Outlook

01 January 2017

2017 ANNUAL OUTLOOK

By London & Capital

GLOBAL MACRO OVERVIEW

Expect the unexpected. That was the lesson of a memorable 2016. From the UK decision to leave the European Union to the surprising US election results, voters voiced their desire to change and reject the status quo, while Central Banks continued to throw money at the problems of anaemic growth.

In 2017, the following 'known unknowns' are of up-most concern and will continue to drive markets: Europe’s political uncertainty, growth in Chinese debt, rise of protectionism, as well as uncertainties about Fed policy and US fiscal policy.

Market outlooks are always, in part, a function of binary outcomes. However, binary outcomes are rarely so far apart as they appear today. Take, for example, the French election, a 'Le Pen' victory would, on one side, pose an existential risk to the Eurozone. On the other, relatively small changes can be expected. It is this differential between the outcomes that make forecasting so difficult today.

As investors, such major shifts require our reassessment of almost every assumption, from tax rates to inflation, to global trade, and all the subsequent spill over effects.

This document will cover our main views for the year ahead, and the implications for asset classes.

 

Global Market Outlook

2017 is going to be a fragile balancing act between two factors:

Stronger cyclical outlook and growth-focused fiscal policy in the US

Structural undercurrents, stretched valuations and political risks (this will be covered in the 'Main Risks' section)

For now, we believe an improving cyclical outlook is the dominant force that is likely to drive markets. Growth prospects for developed market countries should improve as fiscal policy (particularly in the US) is more investment and growth focused. The hope of this boost may, in itself, generate a secondary impulse through ‘animal spirits’. It is this sentiment shift that is the main driver of developed market growth prospects in the short term.

Leading indicators are showing that the cycle has stabilised on a global basis, albeit with clear divergences (strength in the Americas is currently being counteracted by weakness in Europe and Emerging Markets (EM)).

This global stabilisation is encouraging and it lends some comfort that the recent rally in equity markets is not only a function of hope of a US fiscal policy boost. Indeed, short term risks are on the upside, with global growth annualising at above the 3% mark in the next 6 months.

Having escaped the risk of deflation, developed market inflation will continue to move higher in 2017. The tightening US labour market, fiscal policy pivot and oil price rises will edge developed market inflation higher, peaking mid-year above 2%.

 

Developed Market Outlook

US

Trump’s upcoming presidency has led most forecasters to revise up their short-term projections for US growth, but also to expect more interest rate rises from the Federal Reserve. Both seem plausible; if aggressive tax cuts, big infrastructure programme and market deregulations do not result in stronger growth, then something has gone wrong somewhere, and small rises in interest rates should not get in the way in the short term.

It is also worth noting that the US growth pick-up took place ahead of the Trump victory and even if a bit of momentum is lost we are set for growth of over 2% in Q1.

Trump will probably extend the (mature) US cycle, and one should expect for US economy to grow at 2% to 2.5% in real terms in 2017 (vs 1.6% in 2016). This is based on baseline case of tax cuts eventually worth $1 trillion.

The actual timing of fiscal stimulus is still uncertain. Trump will not take office until late January, so budget proposals may reach Congress in late February. The Republican Party holds a majority in both houses of Congress and should be able to pass the necessary legislation to reform the tax code along the lines Trump has proposed. If Congress moves swiftly, tax changes could be enacted by mid-summer, however, if Democratic members of Congress vigorously oppose the tax changes, it could take longer. These uncertainties affect the timing of the pick-up in demand that could lead to faster GDP growth. At the moment, we expect fiscal stimulus to start in the second half of 2017, but it could be delayed until 2018.

On the assumption that a fiscal package is delivered, we should see two modest (i.e. 25bps) Fed Funds hikes this year, reflecting more confidence that the US economy will require slightly less accommodative policy over the next year. It will still be a very cautious tightening cycle as USD appreciation will keep exerting downward pressure on US core inflation. The Fed will also have to contend with the ongoing deflationary influence that the world’s major current account surplus economies (China, Japan, and Germany) will keep imposing on the rest of the world.

