She commented that, ‘For investors, 2016 will also go down in history as the year when global deflation fears were extinguished, long-term interest rates finally started to rise, and central banks stopped being the “only game in town”.’
The economist next turned her thoughts to what this means for investors.
She commented, ‘So what do faster reflation and a lesser emphasis on monetary policy actually mean for investors? Both factors would tend to increase the returns of equities vs. bonds in the future, steering investors towards cyclical assets and away from more defensive ones. What’s more, these factors would generally lead investors to avoid holding long-dated bonds.’
She continued, ‘But the structural and supply-side factors that are holding back global investment and productivity growth, and pushing up the relative demand for safe assets, haven’t changed. These structural constraints, coupled with the fact that the US is much further along the reflationary road than other parts of the developed world, tell us one thing: the search for both income and new forms of “safety” will continue to be crucial for investors.’
A major event in the UK markets next year is the impact of the political path towards the UK leaving the EU.
Flanders said, ‘Brexit will be one of many sources of uncertainty for investors in 2017. The UK government has promised to start the formal Article 50 process for leaving the EU by the spring of 2017. Though the economy has performed surprisingly well since the summer vote, most economists continue to believe that the exit process will dent growth by several percentage points of GDP over the next two to three years.’
She added, ‘Consensus forecasts for the UK are for 2 per cent growth in 2016, up from 1.5 per cent immediately after the EU referendum. But most are expecting the recovery to slow sharply in 2017, to around 1%, as higher inflation squeezes consumers’ real incomes. Exporter profit margins will benefit from the weaker pound, but surveys of investment intentions have been turning down since before the referendum. If the consumer side of the economy falters in the second half of 2017, uncertainty over the Brexit negotiations could make it difficult for investment to fill the gap. Fiscal policy is set to be looser between now and 2019-20 than before the referendum. But the extra spending on public infrastructure won’t kick in until the years immediately before the next election. There is still a significant tightening built into the plans for 2017.’
She commented that market expectations as to when interest rates rise in the UK have shifted rapidly.
Flanders commented, ‘By the end of 2016, markets were pricing in a small rise in the official policy rate in 2017 and very gradual tightening in the years after that. The latter seems reasonable, but we would be surprised to see a rate rise as early as 2017, given the BoE’s concern about the possible consumer reaction to higher inflation and the Brexit-related uncertainties hanging over UK businesses. A forecast for 1 per cent does not provide a lot of room for downside surprises.
On how a UK investor’s portfolio can be effectively positioned for 2017, Flanders commented, ‘The shifting fortunes for bond and equity markets through 2016 have rewarded investors with risk-orientated portfolios, but also highlighted once again the benefits of diversification. A basic portfolio of 50/50 developed market stocks and government bonds would have delivered a total return of 4.4% since the start of the year. The same portfolio barely broke even in the 2015 calendar year.’
The economist continued, ‘The UK, with its large-cap bias and exposure to the rest of the world, has done better than many in 2016, but for non-UK-based investors, the benefit was more than offset by the falling value of the pound. Though UK equities look reasonably well supported at current valuations, they are clearly less attractive than they were at the start of the year. We will be looking to see whether earnings momentum can continue to improve in 2017, though within the equity market the relative shift back from mid and small cap equities to the larger businesses probably has further to run.’
Flanders concluded her comments with the remark that, ‘Our base case is that UK slows down markedly in 2017 but does not fall into recession. However, we should be alert to the negative impact on consumers of higher inflation in an environment in which many businesses have put investment plans on hold.’