligate spending proposals and the expected shift in Fed leadership and scope of authority (Yellen’s retirement in 2018 and the risk of a Fed Congressional audit program) create the conditions for bond vigilantes to wreak havoc.
 
Elsewhere, further monetary stimulus seems possible, but its benefits may be waning and, in the case of negative interest rates, potentially harmful to the very same credit-transmission channel that monetary policy attempts to stimulate. Even so, the European Central Bank (ECB) and Bank of Japan (BoJ) could yet add to the quantitative easing implemented in 2016.
 
Chinese policymakers have the most difficult task of engineering a “soft landing” by lowering real borrowing costs and the real exchange rate without accelerating capital outflows. The margin of error is slim, and policymakers should continue to provide fiscal stimulus to the economy this year to avert a hard landing. The most important policy measure we are monitoring is the pace of reforms for China’s state-owned enterprises, which are currently key sources of overinvestment and deflationary excess capacity.
 
Of course, other risks exist, including the risk of spiking inflation, the continued threat of terrorism, and geopolitical developments in emerging markets (for example, unpredictable policies in the Philippines, Russia’s foreign policy adventures, political uncertainty in South Africa, and ongoing political and economic uncertainty in Venezuela).
 
Ultimately, our global market outlook points toward a somewhat more challenging and volatile environment ahead, yet one in which investors with an appropriate level of discipline, diversification, and patience can be rewarded. As always, we will do our best to steward our clients’ capital through these times, remaining on guard for risks and on the lookout for opportunities.