2017 Outlook: Focus Shifts to Fiscal Policy and Populist Politics

Neil Dwane | 12/06/2016
China flag

Summary

As the markets close the books on another tumultuous year, investors should keep watch on the rise of populist politics, China's re-emergence as a global growth engine and a renewed focus on government spending as interest rates remain low.

Key takeaways

  • Populist politics will drive market volatility: Europe will confront a year of Brexit-fuelled political uncertainty within a slow, low and dull global economic environment. As US policy turns inward, we expect China and Russia to get more assertive.
  • Lower-for-longer rates will linger: Financial repression will remain in effect as the world finds new ways to delever. Inflation will remain key, but it takes decades to work. Facing volatility and low beta returns, investors must be active and seek alpha.
  • Hopes will turn from monetary to fiscal policy: Negative interest rate policies and quantitative easing will evolve as countries shift attention from monetary to fiscal policy—though new fiscal efforts may not be big enough nor economically effective.

This past year has been an exhausting one for many investors: China started rebalancing, the Fed failed to raise rates, Europe grappled with Brexit, tensions rose in Ukraine and the Middle East, and the US suffered through painful elections before ultimately choosing Donald Trump. Surprisingly, while any one of these events could have caused a serious market setback, they kept plugging along valiantly—albeit with bouts of volatility—even as global growth stayed slow.

For their part, central banks all but exhausted themselves this year with their extreme monetary policies, prompting a renewed focus on fiscal expansion as one of the few remaining ways governments can hope to stimulate much-needed growth.

Moreover, economies around the world are still grappling with monumental levels of excess debt that are only serviceable at record-low interest-rate levels. As such, we expect 2017 to be a year of nominal growth and low returns as our long-running thesis of financial repression remains in full effect.

2017 outlook by region

  • US: Escape velocity elusive as Fed tries to raise rates – yet consumers see little wage growth, and health-care costs start to rise. Trump boosts infrastructure and defence spending, pushes for return of cash held overseas. US dollar could weaken.
  • Europe: Investors grow nervous about cloudy outlook from elections and triggering of Article 50. Euro-zone financials weaken, hurt by ECB’s moves toward tapering. Equities look attractive and high- yielding in a marketplace distorted by QE and NIRP. Growth should slow.
  • Asia and EM: Fundamental economic restructuring in China, India and Indonesia offset stronger USD and slower global trade momentum. Rising global protectionism boosts regional development, spurring local consumer spending. Commodity outlook changes with China’s shift to oil and softs.
  • Japan: Economic growth still very fragile as demographics and policy uncertainty affect confidence. New fiscal dominance allows Abe (with BOJ support) to legislate for inflation, which boosts domestic activity at yen’s expense.

5 investment themes to understand in 2017

As the markets close the books on one year and turn their attention to the next, investors looking to make informed decisions need to understand what's driving markets and economies. Here are the core themes to watch in the coming year.

Global economic growth: Still low, slow and dull
Investors should expect muted growth as the US enters its late-cycle period, Japan struggles with its ageing population and Europe suffers from Brexitosis. The US and EU should ultimately avoid recessions while staying stuck in the weakest economic expansions ever recorded. Emerging markets should prosper as China rebalances and much of Asia reforms.

Central banks: Rates "lower for longer” overall
We expect the US Federal Reserve to modestly increase rates, prompting central banks in emerging markets to lower their rates as inflation falls. The European Central Bank and Bank of Japan should maintain their loose monetary policies. We have passed peak global liquidity as central banks have pushed past negative interest-rate policies to begin supporting government spending.

China is still the big story, with Asia attractive overall
The biggest contributor to global growth is still China, which is requiring fewer industrial commodities and more oil and soft commodities as it urbanizes rapidly. Concerns remain over its capital position, but its "one belt, one road" policy for expanding trade and investment may be the new Marshall Plan the world needs after the Global Financial Crisis. With India and Indonesia now making significant reform progress, Asia offers the best balance of growth and investment.

Oil sees demand and supply fall into balance
For some time, we have advised investors not to expect oil prices to stay too low for too long, and our constructive position has begun to be validated. These very same low oil prices have led to receding industrial capital expenditures, and have helped demand and supply fall into balance. We believe a slightly rising oil price in 2017 should boost oil investment and global inflation, but we believe it will not ignite a new shale boom in the US. Supply will still be pressured by a fraught geopolitical situation in the Middle East, Latin America and Africa.