US Trade policy will be surrounded by uncertainty in the year ahead. If there is a lack of progress in the negotiations with China, Mexico (and other countries that have large trade surpluses with US) Trump has threatened to substantially raise tariffs, potentially disrupting both trade and capital flows. 

 

UK

The UK has defied expectations of a slowdown since the Brexit vote so far, with neither consumers nor businesses having meaningfully adjusted their behaviour in the wake of the vote. In fact, UK GDP grew by 0.6% in the quarter immediately following the referendum, with retail sales and consumer credit both growing at their fastest rate in over a decade in Q4 2016. With momentum still looking relatively strong, we should see UK growth at around +1% in 2017.

Uncertainty levels are likely to rise when Article 50 is triggered, we presume by March 2017 or very soon after, and details begin to emerge of the reality of what price the UK may have to pay for Brexit.

There are two key questions for the post-Brexit vote outlook for Britain’s economy as the process gets underway. One is the consumer response to higher inflation and the expected squeeze on real incomes. In the period between 2010 and 2012, when there was a more significant squeeze on real incomes (than is expected this time), consumer spending slowed to a crawl.

Whether it does so this time depends partly on the second question; the ability of the government to keep business on side as it embarks on Brexit, and thus to maintain confidence. If not, we can expect weaker recruitment (already evident in the official labour market numbers if not in the surveys) and business investment.

There is a plausible argument that the real issue for business comes later, with the question of whether there will be a 'cliffedge' exit from the EU in 2019 accompanied by the immediate imposition of tariffs. But there will be uncertainty ahead of that, including this year, and with the notable exception of Nissan, the government has so far done a poor job of reducing it.

In any case, it will fall to Chancellor Hammond to provide any stimulus that is needed, as the Bank of England (BoE) rate probably remains on hold throughout the whole year.

 

Eurozone

In Europe, the link between politics and economics will keep intensifying in 2017.

Indeed, nowhere have the subjects of fiscal austerity and rising inequality been as relevant as in Europe today. Stubbornly high unemployment rates combined with declining living standards have contributed to rising levels of civil and political instability. Populist and nationalist parties have been able to capitalise on this phenomenon and raise massive amounts of support from exasperated European citizens.

France will face an important political test when it holds its presidential election in spring. National Front leader Marine Le Pen will be trying to take advantage of the positive momentum she has built up to sweep her party to its first victory. While this would require a vast swing from voters, recent history shows that the rise of anti-establishment parties should not be underestimated.

In Italy, the government seem to have yet again delayed the inevitable, but reality is unchanged: Monte dei Paschi and the other troubled institutions are not going to get better on their own. Monte dei Paschi has at least 36% of its loan portfolio in the non-performing category. The Italians have raised €20 billion for a bank bailout fund, however, it is likely that Italian banks will require more than this amount and Italy does not have the legal right to unilaterally bail banks out.

In Germany, while Merkel may have to surrender her wish to accept more Middle East refugees, the refugee flow will not stop. People will instead migrate to Italy, Greece, and Turkey, all of which have their own serious problems.

Overall, little change is expected to the Eurozone’s growth trajectory with consensus forecasts at c1.5%, however headline inflation is projected to rise towards 1.5% through the first half of the year. The recent extension of Quantitative Easing (QE) to December 2017 and improving inflation conditions, will likely keep the European Central Bank (ECB) on hold for some time, but if core inflation shows no sustainable improvement, further monetary support would be likely towards year end.

 

Emerging Market Outlook

Trump’s victory has a number of wide-ranging implications for EM. At first glance, the result is clearly negative, given the potential risks from factors such as increased trade protectionism, large fiscal expansion, anti-immigration measures, and foreign policy uncertainty.

However, as is often the case, the impact of a Trump presidency will not be felt uniformly across the EM. As US rates rise, those economies with high external debt and a high degree of foreign participation in local bond markets are most vulnerable to a rise in debt service costs and capital outflow. Even for countries that have less foreign-currency-denominated debt but which are still reliant on credit growth, a slightly more active Fed and a stronger dollar imply less ability for many EM central banks to provide support through monetary policy.

