Global political risk, currencies to drive economy

Predicting the U.S. gross domestic product ranging from 2.3% to 2.9%, a Standard & Poor's 500 total return ranging from 2% to 6% and an MSCI EAFE total return ranging from -12% to 10%, institutional investment strategists see three main drivers in the global outlook for the capital markets and economy for 2017.

Read the forecasts and expectations of P&I's panel of experts here.

Looming the largest are:

• the election of Donald Trump as U.S. president in November and uncertainty, optimism and obstacles facing the new administration;


• heightened political risks in Europe, incited by populist fever set off by the U.K.'s June referendum to leave the European Union, amplified by the Italian constitutional referendum in December and building up with elections in the Netherlands in March, France in April and Germany later in the year; and


• currency turmoil, from sustainability of the euro to the strengthening dollar.

“Trump has to be the biggest source of risk for markets,” said Craig Mackenzie, chief investment strategist at Aberdeen Asset Management PLC, Edinburgh. “We really don't have much of an idea what kind of president he is going to be.”

“There is a huge range of possible outcomes over the next year or so, a much wider range than would normally be the case” with a new administration, Mr. Mackenzie said. “We have certainly become more positive about the U.S. but ... we think that the secular stagnation story is still largely in place.”

Donald G.M. Coxe, chairman, Coxe Advisors LLC, Chicago, said: “Investors are anticipating all the good things that are going to come from this new (Trump) government, but getting a lot of this stuff done is going to be painfully hard and going to take longer” than thought.

“There is a degree of volatility and emotion,” Mr. Coxe said. ”It was better for investors that Trump win the election, but this was an astounding conversion to occur in a short space of time.”

Expressing more certainty, Krishna Memani, chief investment officer and head of fixed income of OppenheimerFunds Inc. and its institutional unit, OFI Global Asset Management Inc., New York, looks for Mr. Trump “to implement a set of fiscal expansion policies that lead to somewhat higher nominal and real GDP growth at least for the first half of 2017 (and) to better return on equities, pressure on bonds, slightly higher inflation and a strong dollar.”

The Trump effect “is pointing to a more U.S.-centric world because the impetus for growth is coming from the U.S. and that's where you are going to see the biggest impact,” Mr. Memani said.

That Mr. Trump “has a clean sweep (with Congress controlled by Republicans) adds a bit of certainty to everything,” Mr. Memani said. “The agenda is pretty clear cut and now they have the political power to get some of those things going.”

But others are reserved in their outlook.

A. Gary Shilling, president of A. Gary Shilling & Co., a Springfield, N.J.-based economic and investment strategy consulting firm, said: “Markets do anticipate ... but they really jumped the gun because it takes time to get fiscal action underway,” such as Mr. Trump's proposed infrastructure programs.

Mr. Trump “didn't exactly endear himself to everyone in Congress, running as an independent, so getting a program through Congress is not going to be a walk in the park,” Mr. Shilling said. And implementing an infrastructure program takes time, including the need for environmental impact studies. “You are talking more like 2018 or 2019 before really it gets tooled up,” he said.

James Paulsen, chief investment strategist, Wells Capital Management Inc., Minneapolis, said: “The underlying character of the economy is changing. A Trump presidency reinforces the trends that were already building prior to him winning the election.”

“How fast and how dramatic change will be from a Trump presidency is far overstated. The pace of change and the degree of change will be far less than currently anticipated. ... There is still a lot of gridlock and the change from (a Trump presidency) won't be nearly as dramatic as advertised,” he added.

But “the fact we are showing the ability to produce inflation is boosting (investor) confidence ... and maybe ... over the balance (will) bring some animal spirits (or bullish) behaviors we just haven't seen” among corporations and investors.

Aside from fiscal stimulus, the strategists see Mr. Trump trying to bolster the economy through tax cuts as well as deregulation of the financial market and potential restrictions on international trade.

“Protectionism is more likely to come before fiscal stimulus (in the Trump economic agenda) because the president has a lot more power in the international area than he does domestically,” Mr. Shilling said.

