IF 2016 was a year of shocks, what will the next 12 months bring? It’s no surprise that the year will presumably have its share of surprises.
A regular survey of global fund managers by Bank of America Merrill Lynch points to what most people believe: Following the election of Donald Trump, investors are expecting above-trend economic growth, higher inflation and stronger profits. They have invested heavily in equities and have a much-lower-than-normal exposure to bonds.
It’s not too difficult, then, to see how the first surprise might play out. Expectations for the effectiveness of Trump’s fiscal policies are extraordinarily high. It takes time for such policies to be implemented, however, and they may be diluted by Congress along the way, especially on public spending. Indeed, it may well be that demography and sluggish productivity will make it hard to push economic growth up to the 3% to 4% hoped for by the new administration. Neither fiscal nor monetary stimulus has done much to lift Japan out of its torpor, after all.
American profits, which were falling in early 2016, seem certain to rebound, particularly if the new administration pushes through corporate-tax cuts. However, with the market priced on a cyclically adjusted price-earnings ratio of 28.3, according to Robert Shiller of Yale University, a lot of good news already is priced in. The ratio, which averages profits during the past 10 years, is 70% above its long-term average.
Meanwhile the Federal Reserve is penciling in three interest-rate increases in 2017, something that probably will push the greenback higher and reduce the dollar value of foreign profits for American multinationals. Thus the surprise might be that Wall Street will not be that great a performer in 2017.
By extension, the second surprise may be that government bonds do not do that badly. The yield on 10-year Treasury bonds already is approaching the top of the 1.5%-3% range in which it has been trading in recent years. Private-sector borrowing costs, including corporate bonds and fixed-rate mortgages, tend to move in line with Treasury yields. Increased borrowing costs would have an adverse effect on economic activity. As a result, sharp rises in bond yields often are self-correcting, since weaker economic data tend to drive yields back down.
The third potential surprise of the year might be a dog that doesn’t bark. The biggest worry of the fund managers polled by Merrill Lynch is that of the disintegration of the European Union. As a result they have a lower-than-normal holding in European shares. The EU might get through the year unscathed, however, if Marine Le Pen is defeated in France’s presidential vote and Chancellor Angela Merkel is re-elected in Germany. Populism does not win every time, as the recent Austrian presidential vote demonstrated. Indeed, the euro-zone economies could grow at a respectable 1.6% next year, according to Organization for Economic Cooperation and Development forecasts. The continent might even seem a safe haven, given events elsewhere.
Another potential surprise in 2017 could come from a big market disruption. There have been a few of these events in the past, from flash crashes to sudden leaps in bond yields. They seem to be the result of computer programs that trigger sales when specific price points are reached and a retreat by banks from trading, which has made markets less liquid.
The trillions that flow through financial markets every day are also a tempting target for cyberwarfare and cybercrime. The big story of 2017 could be an inexplicable—if temporary—crash in a vulnerable market, such as high-yielding corporate bonds.
The final surprise may be served up by that most enigmatic of metals—gold. Working out a target price for gold is a mug’s game. You can understand why investors bought gold when central banks started expanding their balance sheets after 2008, but it is harder to explain why the price more than doubled in less than three years before falling back since 2011.
Because investors’ inflation expectations have risen since the American elections, gold might have been expected to rally. Instead it has fallen sharply, perhaps because investors see the metal as an inferior alternative to the surging dollar.
Gold is not merely a hedge against inflation, however, but also is sought out in periods of political risk. With the Trump administration apparently poised to pursue a more aggressive approach toward China and Iran, it is hard to believe that gold won’t find a few moments to shine in 2017.
© 2016 Economist Newspaper Ltd., London (December 24). All rights reserved. Reprinted with permission.