Brazil’s central bank will now be able to deliver less easing than previously seemed likely. Many of the rate cuts we had been forecasting in Asia have been removed, while Turkey has already started a rate-rising cycle we did not envisage three months ago. Nor can EM really pin their hopes on a big boost to competitiveness from the currency as exchange rate weakness has been broadly based across EM.

Elsewhere, Eastern European markets, such as the Czech Republic, Hungary and Romania, are much more dependent on Europe than the US for their exports. Meanwhile, Russia may benefit if the US starts easing financial sanctions against it, and the Ruble rallied in the immediate aftermath of the election result.

Much attention will be focused on US relations with China. As the biggest foreign holder of US government debt, China may look to reduce its holdings to prevent its currency from depreciating too rapidly versus USD. Any imposition of trade tariffs or move by the US Treasury to name China as a currency manipulator will be the key events to watch out for.

China’s stabilizing growth has eased some of the anxiety that rattled investors in early 2016. But it is partly the result of returning to an old habit: hefty lending to state-owned enterprises and local governments. China‘s debt-to-GDP ratio has surged to more than 200%.

The better news is that China has little external debt, a factor which has sparked many an EM crisis. Beijing is working on fixes, such as turning short-term bank debt into longterm bonds and redirecting credit to the private sector and households. The longer China delays attacking the problem head-on, the greater the risk of accidents.

Expansionary fiscal policy should continue into 2017, supporting infrastructure investment growth. The property market may soften somewhat in the coming months, but the overall impact on growth will likely be quite modest given that the tightening measures have been quite selective.

The key challenge for policymakers is to broaden the basis of the recovery to the private sector: reducing corporates’ social insurance burden, and even selective tax cuts, could help. A faster pace of reforms, including the shutting down of zombie State-Owned Enterprises (SOE) and accelerating bad debt resolution, would also help to boost the confidence of the private sector.

Despite more internal stability, the external environment looks more uncertain. More protectionist trade policies, including higher tariffs or trade tension, could weigh on sentiment as well as economic activity. Increased external uncertainty should give policymakers more reasons to accelerate domestic reflation policies in order to anchor the growth outlook.

 

Main Risks

Despite the many uncertainties (and the binary nature of many of them), financial markets are indicating few signs of nervousness about economic prospects for 2017. This section goes over the main risks affecting our markets.

Policy uncertainty

A large part of our constructive view around short-term cyclical pick up is based upon Trump delivering on most policy promises (mainly around tax breaks and infrastructure spending). In itself, this immediately generates three types of risks:

‧ Policy promises are not kept

‧ Policy mix does not have the intended impact on the real economy

‧ Negative moves in financial markets start to impact real economy before the policies are even delivered

In the US, the risks of disappointment are more likely to stem from the anticipated fiscal stimulus not being delivered or because tightening of US financial conditions slows the economy before the fiscal stimulus has a chance of being put to work.

Indeed, Trump does not have the fiscal headroom that Reagan† enjoyed. From an inflation perspective, the likely increased fiscal stimulus will support the upward signals that were already building as a result of a tightening labour market and rising oil prices. The US is near, or even at, full employment now (in contrast with the backdrop that Reagan picked up back in the 1980s). Should Trump engage in an out-and-out trade war, the impact on inflation could be even more pronounced, with tit-for-tat trade tariffs pushing up the cost of imported goods.

Against such a busy scenario, governments that borrow too much typically watch their bond yield curves steepen, as we saw from the US Treasury market’s behaviour in the weeks following the election result. The term ‘bond vigilantes’ refers to the bond market’s ability to serve as a restraint on a government’s ability to overspend or borrow; investors can sell bonds, pushing yields upwards, in protest at what they see as inflationary policies. This would serve to break the growth arising from Trump's initiatives.

After years when inflation was in the wilderness and austerity rather than fiscal stimulus has been in vogue, we could well see bond investors start to flex their muscles once again.

