Market overview December 16 The major event of the final quarter of the year was undoubtedly Donald Trump s election as US President, which marked a turning point in global politics. His victory is likely to catalyse a shift from monetary to fiscal stimulus in the US that will have global ramifications. Expectations of greater government borrowing, higher inflation and stronger economic growth are likely to put sustained upward pressure on global bond yields, particularly given that the Federal Reserve (Fed) also plans to tighten US monetary policy. This may mean that the multi-decade global bond bull market has now passed its apex. Elsewhere in the world, the UK Government announced plans to increase its fiscal stimulus to counter the expected adverse impact of Brexit on its domestic economy. Likewise, Japan is expected to follow suit, with Prime Minister Shinzō Abe having proposed a significant fiscal stimulus package in the preceding quarter. Meanwhile, the European Central Bank (ECB) is encouraging eurozone countries that have the ability to increase their fiscal spending to do so. Although the European economy s recovery is still far from complete, the ECB announced that it will reduce the value of its monthly asset purchases from April next year as a result of building global inflationary pressures. It also announced changes to the length and breadth of its asset purchase programme, which had varying effects on Europe s individual sovereign bond markets. Alongside the developments in the US, UK and Japan, the ECB s actions helped proliferate the sell-off in global sovereign bond markets that began around mid-year. Within bond markets, longer-dated issues saw the biggest losses amid rising growth and inflation expectations, while shorter-dated bonds did slightly better as investors sought to reduce duration risk. Investment grade bond markets generally outperformed their sovereign peers amid improving economic prospects and various political developments, such as promises Market performance of lower corporate taxes rates, although they still lost ground in absolute terms. High yield bond markets did better, with the energy and materials sectors helped by rising oil and commodity prices, respectively, and the stressed financial sector benefitting from rising longer-term yields. The trends driving bond markets also caused a rotation in sectoral performance within global equity markets. The financial, energy and materials sectors generally outperformed across most major regions, while the bond-proxy sectors (utilities, consumer staples, telecoms and health care) generally lagged as bond yields rose. Regionally, the US was the best performer amid a relatively strong domestic economic backdrop and as Donald Trump s campaign pledges of more fiscal spending, lower taxes and reduced regulation were taken positively by investors. However, a strengthening of the US dollar, tightening global financial conditions and the risk of protectionist policies being implemented in the developed world caused emerging markets equities to lag, despite higher global growth expectations and some positive policy developments, such as the Organisation of Petroleum Exporting Countries (OPEC) decision to cut its oil production. Global equity performance by sector Return (%) 4% 3% 2% 1% % -1% Oil & Gas Financials Materials Industrials Cons discretionary Technology Telecom Utilties Q4 16 Health care Figure 1: US dollar-denominated global equity market performance by sector to 31 December 216. 216 Cons staples 2% 1% Q4 16 216 Return (%) % -1% -2% -3% Yen per US dollar Japan equities Yen per sterling US dollar index UK equities US equities Euros per sterling Developed market equities Global equities Figure 2: Local-currency market performance to 31 December 216, total return performance figures. Europe ex UK equities Emerging market equities Sterling gilts US dollars per sterling China H shares US dollars per euro
The US Donald Trump s surprise election as US President will likely mean a higher US minimum wage, lower corporate taxes and increased fiscal spending, as well as the implementation of protectionist US trade and immigration policies. After a risk aversion-driven selloff that lasted only a matter of hours, these expectations began to be reflected in asset prices, with US equity markets rising to new all-time highs and treasuries selling off. In particular, longer-dated treasuries suffered from the combined forces of rising economic growth expectations, increasing inflation projections and the prospect of higher US government borrowing and, therefore, debt issuance (Figure 3). US government borrowing Debt : GDP (%) 15 1 5 Early in the quarter, sterling suffered further heavy declines and reached lows against the US dollar not seen since the mid- 198s. However, the UK High Court