It's hard to believe 2016 is almost behind us, but as businesses begin to hang up their holiday decorations (to the chagrin of some), it's time to look ahead to what 2017 may have in store for us.
Based on total returns (%) calculated using month-end total return prices of various indices/spot prices, here are the performances of major asset classes as of September 30th, 2016:
The stabilization of oil, the spike in investor demand for gold, and the recovery of stocks post-Brexit were some of the most significant stories of the year. High-yield and emerging market bonds also managed to hold their own despite expectations of increased default rates going into 2016-2017 due to the oil price shock. The combination of these various factors may have contributed to the "reflation" of inflation expectations this year-end.
Core inflation in the U.K. surged to 1.5% last month while the U.S. measure (excluding food and energy) clocked in at 2.2% in August. Not to mention, China's factory-gate prices turned positive for the first time since 2012, leading some to conclude that China's days of exporting deflation may be finally over.
Of course, along with increased inflation expectations, interest rate expectations often follow. Indeed, interest rates have experienced significant appreciation this past year, albeit for completely different reasons than macroeconomic factors. The global benchmark for interest rates, LIBOR, has nearly tripled from a year ago, with the three-month rate at 0.88% as of this week. And U.S. real narrow money supply (M0) actually declined 8.8% on a year-over-year basis - the steepest annual slide since 1948 - meaning the Fed is serious about pulling the reins on accommodative monetary policy.
In any case, looking ahead to 2017, investors should have a lot of questions for what the future may hold. We will attempt to examine some of those questions here.
Reflation vs. Stagflation
As inflation and interest rate expectations have risen globally, will real growth and capital investment follow?
This is the most important question economists and policymakers should be focusing on - can the global economy "reflate" and escape the deflationary slump it's been in for the past several years, or will we experience a repeat of Greenspan's "stagflation", i.e. low growth, high inflation? Unfortunately, growth (GDP or however you want to measure it) is a lagging indicator; however, we can look at the most recent data to see how it has been trending.
rGDP in the second quarter only increased 1.4% according to the latest revision by the BEA, and GDPNow estimates for Q3, as shown above, continually track down with each new set of data, down to 2.0% from an initial 3.6%. With already tight labor markets near full employment (~5%) and higher inflation expectations, growth needs to pick up the slack and quickly; otherwise (1) incomes will continue to stagnate, (2) spending will not recover, and (3) purchasing power will only depreciate, sending us back into the deflationary slump we were just in. If inflation continues to surpass rGDP, as the latest GDPNow estimates imply, the growth outlook becomes more lackluster.
Equities vs. Bonds
Both equities and bonds in the advanced economy sphere trade at a premium, but which is more likely to outperform?
Ignoring the usual market makers playing their books, there has been an extreme divergence between investors fighting over whether equity or credit is the more preferable to hold in the near future, and it hasn't helped that both asset classes trade at a hefty premium.
For example, Goldman (NYSE:GS) in its latest note to clients admits that equity risk premia (e.g. S&P 500 earnings yield less 10-yr Treasury yield) "on the surface... appear more attractive..." for equities; however, the low growth outlook makes credit more preferable. And yet in a recent interview with CNBC, Peter Oppenheimer, chief global equities strategist at Goldman, pushes that rising bond yields are better for equities and that bonds have been highly overbought.
With such conflicting viewpoints abound at a critical market inflection point, it is prudent to stand back and take a look at all of the possible factors involved.
In support of equities...
- Equity risk premia are high, meaning equities are yielding higher earnings than their more expensive counterparts (e.g. S&P 500 earnings yield less 10-yr Treasury yield ≈ 4%).
- Bonds will be subject to considerable volatility and downside risk as the market is vastly underestimating the Fed's intention to tighten (The Fed projects seven rate hikes before Dec. 2018 while the market is implying only two and a half).
- Rising inflation is good for equities (...with the caveat being, growth, profits, and incomes must follow).
In support of credit...
- The globe is experiencing record debt overhang, with about ~$152 of nonfinancial debt, two-thirds of which resides in the private sector. On a global capital structure scale, credit far outweighs equity, implying any possible future gains will go to existing bondholders not equityholders.
- The risk of inflation outpacing growth and destroying corporate earnings further implies more downside risk for equity.