 

Excessive USD strength

Between 2009 and 2011, the USD remained weak as Fed policy was very accommodative and the Euro crisis and ECB monetary easing hadn’t yet begun. This coincided with a period of fast global economic growth. Post 2011, with a strong USD, slower growth in global FX reserves and a broadly static US current account deficit, global economic growth - measured in US Dollars - has struggled to gain any real momentum, actually declining in 2015.

As we stand, Central Banks are between a rock and a hard place. The USD will keep strengthening, which will increase strains in the system: just as in August 2015 and again in January 2016, there comes a point when the USD becomes too strong. Not only does it impact global trade growth, it makes funding USD debt much more expensive. In fact, with 40% of S&P 500 corporate revenues coming from overseas economies, a USD Dollar that is too strong, tightens financial conditions and risks hurting the US economy at some point as well.

If the USD becomes too strong before Trump's reflationary policies have a chance to kick in, then a US and global slowdown becomes a significant risk later 2017.

 

European fragmentation

A structurally sluggish growth environment intensifies the underlying political risks, as more and more voters feel disengaged from economic growth.

In Europe, these mounting pressures could not come at a worse time, as the 2017 political schedule looks particularly busy. The extra difficulty is that its capacity to boost growth and employment, via increased public and infrastructure spending and tax cuts, is more limited than other economies; on one hand, high levels of public debt are forcing most European countries to reduce spending rather than increase it. On the other, not having the ability to print money at an individual country level requires each member to demonstrate even more fiscal discipline for the union to remain viable.

2017 will be a key year for the future of the Eurozone.

 

China

China is struggling to maintain control of both its economy and its currency whilst trying to cool down a red hot property market and deliver some deleveraging at the non-financial corporate level.

After the first round of tightening in October, property sales in first tier cities have already started to moderate. Some of that may translate into softer investment growth in the next few months. If property investment falls more significantly, it would require much more aggressive infrastructure spending to offset the impact, putting more pressure on fiscal policy.

External uncertainty will also likely continue, at least in the near term. Our base case scenario mostly reflects a continuation of the sluggish external demand over the past few years. But if US trade policies become materially more protectionist, it could mean additional downside risks to growth.

Rising global rates and a stronger U.S. dollar are creating challenges for China. If China keeps running down reserves to smooth the Yuan's drop, speculation may build that authorities will engineer a one-off large devaluation to stem capital outflows. This would likely have knock-on effects on other EM currencies and asset prices.

 

Rich valuations

Equity valuations are generally two or three times higher today than they were 25 years ago. Interest rates are generally at near all-time lows around the world. Corporate margins are generally high and demographics are deteriorating and, while the domestic regulatory burden may decrease in the US, it comes at the cost of rising trade protectionism.

 

Geopolitical instability

Over the decades, we have moved from a bipolar world (US / Russia) to G8 to G20 to no global peacekeeper: As US keeps pulling back from global geopolitical leadership, we are now in a world where virtually no country is willing or able to provide a security blanket to ensure stability. In this new environment, geopolitical risk premia needs to be higher on a structural basis.

 

Beyond 2017

As discussed before, our baseline scenario for 2017 is one in which strong cyclical tailwinds trump (no pun intended) structural headwinds, rich valuations and political risks.

Longer term though, the skies appear to be much darker. The very same effects of higher US growth (i.e. higher rates & inflation) have the potential to wreak havoc at some point when combined with two inescapable realities for US (low productivity and high corporate debt).

What happens to (highly levered) US corporates when they have to refinance at much higher rates (growth pick up will mean higher cost of capital)? Not a problem for next couple of years but a looming threat nevertheless.

What happens to profit margins when low productivity combines with wage inflation? For a while, growth pick up will mean higher sales for some sectors, which will offset the impact of lower margins. For the rest, a painful reality check.

So the likely picture is one of higher growth followed by a bust.

 

The End of Globalisation

Trump’s victory and the UK’s vote in favour of Brexit are two of the biggest challenges in recent years to the global economic status quo. One of the main outcomes is a renewed debate about the impact of globalisation on the developed world.

