Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, BMO Asset Management’s multi-asset team takes a look back at the year that was 2016.
2016 will go down as a year when conventional wisdom was turned on its head. In the political arena, Prime Minister David Cameron, emboldened by the Scottish referendum, lost an even bigger gamble with the Brexit vote. Trump defeated all-comers in the Republican nomination race before confounding pollsters to take the US Presidency. In financial markets, investors determined that you can, indeed, have too much of a good thing with the response to Japanese and European policymakers’ efforts to push interest rates into negative territory.
Defensives have been Shunned
With the response function to changes in monetary policy reversed, 2016 has seen a revolt against previous winners with expensive defensives and bond proxies performing poorly and a renewed interest in cyclicality and reflationary trades. Considering the mood in the first few weeks of the year, when the focus was on the prospect of US recession, economic and financial damage from the collapse in oil prices, and the Chinese slowdown, the turn in sentiment and leadership has been extraordinary.
Equity Markets Unlikely to Move Higher
Equity markets, in aggregate and when considered in local currency terms, have continued to trade in a broad range since the early part of 2014. It remains our view that valuations in equities are unlikely to move sustainably (and materially) higher from current levels and, in order to see meaningful sustained upside to equity prices, corporate earnings will need to show improvement.
Multi-year Trends have Continued
Despite the scale of some of the moves within equity markets, in a longer-term historical context, they do not seem outsized and have simply reversed a portion of what, in many instances, are multi-year trends. Much of what happens next will be determined by movements in bond markets which, in turn, relate to expectations on inflation and future growth. Reasons to believe that bond yields will be heading higher relate to clear signs of wage pressure in the US, some signs of capacity constraints being hit in the US economy, an upturn in Chinese Producer Price Index rates, the generalised move from monetary to fiscal stimulus, and the fact that simple maths, relating to the oil price moves, will almost guarantee a rise in inflation into the middle of next year.
...But with Some Curious Anomalies
Despite the generalised embracing of reflation globally there are, as always, some curious anomalies which exist. Included in this list is the recent performance of European equities which do tend to perform better when bond yields are rising and the euro is falling. Despite these factors, Europe is not performing as well as would be expected. The obvious reason Europe may be lagging expected performance relates to political risks and a greater risk premia demanded by investors.
The Italian referendum took place on Sunday and there is a slew of elections in 2017 – with France and Marine le Pen firmly in focus. Italian equities have already lost considerable value year-to-date, down by a quarter while banks have almost halved. A ‘No’ vote in Italy really was not considered a surprise. While the referendum there has nothing to do with the euro, or Italy’s place within the eurozone, it is being viewed as a referendum on PM Renzi. Our view is that, early elections are unlikely and that a government will likely be formed and will hold until early 2018.
A Change in the Political and Economic Orthodoxy
If one considers the Trump election, Brexit, as well as the clear groundswell in nationalism across a range of developed economies and a renewed focus on domestic interests above all else, then 2016 may, without appearing overly melodramatic, represent a major reversal globally in ruling ideology. This could have a profound impact on the global economy and on financial markets, and is a possibility, and potential likelihood, that we have seen the secular low in inflation and government bond yields.
Aside from this, what has been surprising is the manner by which markets have embraced the positive aspects of a Trump victory. It seems that ‘Trump without the bad stuff’ has largely been assumed post-election, unless you are an investor in emerging markets assets or in some stocks specifically targeted by Trump in his campaign, such as Amazon.
It is impossible to assess at this stage exactly what Trump’s policies will actually look like and how they will impact consumers and businesses but his victory is the latest in a series of extraordinary events which do signal a change in the political and economic orthodoxy.
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