Despite political uncertainty, and some notable surprises, UK investors have largely benefitted from some positive trends during 2016. But what does 2017 hold in store for the major asset classes?
It remains to be seen whether Donald Trump’s widely-anticipated reflationary policies will pass through Congress. If his planned infrastructure spending aimed at igniting growth fails to materialise then the equities that have enjoyed a strong rally in recent months could come under pressure. These are largely in areas such as financials and industrials, which largely rely on the health of the economy for profits. Investors could once again turn to more defensive areas such as consumer staples that have had a tougher time recently – albeit after a strong run over the previous three years.
Essentially the outcome will be down to the performance of the economy; should global growth pick-up, as we believe it will, then the performance of economically-sensitive areas at the expense of more defensive ones may have further to run; but maintaining a balanced portfolio that includes both would seem sensible, and overall we believe equities can make solid progress.
Political developments, notably Brexit negotiations and European elections could have an impact on the stock market, both directly and indirectly through fluctuations in currency. We believe investors will be rewarded by staying invested rather than reacting to such events. Twelve months ago a Trump presidential victory and a vote for Brexit were seen as significant risks for investors, but stock markets have progressed as the benefits (economic stimulus and a weaker currency respectively) were seen to outweigh the negatives.
The US is more advanced in terms of its economic cycle than that of the UK – which is ahead of both Europe and Japan. Currency will likely be a key factor once more, with renewed US dollar strength favouring the rest of the developed world and export sectors or nations in particular. During 2016, for instance, the FTSE 100 has benefitted from a weaker pound flattering the earnings of stocks with sizable overseas activities. A period of pound strength would reverse this trend and likely prove a headwind for many of the UK’s internationally-oriented stocks. Japan too has seen favourable conditions, with its stock market thriving amid the weak yen and the prospect of accelerating global growth, but it is vulnerable to a reversal in either trend.
Emerging markets, meanwhile, are caught in the middle of two conflicting trends. On the one hand dollar strength is a headwind – as it makes dollar-denominated debt servicing more expensive – but the positive impact of a strengthening US economy on world growth is beneficial. Add to the mix the impact of uncertain US trade policy and we may see something of a mixed year for emerging markets despite structural growth domestically. China will remain a key economy to watch as world growth is increasingly reliant on its health.
Developed world government bonds are still expensive but they have fallen quite a lot in recent months (and yields have risen). We believe this has been down to “good” rather than “bad” reasons; it reflects improving confidence in economic growth rather than loss of faith in central bank policies. Plus in the US rising bond yields could effectively do some of the Federal Reserve’s monetary tightening for it – meaning a potentially shallower path for interest rates over the longer term.
Interest rate increases are therefore likely to remain small and infrequent. It is uncertain just how sensitive the economy is to interest rate changes, and the Federal Reserve does not want to risk tapping the breaks too hard. While the Trump administration will seek to cut taxes and increase spending, which might warrant higher interest rates, this will take some time to implement. Indeed the futures market is not fully pricing in a rate hike in the US until June 2017. Meanwhile, in Europe and Japan authorities are still trying to reflate their economies, and in the UK the Bank of England remains very nervous about the implications of the EU referendum. So UK interest rates should remain very low, even if US rates do begin to ascend.
We believe that an aggressive sell off in bonds from this point is most unlikely, and although lukewarm on the prospects for government debt other than for diversification reasons, there are parts of the fixed interest sector we believe are worth exploring. For instance, higher risk high yield bonds (which tend to benefit in the event of stronger economic growth and can tolerate higher interest rates), and shorter-dated corporate bonds, where rising inflation and interest rates have less impact on prices than the creditworthiness of the issuer.
Inflation remains a potential banana skin the bond market could slip on, and in here the UK it will partly be dictated by the direction of Sterling. Yet despite the chatter of “Marmitegate” and shrinking Toblerones in 2016, we believe inflation may only gently rise in 2017 due to a high level of competition across most sectors and significant deflationary forces on the high street. In short, we do not expect an inflation shock to upset UK bonds.
Following the post-Brexit panic that resulted in the suspension in dealing of a number of property unit trust funds, there are signs of stabilisation in the property sector. With post-Brexit transaction prices similar or a little lower than before the referendum, there is confidence in the income-generating characteristics of the asset class for the longer term, even though there may be short-term pressures on rents.
Property is a diverse asset class, with variants such as type, geography, lot size and the extent to which a building requires active management, meaning that is hard to identify trends reliably. In addition, the UK’s path of exit from the EU will likely affect some sectors of the market more than others. Property overall tends to have both equity and bond characteristics. Stronger economic growth tends to be good but rising interest rates would be negative; therefore we would expect property to continue to perform reasonably in our core scenario, which is where growth is resilient but inflation and interest rates remain modest.
Despite US dollar strength (which makes commodities more expensive for borrowers and tends to subdue demand) most commodities enjoyed a bounce in 2016 in anticipation of US economic stimulus and greater demand. A strong US dollar is an impediment , and our general view still holds that commodities themselves provide little in the way of long term return compared to other asset classes but a great deal of short term volatility. In particular, gold offers little more than “disaster insurance” in an environment of a strong dollar and subdued inflation. However, it is possible that shares resources companies could continue to do well as global growth continues.
The fallout of Brexit means interest rates are likely to remain low for longer in the UK. We have had one interest rate cut since the referendum, but the resilience of the UK economy now means that the Bank of England is unlikely to cut rates further. Although we expect inflation to remain fairly subdued, the return on cash is unlikely to outstrip it. Given our broadly positive view on riskier assets, we would continue to maintain low cash weightings where an individual’s tolerance to risk suggests this is appropriate.
The above article was first published by Charles Stanley on 22nd December 2016.