- Five consecutive quarters of negative corporate earnings and capex outpacing cash flows, flat yield curves on corporate debts, and overcapacity all suggest recessionary risk, which further implies more downside for equity.
To sum it all up, Scott Grannis, former chief economist of Western Asset Management, puts it like this:
...consider the difference between the PE ratio of the 10-yr Treasury today (i.e. 57, the inverse of its 1.75% yield), and the PE ratio of the S&P 500, which is just over 20. Investors today are willing to pay $57 for a dollar's worth of annual earnings on T-bonds, but only $20 or so for a dollar's worth of corporate earnings. Wow. If this isn't risk aversion I don't know what is. In effect, the market is saying that it is extremely unlikely for corporate profits to maintain their current levels for the foreseeable future.
EUR/JPY vs. USD
As Kuroda and Draghi hold open the spigots, Yellen prepares the markets for "normalization" - will European/Japanese investors be able to survive the fallout from an ever-stronger dollar?
I've already talked at length in previous articles about rising funding costs for banks in Japan and Europe, the impact of NIRP, and the global search for yield:
- Constructing A Pure Alpha Japan Portfolio: Money Market Funding Crunch Means More Doom And Gloom For Japanese Financials
- Mass Frenzy For Quality CLOs As Money Market Reform Takes Effect And Dodd-Frank Risk-Retention Regulation Approaches
- Is Kuroda's Operation Twist Really A Windfall For Banks?
And it seems that in 2017 this scramble for U.S. dollar-denominated assets will only get worse as the Fed seems intent on "normalizing" rates and the ECB/BOJ have no desire to taper in any significant manner. This policy divergence, which hasn't actually happened yet, has already had extreme effects on money markets, lending, funding, and especially FX hedging.
What was once colloquially dubbed the "carry trade" is nearly dead as the yield differential between 10-yr US Treasuries and local market FX hedges, i.e. the "yield pick-up", is non-existent, all while hedging costs have risen significantly. This will have more of an effect on the hedge funds and active institutions that had replaced banks in pursuing such easy profits... but the critical caveat is if it becomes uneconomical for foreign investors to buy U.S. assets at all, then we have a real problem. So far, we have not breached that point, but once you see foreign banks start accessing cross-currency swaps or Fed swap lines, then you know the problem is already here.
Investors vs. The World
While "winner-takes-all" politics grows in popularity and demagogues attack the free market, historically high asset correlations have left portfolios extremely vulnerable, scaring off even some of the most prominent and intelligent of investors. Investors must take a stand.
This is more an anecdotal observation rather than an empirical observation - although, if you prefer a strictly objective study, Citi's Matt King does some wonderful pieces on the topic - but it seems investors, banks, and the financial sector in general have been the subject of extreme prejudice and unwarranted targeting. I'm not referring to increased regulations and restrictions on capital, financial repression, or even Elizabeth Warren's tirades against the "evil big banks" but a growing concerted movement against the fundamental ideal of Western liberal-democratic capitalism.
We could bring up charts about the polling on the popularity of more radical ideologies, such as socialism or isolationism, or historical indices showing the unprecedented divide in the U.S. gov't, but I think it is clear to most people that, as overly pessimistic as people can be, the world is truly more divided than ever. This is not only bad for investment or trade or incomes, but also it is bad for our survival.
Resisting the urge to digress on the example of North Korea, I would argue the life span of societies is a speck of dust on the geologic stretch of Earth's four-billion-year history; things change in an instant, empires crumble, and peoples disappear. Just look at how quickly our global financial system unraveled a mere eight years ago. If we do not defend the very system that has brought us such prosperity and took generations to build, then we have no one to blame but ourselves.
Investors have a lot to think about going into 2017 - inflation, interest rates, valuations, and politics. But while it may get ever more difficult to make profits in this uncertain world, that should make investing all the more exciting and challenging. For now, enjoy the holidays!
Relevant ETFs: iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), iShares Russell 2000 ETF (NYSEARCA:IWM), ProShares 30 Year TIPS/TSY Spread ETF (NYSEARCA:RINF), SPDR S&P 500 ETF (NYSEARCA:SPY), and PowerShares QQQ Trust ETF (NASDAQ:QQQ).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.