On the issue of trade, the move by rich countries to locate manufacturing hubs offshore and the associated loss of jobs in rich nations have both been identified as negative consequences of free trade by populist politicians.

In order to assess the impact of globalisation on low- and middle-income households, analysts have used the ‘elephant curve’ (see page 17), which shows how average household incomes have grown between 1988 and 2008 for each part of the global income distribution, from the poorest on the left to the global top 1% on the right.

The chart shows that incomes for the poorest half of the world – typically those in EM, in particular, emerging Asian economies – have grown as fast as those of the world’s richest 1%. However, incomes for the lower middle class of the developed world (between around the 50th and 80th percentiles) have, at best, stagnated. As a result, it highlights how many have missed out on the much-vaunted benefits of globalisation, and helps explain the rise of nationalism across the developed world.

The problem is not trade itself, which has lifted hundreds of millions out of extreme poverty. The issue is that countries do not design policies to support those that suffer as a result of lowering trade barriers. In many instances, globalisation is implemented in a way that makes the playing field slanted in favour of the rich. Also, the gains from globalisation are never likely to be even for all the participants.

Of course, the rise of populist movements is too complex to be explained by a single graph; other factors are at play, such as protest votes on existing government policy, corruption, and immigration.

The key question now is to assess the impact of a more inwardlooking US on the global economy. If countries begin to renege on trade agreements and begin to raise tariffs, we may see countries enter into a vicious circle of action and reaction, which would ultimately lead to a contraction of global growth. In this environment, everyone loses.

 

ASSET MARKET OVERVIEW

Fixed Income

The bears will be calling for the end of the bond market rally as global growth momentum picks up and the Fed embarks on a faster pace of monetary tightening. This is not our base case scenario and, if anything, we are minded to increase credit risk whilst being intermittently cautious on running excess portfolio duration. Faster growth is supportive of credit markets and global monetary policy will still be exceptionally accommodative. A bear view, from our perspective, requires a turn in the default cycle (driven by a deterioration in the economy and underlying leverage).

The bond allocation will be overweight financials (particularly subordinated debt), moderate weights in high yield and EM debt offset by underweight high grade investment grade and sovereign paper.

 

Government Bonds

Tactical underweight

US Treasuries are the most vulnerable to the pick-up in growth in the US, pronounced Fed rate hikes and the potential for fiscal loosening. Post-Trump victory we issued a note indicating that the 10-year benchmark should rise towards 3% and having hit 2.65% pre-Christmas there has been a rally. However, this sort of counter rally is typical in a general move higher in yields and does not signal a sustained move towards ever lower yields. The basic premise for us is that nominal growth in the US will edge higher and this should lead to a gradual rise in nominal Treasury yields as well.

Outside the US, growth should also be higher -albeit less so than in the US- but in stark contrast to the US, central banks will remain in accommodative mode for a considerable period. This should underpin these markets, allowing for some outperformance to Treasuries. However, bond correlations should also be borne in mind and during sell-offs in Treasuries, all sovereign bonds will also be under pressure.

 

Financials

Strategic overweight

London & Capital’s strategies have gradually increased the weighting in bank and insurance bonds over the past 5 years and we recommend an overweight in 2017, particularly in subordinated bonds. The focus remains on the Global- Systematically important financial institutions’ (G-SIFIs), national champions and major insurance companies.

Rationale for overweight

Tighter regulations have driven a significant improvement in bank balance sheets with higher CET1 ratios, lower risk weighted assets and far greater high quality assets. In essence, banks have deleveraged significantly. This basic drive towards higher regulatory capital ratios will remain intact over the next few years. There is likely to be some easing back on certain bank restrictions, particularly in the US, but in our judgement this should not materially dilute the move towards stronger balance sheets. The revenue stream for banks should also be in better shape as a direct function of higher rates, a stronger economy and greater lending margins. Insurance companies are also undergoing their own tightening regulatory cycle, a process that aims to strengthen their equity base.

