The recovery from a global industrial recession during 2016 set the stage for rising bond yields and inflation expectations in the second half of the year, which accelerated after the U.S. election results boosted hopes for a pro-growth change in U.S. economic policy. There remain a wide distribution of potential policy outcomes in 2017 that may inject volatility, but the solid U.S. and global expansions provide a positive context to start the year. The election of Donald Trump as U.S. president has thrown an extra element of uncertainty into our outlook. We believe markets are assuming that the new administration will have a policy mix that will boost growth, equities, and the U.S. dollar, as well as push the Fed into increasing interest rates. But there are large uncertainties about the president-elect's views. Some of his campaign comments about withdrawing from trade deals and imposing tariffs on China, if enacted, have the potential to send the global economy into a renewed downturn. The post-election optimism driving markets in late 2016 could quickly reverse. The tactical process used by our global team of investment strategists is based on the building blocks of business cycle, value and sentiment. This process has helped us navigate markets in recent years, balancing concerns about valuations against positive cycle views and sentiment shifts between extremes of overbought and oversold. 2017 offers few certainties and plenty of potential risks. We believe investors will need to take a grand tour of the returns landscape with a good map to arrive at some rewarding portfolio destinations. U.S. Equity Sectors 2016 Performance The performance of bond-proxy equities, such as utilities, consumer staples, REITs and telecommunication services, surged during the first half of 2016 as investors sought higher-yielding assets. As bond yields reversed course and headed upward during the second half of the year, bond-proxy sectors experienced negative performance and trailed the broader U.S. equity market.
The U.S. dollar surged to a 15-year high in the aftermath of the elections and is at the upper end of historical ranges versus many currencies. Expectations for higher U.S. growth boosted bond yields and estimates for the Fed's tightening cycle, which made the yield differential versus non-u.s. bonds more attractive. Concerns about protectionist policies may also have played a role, as the Mexican peso (MXN) sank to an all-time low. (Left)Trade-weighted U.S. dollar against major currencies, (Right) Percentiles include period 2000-2016
Repeating Reaganomics overshoot? A repeat of the 1980s overshoot of the U.S. dollar is unlikely, although the greenback could strengthen a little further from current levels. The situation today is different from the 1980s insofar as the Fed under Janet Yellen is not fighting high inflation and is unlikely to be as hawkish as the Fed was in Volcker's era. In addition, Mr. Trump's protectionist and isolationist stance may weaken the dollar's appeal as a reserve and safe-haven currency. Weighing up these countervailing forces, we think a Trump presidency is indeed a net positive for the U.S. dollar due to the new president-elect's fiscal plans. However, already rich valuations and limited scope for policy divergence will likely restrain the dollar's upside potential against other developed market currencies to 5% to 10%. Europe Expansion Intact, though Political Risks Abound Political risk is an issue for Europe with elections in Germany, the Netherlands, France and potentially Italy in 2017. France's Marine Le Pen is the closest populist leader Europe has to a President-elect Trump, and Italy's Five Star Movement has threatened a referendum on the euro if elected. But support for the euro is still strong across the wealthier European countries, and the immigration crisis that fuelled populist support in 2015 looks to have abated. Europe looks poised to benefit from stronger profits, the weaker euro, supportive ECB policy and an improvement in bank balance sheets.
Europe continues to experience a sluggish expansion. The U.K. and the European Union have been able to shrug off post-brexit headwinds, as industrial activity has recovered and economic expectations have risen across several large developed economies. The political environment poses risks in 2017, as investors will be concerned about the potential for populist parties to gain power in several core-country elections. European banks lag their US counterparts Economically, some states may feel less constrained to stimulate their economies and more resistant to reforms, given the cover of bond buying by the European Central Bank (ECB). More broadly, in the aftermath of opposition to the Transatlantic Trade and Investment Partnership (TTIP) framework by several European politicians and the apparent tit-for-tat fines by the USA and the EU on each other's companies, the EU needs to take a clear stance on trade and globalization and clarify whether it actually supports them. For the moment, we expect the Eurozone to record tepid growth of close to 1.5%, which will continue to be unevenly distributed among the various countries.
