A wind of change is sweeping through politics, economics and markets and it threatens to bring with it a new direction for economies and financial markets. Three core themes are evident in this new dawn: rising Vox Populi risk, increased headwinds to globalization trends and a transition in the policy landscape.
Rising political risk is not a new theme for us at Citi. Vox Populi risk in its various forms has been a mainstay of our research over the last few years. However 2016 saw a dramatic shift in focus, away from geo-political tensions towards a new socio-political discord that culminated in unexpected outcomes such as the UK referendum on EU membership and the U.S. presidential elections. Neither the vote for Brexit nor Donald Trump's election victory should necessarily be systemically critical, but both are symptomatic of a strong underlying dissatisfaction. Not all of the Brexit supporters voted because they really believe that the UK will benefit from leaving the UK and not all Trump supporters fully support his campaign policies. What many people voted for was change. Change from a status quo in which they had lost faith. Change of any type is now viewed as better than no change at all. The crucial aspect of this phenomenon, and what makes it potentially more consequential than geo-political unrest, is that it has triggered a wave of populist policy responses that have a very direct transmission mechanism into economies and markets.
It would be disingenuous to claim that globalization is going into reverse. Many aspects of the globalization trend are robust and even accelerating. In a few key areas, however, there are signs of mounting headwinds; the most notable among these being migration, trade and investment. Overall, a shift away from globalization is likely to weigh on economic activity and investment; however these trends are not at all uniform. The impact of changing momentum in these areas is, nonetheless, likely to be heavily felt in 2017 although it may be more marked in regional and cross-sector variations than in aggregate global growth.
The third key theme in our 2017 outlook is a major shift in the policy landscape. Monetary policy is likely to become much less accommodative, led by the Federal Reserve raising rates and followed by tapering from the ECB and perhaps the BoJ. At the same time, fiscal stimulus is likely to accelerate. Fiscal policy has been a long time coming, but history suggests that it is usually quite persistent. Now that it is here, it is likely to stay, and while it will be a welcome support to beleaguered monetary policy, fiscal policy is not without its costs. There is a risk that, being somewhat driven by political factors, the policies chosen may not always be the most economically effective. Furthermore, with high levels of debt across most advanced economies, it is possible that the bond markets may look upon fiscal stimulus with considerable skepticism.
As with all periods of transition there are considerable risks, both to the upside and the downside. While the shifting direction of the major trends may become increasingly apparent, the exact trajectory of those trends will be hard to predict.
We see three areas of uncertainty that could have an impact on economic and market dynamics: the question of whether or not inflation is now rising in the advanced economies, commodity prices and whether or not emerging market growth can withstand the effects of Trumponomics. Historically, a stronger dollar and rising U.S. rates has been an unpalatable combination for emerging economies. Coming against a backdrop of increasingly protectionist policies and slowing trade and investment, many countries will have to search hard to find new growth drivers.
Combining our core themes with these risks, we get a fascinating set of challenges for investors to navigate. We see three major investment themes for 2017: a stronger dollar, a turn in the yield cycle and a major shift in the policy landscape.
The impact of a rising U.S. dollar will be felt not only in emerging markets, but also in broader financial conditions. Investors will need to evaluate the extent to which this becomes self-regulating. If tighter financial conditions destabilize the recovery before fiscal stimulus has had a chance to work, we could see another dip in growth next year.
The question of whether or not the 30-year bull market in bonds is over is of huge importance. Bond technicians will tell you that it is too soon to call the end of the bull market, while bullish fundamental analysts will point to the risk of tighter financial conditions as a self-regulator. Nonetheless, yields are rising. The big issue for investors to focus on in 2017 is the evolution of risk premia. Bonds have three main drivers: funding costs, inflation risks and credit risks. All three of these probably merit higher risk premia going forwards. It may be too early to call an aggressive cyclical bear-market for bonds, but we have probably seen the secular lows in risk premia.
Our third investment theme is how the new policy mix, with tighter monetary policy and greater fiscal stimulus, will impact asset allocation decisions across fixed income and equity markets and how the investment industry is adapting to these new challenges.
With monetary policy turning less accommodative and fiscal stimulus on the horizon, there will be renewed expectations of a "Great Rotation" out of bonds and into equities. However, as we argued in our October 2014 GPS report, risk rotations tend to take place within asset classes and not between them. This has clearly been the case over the past couple of years as bond and equity prices have become positively correlated, reflecting reduced risk premia in both markets on the back of a very supportive policy environment.
Just as the impact of the various macro-economic drivers is likely to be nuanced across geographies and business sectors, so we expect risk rotations to remain predominantly in-asset class. This means rotation between cash and bonds and rotations up and down the yield and credit curves as inflation and credit risk premia fluctuate. In equities, the shifting risk premia are likely to be seen across regions and sectors, reflecting shifting trends in buybacks, dividends and capex. As such, the positive correlation between bond and equity prices is likely to break down as the drivers of each asset class diverge. A more traditional cyclical-looking price dynamic may emerge, but it is important not to confuse a re-pricing of risk premia with a real money flow rotation.
This changing dynamic in risk premia and asset correlations is also being reflected in broader industry trends. A recent Citi Business Advisory Services survey revealed a steady transition from asset class-based to factor-based portfolio construction that is helping fuel an accelerated move in capital pools away from actively managed to passively managed funds, particularly towards Exchange Traded Funds (ETFs).
These themes are all investigated in more detail in a series of essays over the following pages of this report. Alongside the major macro and investment themes, we also present three essays that examine trends affecting equity investment and stock selection.
We look at how technologies like sensing and data collection, optimization, and analysis could redefine the future of manufacturing. We also investigate the impact that China's burgeoning semiconductor demand could have on the sector globally and finally we examine how increased energy efficiency and rising demand for renewable energy sources is impacting the landscape of energy production, consumption, pricing and hedging.
We are pleased to present our investment themes for 2017 in this report. Overall we believe that 2017 may herald a new direction for economies and financial markets after several years of stasis. The future looks uncertain, but uncertainty can be a good thing. With shifting trends come shifting risk premia and greater price volatility. With greater volatility comes greater opportunity. We wish all readers of our Citi GPS series successful investing in the year ahead.
Tina M Fordham
My Account
The introduction to our 2016 Investment Themes Citi GPS report was titled "New Normal or No Normal". In it we argued that a return to strong growth and increased cyclicality in economies was unlikely. We said that a return to the historical levels of growth and inflation would require far more radical changes than looked likely at that time. This proved to be an accurate assessment of the 2016 outcome; however, a number of events have taken place during the past year that make us think that 2017 could be very different.
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