subsequently ruled that a Parliament vote must be undertaken before the formal process of seceding from the European Union (EU) can begin. Investors took this as likely to delay the UK s EU exit, potentially by a number of years, which helped sterling to recover some of its recent losses. Nevertheless, the UK currency still remains well below its prereferendum level. Despite the economy s overall resilience, Chancellor Philip Hammond set out significantly lower economic growth projections in his Autumn Statement as Brexit is anticipated to have an adverse impact on both UK investment and consumption in the coming years (Figure 4). However, he also announced plans to increase fiscal spending to help avert any near-term economic weakness, as well as reforms designed to ensure that the UK remains a competitive destination for international business once it exits the EU. Despite this, UK equities underperformed their developed market peers in aggregate in sterling terms. UK GDP forecasts Figure 3: The incoming US President is expected to ramp up US government borrowing to finance tax cuts and higher fiscal spending. This will boost growth and inflation, but will also mean an increase in the supply of treasuries entering the market, which could put upward pressure on bond yields. Source: Committee for a Responsible Federal Budget, Congressional Budget Office Behind the headlines, the US economy continues to improve. Employment gains have naturally slowed as the unemployment rate has fallen, but the labour market continues to strengthen and wage growth is accelerating. Consumption also remains robust, supported by a falling savings rate, and this is putting further upward pressure on inflation at a time when the deflationary pressures emanating from China and negative base effects of lower commodity prices are reversing. With global financial conditions also relatively stable, the economic backdrop justified the Fed raising US interest rates in December. Although the rate hike had largely been priced into asset markets by the time it was implemented, the Fed s communication was more hawkish than had been anticipated (with the Federal Open Market Committee (FOMC) guiding for three rate hikes in 217) and this caused the dollar to reach new multi-year highs. Nevertheless, investors still expect US monetary policy to remain accommodative in the medium term, with rates projected to remain at historically-low levels. We note that the Fed predicted four interest rate hikes in 216 when it raised rates in December 215, but ultimately only raised rates once, albeit we also recognise that the Fed and market s expectations have converged significantly since then. The UK 2 24 28 212 216 22 224 US public debt to GDP Predicted under Donald Trump The UK s third-quarter gross domestic product (GDP) data showed the economy performing better than had been expected, with its large service sector exhibiting encouragingly resilient performance. Service-sector business investment has remained strong, albeit likely reflecting decisions made before June s Brexit referendum, while robust consumption was underpinned by the country s relatively strong labour market and rising incomes. Forecast annual UK GDP growth (%) Figure 4: The UK Government reduced its forecasts for domestic GDP growth as Brexit is expected to weigh on consumption and investment in the coming years. The Bank of England (BoE) is expected to keep monetary policy extremely accommodative, despite the fact that sterling s decline is likely to cause inflation to rise above its mandate target level. Alongside safe-haven demand this has helped keep shorter-term gilt yields at very low levels. Nevertheless, greater government spending will mean a larger fiscal deficit and higher borrowing, both of which will put upward pressure on gilt yields over the longer term. Investors have somewhat anticipated this, with the yields of longer-duration gilts having already moved significantly higher since June s referendum. Europe 2.5 2 1.5.5 1 217 218 219 22 221 March 216 November 216 The eurozone economy continued its slow recovery during the quarter, with unemployment falling and the threat of deflation diminishing amid rising global inflationary forces. However, this masks uneven levels of progress being made by the region s underlying countries (Figure 5). The German economy, by far the eurozone s largest, remains robust, with unemployment at multi-decade lows and economic activity expanding; however, its economic cycle is maturing. Encouragingly, the Spanish economy appears to be undergoing a robust recovery amid an expansion in credit lending, improving export growth and as its unemployment rate falls from extremely elevated levels. However, the French economy is struggling to improve as bureaucracy and high taxes are weighing on job creation.