Risks

The election cycle in Europe, de-regulation in the US, potential stock market correction and a spike in sovereign yields are all potential risks. However, in our judgement these should not be viewed as akin to 2008 or 2010 but rather a source of more normal price volatility; these risks should not be seen a reason for cutting exposure.

 

High Yield

Selective overweight

Higher yielding corporate bonds have featured across most London & Capital strategies over the past few years but in hindsight were too underweight last year largely due to the (energy-sourced) sell-off in the early part of year. Subsequently, recovery in oil from Q2 onwards dragged the entire sector higher for the remainder of the year. Looking ahead we are recommending overweight in cyclical sectors in the US and Europe.

Rationale for selective overweight

First and foremost, the stronger growth momentum will aid high yield bonds. In addition, generically the high yield sector is still supported by reasonable leverage & interest cover, high cash balances and relatively low refinancing risks. High yield spreads and the technical background are both supportive. Clearly this does not mean that a scatter gun approach can be taken to allocation, as detailed due diligence will need to be carried out.

Risks

A significant correction in stocks and a sharp rise in sovereign bond yields are the two main market related risks. In terms of stocks, a 10-20% correction would be the norm, i.e. not a bear market move but could lead to HY price volatility, although this is unlikely to lead to a major shake-out or a shift higher in default rates. The key risk to high yield is a recession (which is not in the pipeline), which would trigger a significant jump in the implied and observed default rate.

 

Emerging Market, Investment Grade & High Yield Debt

Selective overweight

London & Capital strategies have benefited considerably from the selective approach to EM debt with the overweight in India and China. This overweight in sovereign, quasi-sovereign and large-cap corporate bonds will be maintained. Brazilian exposure has been raised and is likely to be raised further. The overall strategy will however continue to be selective.

Rationale for selective overweight

Internal growth dynamics in China and India look reasonable and credit dynamics are also very supportive. Faster US growth is generally seen as good news for EM and there is no reason for this relationship to break down. We do not see President Trump’s 'Made in America' stance as a major impediment to trade growth.

Risks

An outright trade/currency war is clearly a risk, particularly for the higher beta emerging market economies. However, our selective exposure should shield the portfolio.

 

Investment Grade

Tactical overall underweight

The overall allocation to Investment Grade (IG) will be an underweight but there will be a skew towards cyclical and sectors in the US that should benefit in the medium-term from higher defence and infra-structure spending (construction and home-builders). European IG exposure will be less skewed towards cyclical names as ECB and BoE asset purchases will support the wider market.

Stronger growth momentum, reasonable leverage & interest cover, high cash balances and relatively low refinancing risks are all supportive.

Risks

A sharp rise in sovereign bond yields would overwhelm relative spread compensation and would risk an abrupt end to the economic expansion, in turn, threatening corporate prospects. In Europe, acute political uncertainty could undermine IG appeal particularly for lesser-quality credits.

 

Equities

In 2016, the equity market was neatly divided into two distinct periods. In the first half of the year, defensive stocks were in vogue and outperformed strongly with cyclical sectors struggling. In this period, the only cyclical stocks to perform were Energy and Mining on commodity price stabilisations and recoveries. In the second half of 2016, sector rotation was rapid on the back of rising US rate expectations. Cyclicals, especially Financials, outperformed defensive sectors.

Moving into 2017, we start the year with equity investor sentiment being extremely bullish on the prospects of a higher growth environment. The risks are that US political policy (tax cuts and infrastructure spending) and PMI indications don’t drive earnings growth to the extent the market is hoping (c.10% earnings growth forecast in 2017). If this were to happen then equity markets are unlikely to be able to re-rate further, given full valuations and rising bond yields. This could result in a subdued equity market performance in 2017.

However, it needs to be acknowledged that the momentum in the markets could well persist in the first half of the year as a self-perpetuating confidence loop is created which leads to increased capital spending and enhanced order books.

Ultimately, when assessing the potential for equity market returns in 2017, it leaves a mixed picture with the potential for excessive optimism and full valuations being offset by accelerating growth momentum. This means equity investors need to be set for another year of ups and downs and given that equity markets are in a later cycle stage with fuller valuations, moderate returns are the most likely outcome of 2017.