A change in political trends is underway

The tides of de-regulation continued shifting in 2016, and nationalism and populism gained ground: Brexit, the Walloons, Bernie Sanders and Donald Trump all played a part. Given the significant elections looming in Europe in 2017, politics should remain a key investment consideration—though some investors may simply stay away from certain markets despite attractive valuations. Monetary policy will also become more political as it becomes subsumed by explicit government policies of fiscal domination. As to where governments will spend the money their central banks print, we believe domestic infrastructure and defence spending will be the focus of many countries in the coming years.

Asia is investing in long-term competitiveness through increased R&D

Research and development as a percentage of GDP is highest in Korea and Japan

Research and development as a percentage of GDP is highest in Korea and Japan, chart

Source: OECD, Allianz Global Investors, data as at December 2013. *US, Canada and Israel data are as at December 2012. Size of the circle reflects the relative amount of annual R&D spending by the indicated country.

Taking action with a renewed focus on active investing

In many ways, 2017 will offer the same diet as 2016: Thanks to low market returns, investors who take insufficient risk will generally find insufficient results. Moreover, the historical long-term performance many investors hope to see again looks to be just that—a thing of the past. The future demands active, incisive hunting for capital-growth and income opportunities as we wait for a turn in the economic cycle to come one year closer.

Reaching objectives means taking risk

The broad market returns (beta) of many asset classes could feasibly go even lower: Without the earnings growth the markets have been waiting for, yields cannot fall further and equities cannot rerate higher. Taking some credit and duration risk—and employing dividend-focused strategies—may help protect the purchasing power of savings against inflation's ability to slowly increase health-care, education and living expenses.

Become more selective and active

As beta becomes more volatile, investors need to assess their desire for capital growth (through real assets like growth-style equities and property) against their need for income (which can be found in fixed-income and short-duration assets in Asia, the US and emerging markets). Investors can then use active strategies appropriately to generate above-market returns (alpha). Significant diversification with alternative investments can help.

Investing requires patience

As the markets increasingly focus on the short term, investors ironically must become more patient and contrarian: The power of compounding takes time to work in growth- and income-focused strategies, so a long-term perspective is essential for optimizing results.

Diversify, don't herd

Asset correlations and volatility are high, which could cause different asset classes to swing wildly in the same direction. Extreme monetary policy measures from central banks—such as negative interest-rate policies and quantitative easing—have also herded many investors into the same positions, which may reduce returns. Look for strategies that offer risk-mitigation and diversification potential—like alternatives.

Volatility is unavoidable, but manageable

Markets are increasingly susceptible to volatility as politics, geopolitics, divergent monetary policies and internal market structures all converge and evolve. Navigating this sea of uncertainty requires a clear direction and an ACTive mindset, with investors staying agile in their asset allocations, confident in their processes and thorough in their research.

Metrics to watch

Inflation

Fears over deflation and disinflation could fall as inflation rises

  • As monetary policy shifts toward supporting fiscal policy, it could create rising real-world prices.
  • China's rebalancing – plus lower commodity prices and collapsing investment – will tighten supply chains, leaving pricing power in stronger hands.
  • Fiscal dominance will allow governments to create inflation via legislation through higher minimum wages and other inflationary policies.

0.2% Eurosystem inflation Q4 2016

1.2% Eurosystem inflation + one year

Source: ECB as at Nov. 18, 2016. Inflation defined as year-on-year percentage change of the Harmonised index of Consumer Prices published by Eurostat.

Volatility

Volatility could spike from passive’s rise and regulatory shifts

  • The move toward passive investing globally has concentrated flows into certain market segments, which could become more volatile if flows begin to reverse.
  • Regulatory changes have made the markets more shallow; markets have also been rendered less stable by the rising tide of high-frequency and algorithm-based trading strategies.

13.29 Volatility Index (VIX) as at Sept 2016

20.90 VIX average 1996–Sept 2016

Source: FactSet as at Sept. 30, 2016.