Likewise, Italy s economy continues to be held back by its stricken banking sector, which has been unable to support credit creation and, hence, economic activity. European unemployment Unemployment rate (%) 3 25 2 15 1 5 26 28 21 212 214 216 Italy France Spain Germany Figure 5: The European economy continues to improve, but its various underlying economies continue to show diverging fortunes. In Europe, Italy took centre stage during the quarter, with its government heavily defeated in a referendum proposing changes to the country s constitution. This led to the resignation of proreform Prime Minister Matteo Renzi and has thrown significant uncertainty over the country s political future. It is now likely that Italy will hold a general election in 217 (along with France, Holland and Germany), but increased political uncertainty will make fixing Italy s ineffective banking system even more difficult in the near term, which caused significant investor concern over the quarter. More positively, Austria voted to maintain its incumbent pro- European government by a fairly heavy margin, relative to expectations, on the same weekend as Italy s referendum (4 December). Prior to the election, the event was touted as providing a litmus test of sentiment towards politico-economic union on the Continent and the result therefore provided a boost to pro-european policymakers at an opportune time. However, with political risk having risen substantially as a result of the Italian electorate s decision, Austria s result was not enough to prevent the euro falling to levels against the US dollar not seen since 23. Despite the problems faced by various eurozone member states, the ECB continues to focus on its mandate targets of employment and inflation. With unemployment remaining elevated and inflation subdued across the eurozone as a whole, it recently decided to extend its quantitative easing programme until at least the end of December 217. However, it also announced plans to reduce the value of its monthly asset purchases from April 217, as it judged near-term deflationary threats to have diminished. Together with changes to the rules by which it decides what bonds to purchase, these combined factors led the short-dated government bonds of Germany and France to make gains, while longer-dated European sovereign bonds sold off, especially those of the periphery countries. Against this backdrop, European equities made strong gains. Similar to the US, there was a significant dispersion in performance between the various industry sectors in Europe, with the European financial sector the clear outperformer, recovering some of its heavy losses earlier in the year. Likewise, the energy and materials sectors benefitted from global developments, while the region s bond-proxy sectors lagged. The emerging markets The emerging markets lagged over the last three months of 216, having heavily outperformed their developed-market peers in the first three quarters of the year. The primary drivers of the region s underperformance were the strengthening of the US dollar, higher global bond yields (and tighter financial conditions) and expectations that US policy would become more protectionist following Donald Trump s election. Despite these headwinds, there were also a number of positives. OPEC s decision to cut its production helped extend the oil price s recovery, which will benefit the financial positions of oil-producing nations. Likewise, further rises in industrial commodity prices were also advantageous. More broadly, the progress of a number of emerging market economies was encouraging. This included China, whose economy continues to show resilience amid relatively stable industrial and manufacturing production, robust consumption growth and with business surveys indicating accelerating growth in economic activity, particularly in the service sector. An important development was that Chinese producer price inflation accelerated quickly during the quarter, having turned positive for the first time since early 212 in September. This indicates that spare capacity in the Chinese economy continues to fall, but it also mitigates a major headwind acting against the global inflation outlook in recent years. It will also benefit indebted Chinese corporates as the real value of their borrowing will be eroded in time, thereby reducing the risk of a Chinese credit crunch. These developments are encouraging at a time when some investors hold concerns that the economic benefits generated by the Chinese government s early-216 fiscal stimulus package are set to dissipate. Another development with significant global ramifications is that the government continues to devalue the renminbi against the US dollar, with the US dollar-renminbi exchange rate rising to levels not seen since 28 during the quarter (Figure 6). Although this provides support to China s large export sector, it caused the incoming US President to imply that the country is a currency manipulator; any policies he implements to offset China s actions could have a significant adverse impact on global economic and investor sentiment, with markets already concerned that the implementation of protectionist US policies could catalyse a global trade war. Chinese foreign exchange policy Index level 14 13 12 11 1 9 212 213 214 215 216 Morgan Stanley Trade Weighted Renminbi Index US dollar - renminbi exchange rate (inverted) Figure 6: Although the Chinese authorities are now managing the renminbi against a basket of currencies, not just the US dollar, the latter s recent strength has seen it rise to highs against China s currency that have not been seen for nearly a decade. This has caused President-Elect Donald Trump to recently label the country a currency manipulator, which has exacerbated fears that a US-China trade war could be forthcoming. 5 5.4 5.8 6.2 6.6 7 Exchange rate
