26 January 2017

John Iannis Mourmouras: The risks and prospects for the global economy and capital markets in 2017

US new economic policy. In the final months of 2016 financial markets responded to Donald Trump's election in textbook fashion - not only at asset class level, with moves up in stocks and government bond yields, but also within asset classes. In doing so they were responding to prospects for higher growth, inflation and market inflows following the US president-elect's policy announcements on deregulation, tax reform and infrastructure. Trumponomics will remain an important market influence this year, with investors particularly interested in two things: the transition from announcements to detailed design and sustained implementation; and outcomes, particularly when it comes to the mix between higher growth and inflation. The anticipation of a more active fiscal policy is based on the assumption that President Trump will reinvent the package of policies known as Reaganomics. The strength of the dollar since the Trump election is justifiably based on that historic analogy. A skyrocketing dollar may inhibit growth. 

•    There is also the question of foreign policy, both in terms of trade and geopolitical issues. There is a heightened risk on "trade protectionism" under the Trump administration. Overall, a surge of protectionist measures would not only undermine the recovery in global trade, it would also disrupt global supply chains and limit international factor movements, for both labour and capital. A protectionist backlash would not just have an adverse near-term cyclical impact, but also a negative long-term structural impact on potential growth. 

4.   Europe's politics

Political risks to the European order are on the rise after the UK vote to leave the EU and the unprecedented wave of migration from war-torn countries in the Middle East and North Africa that has fueled the rise of nationalist politics and populism. Euroscepticism is now a strong sentiment in Europe. Following what it seems a hard Brexit, elections this year in the Netherlands, France, Germany, and maybe Italy, four of the founding members of the European Economic Community back in the 1950s, are critical as they may provide gains to populist parties that would result in increased Euroscepticism across Europe. 

•    But what exactly does populism mean? And why markets should care about it? There are three reasons. First of all, there is anti-globalism and blaming of free-trade agreements and global finance. Second is an embrace of state activism in the economic field, which implies less structural reforms, undoubtedly inhibits long-run growth and, in turn, jeopardises public debt sustainability which is at the heart of the south of Europe's economic troubles. Third, populists are averse to policymaking based on rules and in favour of discretionary policymaking and interventionist policies. 

5.   Geopolitical risks A third set of risks is geopolitical. To name briefly a few, Russian president Vladimir Putin's revanchist politics; the coming friction between President Trump's US and China, but also Germany; friction between Iran and Saudi Arabia and a possible overthrow of the Saudi royal family, and the real threat of ISIS hitting Western democracies. 

6.   Last but not least, underlying vulnerabilities remain among some large emerging market economies, which may aggravate as a result of an unprecedented strength of the US dollar. Indeed, the last time emerging economies faced monetary tightening and fiscal loosening in the US (in the early 1980s), many of them (notably in Latin America) slid into a lost decade. 

7.   Central banks' monetary policies: In the beginning of 2017, it seems that the major advanced economies monetary easing cycle may be ending soon. I predict that this will be happening in the following manner in the year ahead: more monetary policy divergence in the first half and less monetary policy divergence in the second half of the year, which, in terms of the financial market's jargon, means less distortion from unconventional monetary policies, a gradual return to monetary policy normalization and steepening yield curves. 

8.   Foreign Exchange: 2016 was the year that shook up currencies: sterling took a beating, while the dollar continued to march ahead. This year the dollar will continue to dominate the FX markets. The main question is: How far can the USD run? As a result of the monetary divergence between the Fed and the ECB, together with a higher-than-expected budget deficit from the fiscal stimulus, which with higher long-term government bond yields will attract new capital inflows and a busy electoral calendar in Europe which would be another source of concern for investors, the dollar is expected to remain strong, with the euro against the dollar to move near to parity and break it by year-end. 

•    On other major currencies: An expected range for the British pound against the dollar is between 1.13 and 1.18{and the euro against the pound by year-end is between 0.83-0.90}. The expected range for the US dollar against the yen is 110-115{while an expected EUR/JPY rally should allow the currency to climb towards 125}. Finally, a managed moderate depreciation remains the key theme for the CNY in the foreseeable future as, after its inclusion in the SDR basket, one of the Chinese authorities' priorities is the currency credibility due to China's aspirations for the CNY to become a global reserve currency. An expected range for the USD-CNY is between 7.15-7.30 by the end of 2017. 

9.   Bond Markets: As the global policy mix is evolving towards more fiscal easing and less monetary easing, there is intrinsic uncertainty because effective implementation of such a policy shift is still very much an open issue. This would lead to higher yields, more volatility and higher term premia, especially on the long-end of the yield curve, which is overbought over the last few years due to low-for-long interest rates. As a result, the themes of rebuilding term premia in long maturity rates and steepening yield curves are gaining ground. 

•    The degree of US government yield curve steepening will depend on the pace of policy normalisation by the Fed, on the depth of tax cuts and the level of infrastructure spending. All this could lead to higher inflation expectations and a sharp repricing of term premia. In short, 10-year Treasury yields may gradually rise by around 2.80%-3.20% by end-2017. 
•    The outlook for European fixed income in 2017 requires a careful balancing act between expectations of less monetary policy support on the one hand and structural factors, on the other hand, such as unresolved banking sector issues as well as political developments. In this context, the German 10-year Bund yield could reach 0.50%-0.80% by year-end. Any widening in periphery spreads will depend on country-specific politics, the long-standing issue of economic non-convergence, but also given the assumption that the ECB's APP will run throughout the year. Hence, a rise in the yields in the europeriphery is quite likely and the spread between core and peripheral yields will fluctuate throughout the year. 

10.   Equities Watch out once again for the correlation between bond yields and returns on equities. Since the 2008 crisis, this correlation has been systematically negative due to drastic non-standard measures with a few exceptions (Fed's tapering in 2013 and the Bund tantrum in 2015, during which bonds and equities prices abruptly corrected). In my view, the bond-yield/equity market correlation will remain negative as a trend once more this year, albeit less pronounced and more volatile. [...]

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