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Neil Dwane

linkedIn
Global Strategist
London
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

6 Buzzworthy Books for the Investor on Your List

Neil Dwane | 12/21/2016
Coffee and Books

Summary

This year, our Global Strategist Neil Dwane carefully curated a holiday reading list that centers around China, geopolitics and disruption—three powerful forces that could reshape the world as we know it in 2017 and for generations to come.

Before you begin putting your feet up to enjoy the holiday festivities, you may want to grab a few titles from my new reading list, which gathers interesting perspectives on key political, economic and investment themes. China's re-emergence and rebalancing challenges will be a significant force in 2017; so will shifting political and geopolitical narratives, and the transformative power of disruption and technological innovation. I hope you find something on this list that will entertain, enlighten and provoke your "grey matter" while you enjoy time with your families! Best wishes for 2017.

On China

Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
By Carl Walter
This book is a refresher on how important big banks are to China's economic policy—and why Beijing's recent intervention in the "shadow banking" world is part of a plan to meaningfully refocus these unregulated activities back into its economy. The larger goal for China over the next decade is to "rebalance"—moving away from exports toward consumption and services—as it becomes a global player in finance, trade and geopolitics. Will it work, and will China really surpass the US as the world's premier global economy?

The China Price: The True Cost of Chinese Competitive Advantage
By Alexandra Harney
China's "factory economy" frequently beats the competition by short-changing its workers and the environment, but China's new leaders seem intent on redressing some of the consequences of the country's amazing economic progress. Yet that means China is facing high costs at a time when trade protectionism is growing: It must focus on its environment, which has been greatly diminished by the nation's explosive growth, and it must address its ageing population's challenges while still offering opportunities to its millennials.

On Geopolitics and Finance

All the Presidents' Bankers: The Hidden Alliances that Drive American Power
By Nomi Prins
Who will really rule America in the President Trump era? Wall Street and the White House have a long history of interdependence that can't be dismissed merely as money driving politics—or greed driving bankers. For years, they worked together to champion the expansion of America abroad while focusing on the greater good at home. But eventually, the desire for profits trumped allegiance to public service and presidents lost control over the economy—as we saw during the Great Financial Crisis of 2007-2008. Will the changing political tide shift the establishment's alliances, or will these hidden partnerships continue shaping the nation?

Winter Is Coming: Why Vladimir Putin and the Enemies of the Free World Must Be Stopped
By Garry Kasparov
This book is still holding a place on my list of must-reads for a range of reasons, not least because 2017 marks the 100-year anniversary of the Russian Revolution, a major geopolitical event that still resonates a century later. At risk of drawing too close a comparison between the rise of the Bolsheviks and the state of today's political affairs, the world is clearly seeing a pronounced rise of populism and nationalism. Brexit and President-elect Trump have just set foot on the world stage, with LePen and others waiting in the wings. Meanwhile, President Vladimir Putin stokes nationalism in his own country as he carefully plots his next move. In this book, Kasparov outlines how the West has acquiesced in the ascent of Putin and his cronies, giving Russia's leader the ability to grow into an ever more powerful threat to local, regional and global affairs.

On Disruption

Smarter Than Us: The Rise of Machine Intelligence
By Stuart Armstrong
As an investment theme, disruption is one of the most dynamic forces at play today, presenting an existential danger for some industries while opening up game-changing opportunities for others. Just consider the disruptive auto technologies that will continue to boom globally as the industry embraces artificial intelligence—and then consider what might happen if AI becomes smarter than people. This book investigates the immense potential, both positive and destructive, that this new technology holds, and the ethical challenges today's scientists and researchers are confronting. Is humanity up to the challenge, and how can we as investors build portfolios that sustainably benefit from AI technology and disruption?

Our Final Invention: Artificial Intelligence and the End of the Human Era
By James Barrat
In just a few years, artificial intelligence could surpass human intelligence—the technological Holy Grail for many governments, corporations and scientists around the world. But what happens next? Could we be forced to compete with a cunning rival that has a fierce survival drive? This book delves into the dangers of pursuing advanced AI, asking whether we can coexist with beings that possess intelligence that dwarfs our own—and even whether "they" will allow us to. Perhaps Hollywood's dystopian movies may prove right after all.

105007

Expert-Image

Neil Dwane

linkedIn
Global Strategist
London
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.
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