Japan Although Japan s economic growth remains subdued, retail sales achieved their first year-on-year increase since February in November, although this was largely due to an increase in food prices. Measures of business activity, including the closely watched Tankan business survey, also rebounded over the course of the quarter after slowing earlier in the year. This improvement was assisted by a sharp renewal of yen weakness against the US dollar, which supported demand for Japanese exports. Amid strengthening global growth and inflation, as well as expectations of a large increase in fiscal spending by the Japanese government, these developments were enough for the Bank of Japan (BoJ) to raise its growth outlook in December. However, with inflation in the country still benign (core inflation remains negative despite the headline measure having moved back into positive territory and producer price deflation diminishing), the BoJ is expected to maintain its current policy stance, which it established in the preceding quarter, in the near term. Alongside a significant decline in the value of the yen against the US dollar, Japanese equities made large gains in yen terms. They significantly outperformed the emerging market equities, but lagged those of the US and Europe on a constant currency basis. 217 outlook At the start of the year, we expected 216 to be challenging for the global economy and financial markets amid numerous structural economic headwinds, including high public and private debt levels, adverse demographics, a global savings-investment mismatch and an overreliance on central bank policy. These problems largely remain, as they are the inevitable legacy of several decades of accumulated credit excesses and the policy errors that allowed these to occur in the first place. Given all of this, one of 216 s biggest surprises has been how resilient the global economy and equity markets have been through the year, with the latter probably outperforming most people s expectations. Despite the headwinds, we see potential for global economic growth to accelerate in 217. However, this will largely depend on whether economic policy can successfully be shifted from monetary stimulus, which increasingly appears to have reached the limit of its usefulness, towards fiscal expansion. In the US, Donald Trump has promised to significantly ramp up government spending, Shinzō Abe has announced similar plans in Japan and the UK government has pledged to increase spending to combat the adverse impact of Brexit on its domestic economy; however, the impact of such programmes could take some time to be felt. We note that China s recent economic stabilisation has been achieved with the help of a large fiscal stimulus programme implemented by its government at the start of 216. The country remains a key driver of global growth and while there are tentative signs that the effects of its stimulus programme may be diminishing, recent Chinese economic data has shown promise and we are cognisant that the Chinese government maintains both the financial firepower and resolve to continue to support domestic economic activity. Nevertheless, the country s transition from investment-led towards consumption-driven growth is likely to continue to weigh on its overall growth rate. We see less scope for fiscal spending to increase in Europe given the financial restraints EU membership entails. However, the Italian electorate s decision to heavily reject the terms of their government s constitutional referendum is indicative of the growing dissension against austerity-based fiscal policy on the Continent. Following the referendum, Italy could hold a general election and with Holland, France and Germany also electing their next governments in 217, we see scope for the European political status quo to change significantly over the course of the year. If anti-establishment parties gain power, they could attempt to increase spending, but such developments could also cause questions over the eurozone s ongoing sustainability to again come to the fore; in this scenario, European assets, including the euro, could come under significant pressure. Although deflationary pressures dominated in early 216, global inflation appears to be accelerating as we move into 217, with labour markets in some of the major economies having tightened, global government spending accelerating, oil and other commodity prices rebounding, and producer price deflation from China reversing. In the US, inflationary pressures are likely to encourage the Fed to continue to tighten US monetary policy, thereby supporting the dollar. However, elsewhere in the world monetary policy is likely to remain highly accommodative in support of economic growth. We believe the evolving investment backdrop could mean that the multi-decade bull market in global fixed income may have now passed its apex. Alongside higher interest