China Savings vs. Foreign Treasury Purchases Unlike a decade ago when record Chinese current-account surpluses were circulated back into massive buying of U.S. Treasury bonds, China's move to a large fiscal expansion during the past year has resulted in a downshift in global savings. With most major industrialized countries poised to end multi-year austerity and shift to easier fiscal stances, these developments could continue to put upward pressure on interest rates.
China has kept out of the headlines over the past year, and we see that as good news. Skepticism was rife amongst commentators earlier in 2016, when reported Chinese GDP growth rates of 6.7% had implausibly dislocated from more transparent indicators of activity. Electricity production growth slowed perilously close to zero, for example, and freight volumes were in outright decline. As we move towards 2017, these doubts are abating. The bounce in commodity prices through 2016 has stabilized China's heavy manufacturing sectors and, while this favourable reversal is slowing the structural adjustment process, it is also providing some stability to the transition. As shown in the chart on the next page, China's leading indicators are now turning convincingly upwards for the first time in nearly four years. China real GDP growth: Asia strategy A supportive confluence of firming economic growth, reasonable valuations and improving profitability suggests to us that emerging Asian equities will perform well in 2017, possibly outperforming their global counterparts. To the extent that global liquidity has long been the marginal price setter for Asian equities, performance may be even stronger should capital inflows increase.
Consensus expectations of 12.3% earnings per share growth for the MSCI Asia ex-japan (vs. 5% in 2016) underscore analyst optimism, with cyclicals financials, technology and commodities outperforming. We expect the China and Hong Kong markets to lead regional equities in 2017, as the recovery in earnings, attractive valuations and buoyant liquidity accelerate south/north-bound flows. India's robust macro story remains intact, and a rebound in earnings growth should continue to steer the market higher. South Korea and Taiwan equities are likely to fare better than their Southeast Asian counterparts, which are grappling with either subdued earnings or expensive valuations.
Steady growth The Asia-Pacific region continues to both deliver and promise steady economic growth. For 2016 as a whole we see real GDP growth overall at around 4.75%, down only fractionally on the previous year. We expect a similar steady rate of growth in 2017. Against this constructive backdrop, the long downtrend in inflation and in official interest rates is coming to an end across much of the region, and we believe Asia-Pacific equity markets continue to offer moderately good value. Emerging Markets Led 2016 Gains Despite Weak Q4 Emerging-market equities rallied until the U.S. elections, then retraced some of their gains but still ended the year in double-digit positive territory. Commodity prices recovered during the year, which benefited commodity-exporters, including those in Canada and Latin America. The rising U.S. dollar detracted from returns, particularly in developed markets and during the post-election period. EM: emerging markets. LC: local currency. All returns are gross in U.S. dollars unless otherwise noted. Past performance is no guarantee of future results. It is not possible to invest directly in an index. All indices are unmanaged. 2016 Total Return Valuations and Growth Outlook, Secular Positives for EMs Price-to-earnings multiples in most EM countries equity markets remain at the lower end of their 20-year averages, making them relatively attractive from a valuation perspective. Moreover, we expect growth of emerging countries to outpace that of developed markets over the long term. Both factors should provide a favourable long-term backdrop for EM equity returns.
The Key for International Performance is Security Selection Quantitative investigation of past value returns demonstrates that organization presentation (security selection) is the most critical consideration for clarifying contrasts execution among stocks. An active management strategy can potentially produce higher returns than the benchmark. For example, identifying the highest-quality earnings growers (return on invested capital) at reasonable valuations has been an effective strategy. ThinkPark Tower, 2-1-1, Osaki, Shinagawa, Tokyo 141-6001, Tokyo, Japan