Short And Sharp - 2017, The Year That Dismissed Investor Concerns

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Principal Financial Group

By Seema Shah, Global Investment Strategist, Principal Global Investors

2017 has been a fantastic year for risk assets, despite all the concerns identified at the start of the year. Investor worries about politics, geopolitics, trade, and central bank policy were summarily dismissed as markets focused on the strength of the economy, disentangling fears from fundamentals.

Politics: After a year notable for the shock Brexit result and the divisive U.S. presidential election, it was unsurprising that investors were especially concerned about politics in 2017. Nowhere was this more pertinent than in Europe. As it happened, the threat of a populist or Euro-sceptic party winning one of the elections in the Netherlands, France, or Germany did not materialize and the immediate risk waned.

Warning: Political risk has not disappeared. Coalition building in Germany is taking time, Spain continues to grapple with Catalonia's bid for independence, and Italian elections are set to take place in March 2018. The new Italian electoral law makes it harder for a populist party to win, but given that polls are showing that the largest populist party, Five Star Movement, is leading with over 25% of the vote, the risk is not insignificant.

Geopolitics: While domestic political risk has been contained this year, geopolitical risk has grown. Tensions between the United States and North Korea have escalated, while developments across the Middle East are increasingly causing concerns. Markets have so far dismissed the growing risk, instead focusing on the underlying economic picture.

Warning: A swift change in sentiment could have serious implications for markets, especially at these valuations. This is one space to watch very carefully in 2018.

Central bank policy: 2017 was the year that central banks around the world started raising interest rates and normalizing monetary policy - an event that many investors had feared. But weak inflation allowed central banks to move at a snail's pace, while strong economic growth helped support investor sentiment. Even the Federal Reserve's balance sheet reduction kicked off in October without much market reaction.

Warning: There are growing signs that inflation will make a reappearance in 2018. I expect the Federal Reserve to respond by raising interest rates three to four times, while the European Central Bank will likely end asset purchases in the second half of the year. Quantitative tightening will eventually have an impact on sentiment. In an expensive market, worries about central bank policy are a serious cause for concern.

Trade wars: While the Trump administration eventually managed to pull off its tax reform agenda, its aggressive protectionist campaign rhetoric did not fully play out - to the relief of many of the world's economies.

Warning: 2018 could see a resurgence of this risk - particularly with regards to NAFTA. Negotiations to "modernize" the agreement remain tense, and Mexico is clearly at risk from these talks.

In retrospect, while political risk, geopolitics, central bank tightening, and trade wars may have been pushed aside in 2017, they all have the potential to make 2018 an interesting year for investors. Happy New Year!

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