“The biggest geopolitical event in 2017 is probably going to be the prospect of trade friction,” Mr. Memani said.

The non-U.S. economy and markets are facing other issues.

“Overall in 2017 the markets aren't going to be the big area of interest, but political and military and terrorist events” will be, Mr. Coxe said. “This is going to be a really bad year for bad news. That will mean money will flow into the U.S. fleeing from elsewhere, but this (movement) will not lead to asset price increases because of so many bad news stories out there.”

In Europe, “there is a real possibility we will see a further upset” of populists over elites, Mr. Mackenzie said.

“The biggest worry for us is France,” Mr. Mackenzie said. Francois Fillon, the leading candidate, “would likely implement very radical policies, radical in the French context. He's a Thatcherite. After Trump and Brexit, it's possible Marine Le Pen (Mr. Fillon's chief rival) would win ... (and) that would be an existential crisis for the EU and the euro. Her politics are quite Trumpian in that she talks a lot about fiscal stimulus and try to break Europe from its misguided austerity view of the world, which would be positive” for the markets.

In France, Mr. Coxe sees “the good news is the middle-of-the-road parties have united behind somebody (Mr. Fillon) who is the closest thing to Ronald Reagan that France has ever produced.”

The bad news is he is going up against Ms. Le Pen, who “is going to go after public employee pension funds” and their excesses and employee regulations, risking general strikes “shutting down the system” and making “the country ungovernable,” Mr. Coxe said.

Mr. Mackenzie believes “the biggest question for markets is ... what's going to happen with the eurozone. The eurozone really isn't working for southern Europe and that politically is very dangerous. The buildup of these populist pressures may lead to necessary change, which might in the end help Europe in the long term, but it would likely be pretty destabilizing in the short term and be potentially bad for the markets.”

For his outlook Mr. Memani said: “Of the developed markets, Europe ends up as probably the weakest link for several reasons — higher level of political uncertainty, the risk to the euro because of that political uncertainty, and finally the (European Central Bank) finishing off with their quantitative easing (economic stimulus) program by the middle of (2017). ... All those things end up being a problem for growth and performance of European assets.”

Mr. Paulsen takes a different view. Investors “have chronically overestimated political volatility (and) fear ... about the eurozone blowing apart,” he said. “The reality is politics is pretty volatile, but the ultimate impact on the global economy is far less than currently feared, and that is going to be the case with all these elections” in Europe.

Economic growth in Europe “probably is going to be around 1%,” the same as 2016, Mr. Memani said, a rate “significantly lower” than his U.S. 2.5% real GDP growth outlook for 2017.

Mr. Mackenzie forecasts European GDP at 1.6%, about the same as his 2016 estimate of 1.5%

Mr. Coxe predicted “currency turmoil of a level I haven't seen before. The euro is doomed,” he said, seeing it fall to 80 cents against the dollar in 2017.

The pound will benefit, taking up outflows from the euro, Mr. Coxe said. Eurozone investors “aren't going to put all their money flowing out into dollars. Europe is going to need to have Britain in some way still part of Europe,” he said.

Mr. Shilling forecast the euro between parity with the U.S. dollar and $1.10. Mr. Memani forecast parity.

Mr. Shilling added: “Almost every other major central bank (is) trying to trash their currencies against the dollar because they want to make their exports cheaper and stimulate their domestic economy. When you don't have home-grown growth, you basically want to get it through exports. The Bank of Japan and the ECB have been trying disparately to trash their currencies.”

Mr. Mackenzie sees the euro falling to 96 cents. But Mr. Mackenzie tempered worries, cautioning: “One thing that we've all been taught over the last six months is that big political shocks don't need to turn into big market shocks.”

Mr. Paulsen takes a contrary view, forecasting a rise in the euro to $1.20. “The dollar is peaking and is likely to come down in 2017,” Mr. Paulsen said. “Almost everyone thinks it's on a one-way freight train north. Why? Because the Fed is going to raise interest rates. But that is precisely the reason I think the dollar is going to go south.”