rates, greater government spending will cause sovereign bond issuance to increase, putting further upward pressure on bond yields. However, we recognise that the ECB, BoE and BoJ continue to operate monetary policy programmes designed to support economic activity by keeping bond yields low. Furthermore, we expect investors search for yield to continue as shifting developed-world demographics should ensure that demand for income-producing assets remains robust. Overall, we expect bond market volatility to remain heightened as expectations of higher US growth and policy support elsewhere in the world collide. Indeed, with Japanese government bond yields having risen alongside global bonds in the second half of 216, a big theme for next year is whether the BoJ s policy of maintaining the yields of its sovereign bonds will be tested by the market (its current policy is to maintain the yield on 1-year JGBs at around %, but at the end of the quarter it had risen to.5% after reaching lows of -.29% in July). If the upward pressure on global bond yields is maintained, this will involve the Japanese central bank stepping up its purchases, which could have a follow-on effect on other regions sovereign bond markets. Although higher bond yields could eventually weigh on equity market price-to-earnings multiples, we expect stronger growth and pro-business reforms to support equity prices in 217. We note that US corporate earnings growth has been encouraging in recent quarters, despite a drag from the energy sector, and that although equity-market valuations are generally above longerterm averages, they remain below cyclical peak levels. Within equity markets, the changing economic backdrop could further proliferate the sectoral rotation that has been underway throughout the last quarter. This has generally been away from stable growth bond proxies, such as telecoms and consumer staples, towards sectors that favour higher interest rates and
economic growth, such as financials and the resource sectors. Meanwhile, changes in regulation and policy will also have differing effects on individual industries, with performance also deviating between different geographical markets amid diverging regional monetary policies. Given our view on the US monetary policy and the US dollar we are somewhat cautious on the emerging markets, particularly after their strong performance in 216. Nevertheless, strengthening global growth should provide some support to these regions, particularly if oil and other commodity prices remain buoyant. We hold some fears that a trade war may develop between the US and China, given strong rhetoric from the incoming US President; if this were to occur, it holds the potential to significantly damage global growth. We will be watching developments in this area very closely in order to gauge any developing risks, particularly if China continues its policy of devaluing the renminbi against the US dollar. The performance of UK equities remains vulnerable to swings in sterling and we expect the currency s performance to be dominated by newsflow surrounding the terms of the region s secession from the EU. This is unpredictable, but we recognise that the UK Government seems to be becoming increasingly pragmatic about its position and the need to maintain business competitiveness. Likewise, we expect the performance of Japanese equity markets to be dominated by the direction of the yen, as it has been in recent years. However, Japan could also be the greatest beneficiary of the return of global inflation, with persistent deflation having troubled its economy for many years. Overall we expect 217 to be a challenging and difficult year for investors. With political risk elevated and uncertainty plaguing investment markets, a balanced approach to portfolio construction will remain key to mitigating investment risk. Ultimately, improvements in macroeconomic or corporate profit outlooks will create investment opportunities across all asset classes and current investment environment favours stock pickers who are able to correctly identify undervalued companies or those exposed to positive longer-term trends. Important information The performance indicated for each sector should not be taken as an expectation of the future performance. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a guide to the future. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets. The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others. Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Asset Management Limited is regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 72 Welbeck Street London W1G AY. Brooks Macdonald Funds Limited is authorised and regulated by the Financial Conduct Authority. Registered in England No. 57397. Registered office: 72 Welbeck Street, London, W1G AY. Brooks Macdonald Asset Management (International) Limited is licensed and regulated by the Guernsey Financial Services Commission. Its Jersey branch is licensed and regulated by the Jersey Financial Services Commission. Brooks Macdonald Asset Management (International) Limited is an authorised Financial Services Provider, regulated by the South African Financial Services Board. Registered in Guernsey No 47575. Registered office: Yorkshire House Le Truchot St Peter Port Guernsey GY1 1WD. More information about the Brooks Macdonald Group can be found at www.brooksmacdonald.com.