 

2017 Regional Equity Outlook

US

‧US equities again performed well in 2016 posting a double-digit returns, despite the earnings drag from a stronger US Dollar which caused the market to re-rate on the back of minimal earnings growth.

‧ The US elections caused a step change in growth expectations with the Republican policy changes likely to include tax cuts and fiscal stimulus. Earning growth is now forecast to be c.10% in 2017.

‧ Despite a higher valuation, the US market still looks relatively attractive as the growth prospects for the country are likely to accelerate, US Corporation tax cuts will boost earnings and as the year progresses the impact of a strong US Dollar will subside.

Europe

‧ European markets, excluding the UK, struggled in 2016 due to ongoing political and monetary union uncertainty.

‧ This political focus will remain in the first half of 2017 with French and Dutch elections. This is the main reason why the equity markets trade on wide valuation discount to the US on a historical context.

‧ It is expected to be another year of low growth in Europe but the depreciation of the Euro is beneficial to earnings.

UK

‧ The UK performed well in local currency terms in 2016, despite Brexit, with the international nature of the UK stock market benefiting from the translational impact on earnings and the recovery in Oil, Commodities and Financials assisting almost 50% of the market capitalisation.

‧ Once Article 50 is triggered there is a risk that markets reassess the potential for the UK and the domestic economy suffers.

Japan

‧ The Japanese stock market underperformed in local currency due to the strength seen this year in the Yen.

‧ This reversed at the end of the year and created a fourth quarter rally in Japanese equities.

‧ However, this reversal may not persist and the impact of a weaker Yen is likely to be less positive than on previous occasions, as all exporter currencies are depreciating against the US Dollar.

‧ Furthermore, the domestic economy is structurally challenged and makes Japanese equities an unattractive area for investment.

Emerging markets

‧ EM equities saw a recovery in 2016 after an extremely challenging previous year.

‧ Commodity price recoveries, China’s stimulus plan and low expectations all help to create a more constructive environment.

‧ However, the US policy changes could lead to a more protectionist trade stance which is likely to weigh the most on EM Equities.

‧ The outlook remains extremely market specific with country selection being the crucial element for equity performance. We have partially repositioned from an Asian focus to more Latin American and African stocks, as domestic exposure is now seen as more attractive than exporters.

 

London & Capital Equity Strategy

Given expectations of another volatile year for equity markets, the equity focus remains on holding a core equity portfolio which contains high quality stocks which are well suited to cope with uncertainty. Alongside these core holdings we believe that several satellite strategies will allow investors to participate in opportunities have arisen in equities. We currently see defence and infrastructure stocks as attractive due to the move by governments to increasing fiscal spending. We also believe that there are several valuation anomalies that still exist in US economically sensitive sectors.

 

Hedge Funds

Last year, the broad hedge fund industry made steady progress following the draw-down in the first two months of 2016, and while lagging wider risk assets, hedge fund benchmarks finished in positive territory for the year. Nevertheless, several of the large, marquee names still posted double digit losses for the period which has instilled discontent among some of the institutional investment community. Across the Hedge Fund sector, a flat year was seen as a decent return given the backdrop. We believe this has strengthened the case for a highly selective approach among upper quartile hedge fund managers with a strong, long-term track record of alpha generation.

Overall, industry fund flows have remained negative across several strategies and have been concentrated in the larger institutional funds which make up the bulk of the industry. We believe that a lot of activity among market participants is focused around a shuffling of the pack; re-allocating to recent winners and to smaller and medium sized funds. This is a trend we expect to continue in the coming months as investors adjust their portfolios.

Moving forward, the broad London & Capital hedge fund selection contains a core of uncorrelated strategies combined with some higher risk/return opportunistic funds for those clients with the requisite risk appetite, which we believe will provide the optimal approach into 2017. We continue to see good opportunities for alpha generation moving forward and London & Capital will look to take advantage of multiple strategies across the asset class:

‧ Equity L/S: We continue to focus on sector specific strategies in financials, technology, healthcare and biotech. Continued intra- and inter-market dispersion is creating strong opportunities for those with specialist knowledge that can take advantage of both long and short opportunities.