“Interest rates almost never go up in isolation,” Mr. Paulsen said. “The only reason rates go and the Fed starts to tighten (or raise rates) is because of concerns of overheated (economic) growth and inflation. And the worst thing for the dollar is inflation.”

“Inflation is the most destructive force against the value of the dollar,” Mr. Paulsen said. “When inflation expectations go up, the dollar comes down in value ... If that happens, there are a lot of portfolios that will need adjustment,” Mr. Paulsen said. Such a decline will boost international markets as well as commodities, which will aid emerging markets in particular, Mr. Paulsen added.

“Inflation hurts the U.S. more (because of its more consumer-based economy) than the rest of the world,” which is more industrial based, he said. “Inflation is going to be more beneficial to the rest of the world than to the U.S. and that will include currencies as well.”

Most strategists predict the total return, including dividends reinvested, of the MSCI Europe Far East Australasia index will outperform that of the S&P 500.

Outliers among investment strategists are Mr. Coxe, who predicts for 2017 a -12% total return for the MSCI EAFE and 2% total return for the S&P 500, and Mr. Shilling, who forecasts a negative MSCI EAFE total return and a 6% S&P 500 total return. “I don't have a number,” Mr. Schilling added about his EAFE prediction.

In other markets, Mr. Mackenzie said: “We are quite encouraged about the prospects of emerging markets assets. ... A lot of emerging markets are very exposed to commodity prices and (improvement) of commodity prices is also good for (their) growth.”

He takes a positive view on emerging markets in part “because Brazil and Russia are coming out of their recessions and are likely to deliver meaningful growth” in 2017. “That is also true for a number of other emerging markets that haven't done particularly well,” he said.

China, the biggest emerging market of all, “for 2017 is looking reasonably stable and for a fairly strong growth phase that is very significantly driven by fiscal and credit stimulus,” Mr. Mackenzie said.

But Mr. Shilling takes the opposite view on Brazil and Russia, saying they have “poorly managed current account deficits (and) not much in the way of foreign currency reserves. They tend to have higher inflation, weaker stock market performance, rising central bank rates and ... slower economic growth.”

With his contrary view, Mr. Mackenzie forecasts “emerging world (economic) growth somewhere around 4.8%” for 2017. “That's obviously a lot faster than developed markets and faster than it has been this year and the last couple of years,” Mr. Mackenzie said.

Mr. Mackenzie sees the dollar as the best asset class for 2017, while the worst will be the renminbi and long-duration government bonds in developed markets in the face of rising interest rates.

“Given government bonds in developed markets yield next to nothing, there is very little to protect you against a sell-off,” he said.

In Europe, “the picture ... is a little bit clearer,” said Mr. Mackenzie. “We already have an economic regime in place, which is fairly lackluster. But it's delivering a very slow recovery,” about 1% GDP growth. “We would expect that recovery to continue at a snail's pace with gently positive implications for European equities and nothing too frightening for European bond markets.”

In the U.S., Mr. Memani said: “The biggest risk for 2017 is either President Trump is not able to get the high level of fiscal stimulus the markets are now expecting him to deliver, or the growth impact of that stimulus is large enough so the Fed is forced into tightening (or raising its target interest rates) at a much more rapid clip” than expected.

The best asset class in the first half of 2017 will be value equities, propelled by earnings momentum and rising interest rates, he said. But Mr. Memani sees growth equities as the best asset class in the second half as inflation flattens.

Mr. Coxe said he believes “the best asset classes will be precious metals ... and the dollar.”

Mr. Shilling sees the Fed keeping rates at their year-end 2016 level. Rising rates are one factor in bringing economic expansion to a halt and creating a bear market in stocks, Mr. Shilling said. ”But I don't see them jacking up rates to the point they are going to kill the economy.”

“Central banks have basically admitted that monetary policy is impotent” for economic stimulus, Mr. Shilling said. He added that he didn't think monetary policymakers were irrational enough to raise rates and choke off a recovery.