‧ Equity Market Neutral: Both discretionary and systematic market neutral strategies have exhibited strong alpha and we believe this will continue in a bifurcated market. In addition, the low risk profile of neutral strategies ensures a focus on capital preservation in volatile markets.

‧ Macro/CTA: Macro and CTA strategies will continue to benefit from diverging global macroeconomic policies and dislocating events such as the European elections and the inauguration of a new US administration. In addition, CTAs have the potential to benefit from any extended periods of risk off sentiment as evidenced by Q315 and Q116 performance and therefore we believe these strategies provide a complimentary hedge to traditional asset classes.

‧ Opportunistic: We continue to favour niche strategies in power, agriculture and volatility trading and believe the uncorrelated nature of these strategies is extremely attractive in the current environment if sized correctly.

 

REITs

As reflationary expectations have emerged from Q3 2016, the market has turned on anything deemed to be a bond proxy. Pleasingly, real estate is not a bond, has solid growth metrics and in our opinion has been unfairly caught up as a proxy for lower growth. This is ultimately a misperception, as growth is still strong, and especially when history proves that listed real estate actually outperforms equities, on average, over the subsequent 12 months from a rate rise. Over the longterm, real estate is a proxy for the strength of the underlying economy, and importantly an inflation hedge.

Rate increases, as a consequence of an improving economy, is ultimately a positive for real estate fundamentals. More growth means more jobs, which means more real estate is needed to facilitate that expanding economy. We see the real estate market to still present many of the goldilocks characteristics it has maintained over the last five or so years including:

‧ Low relative constriction supply.

‧ Strong demand as the wall of global institutional capital continues to chase higher real estate locations.

‧ Access to credit.

‧ Although the cost of debt is rising, it is at a considerably lower cost to historical levels.

‧ Robust fundamentals from tenants.

We continue to see expanding opportunities from a growing retirement boom – for example, in manufactured housing and medical office buildings– and technology growth. The technology story can be accessed by investing in global, e-commerce logistics companies (but with a key focus on the US and Japan), through technology-based office markets such as San Francisco, Midtown South in New York City and London's East End tech belt, and also through A++ malls, where landlords are ahead of the curve and embracing e-commerce and digital technology given retailers need an omni-channel approach in the US, Australia and Europe.

 

SUMMARY

2017 is going to be a fragile balancing act between a stronger cyclical outlook and the risks presented by structural concerns, stretched valuations and political unknowns.

For now, we believe an improving cyclical outlook will be the dominant force driving markets. Growth prospects for developed market countries should improve as fiscal policy (particularly in the US) is more investment and growth focused. The stabilisation of economic conditions globally, is encouraging and it lends some comfort that the recent rally in equity markets is not only a function of fiscal policy hopes.

Asset allocation will be tilted towards sub-assets that will benefit from the cyclical pick up in US growth as this is where we believe the relative risks are most benign.

Fixed income exposure will be reduced, mainly from duration sensitive areas, but the overweight to financials will be maintained, together with moderate allocations to high yield and emerging market debt.

Equity allocations will increase, but the focus remains on holding a core equity portfolio containing high quality stocks well suited to cope with uncertainty. Alongside these core holdings we believe that several satellite strategies, including cyclical acceleration and US growth pick up, will allow investors to participate in recent opportunities.

† Much has been made of the similarities between the situation facing Donald Trump in 2017, and Ronald Reagan in 1981. Back then, Reagan inherited a sluggish economy and inflation approaching 15%. His initial answer to this was the Economic Recovery Tax Act, which contained significant tax cuts (including across-the-board cuts in individual marginal income tax rates, as well as various business taxes), lower government revenues, and a reduction in government welfare spending. As a result, US Treasury yields climbed to all-time highs, with the yield on five-year US Treasuries peaking at 16.3%. This was in an era when the debt-to-GDP ratio was just 30%, a far cry from the level of nearer 100% that president-elect Trump is inheriting today.