Inaugurating 2017: Extraordinary optimism – extreme uncertainty
“2017 begins with a number of conflicting signals that need to clear the right way for market expectations to be met. In the aftermath of the US election, optimism has risen rapidly within a very short time frame. Simultaneously, uncertainty has stayed high. As usual, markets are front running reality, pricing higher growth for 2017. But this optimism cannot translate into higher growth in the midst of pervasive uncertainty. Something has to give, and the longer uncertainty stays high, the greater the likelihood of disappointments for financial markets.”
“Whether it’s about Trumponomics or global growth prospects in general, optimism requires a degree of certainty in order to translate into concrete investments, hiring and, ultimately, growth. Persistent uncertainty, on the other hand, is negative for growth. In reality, uncertainty and optimism cannot both stay high. Something has to give.”
Leaving 2016 behind, it’s time to take stock of the economy and markets heading into 2017. Although the most popular so called “Trump-trades” (in essence long developed market equities and short government bonds) are losing steam just days before Trump’s inauguration, there is still breath-taking optimism on both Main street and Wall street. This is mainly fuelled by hopes of unprecedented fiscal stimulus outside recessionary episodes from the incoming US administration. Equities are discounting a significant growth pick up without meaningful monetary tightening spoiling the show. Confidence among small- and medium-sized companies in the US is at the highest level since 2004 and US companies’ earnings estimates for the next year have not been revised down at the end of last year like they normally are.
All clear for 2017 then? Not so fast. Scepticism is warranted, especially as some markets seem to be priced to perfection when it comes to the overall economic outcome for 2017. More specifically, three inconsistencies underline the vulnerability of the markets heading into the new year. These conflicting signals need to be addressed the right way before we can deliver an optimistic outlook for 2017 as a whole.
First and foremost, the current optimism seems at odds with still high or even increasing uncertainty. Whether we look at investors, analysts, companies or consumers, optimism is all around. Take the bond market: the spread between European and US interest rates has risen to the highest levels since the 80s. To justify this, we probably need US growth to head back above pre-Lehman trend levels in the near future—which would require the absolute success of Trumponomics. At the same time, policy uncertainty is extremely elevated, not least caused by conflicting signals from the incoming US government. And although companies are becoming more optimistic, they also remain very tenuous about the future.
But whether it’s about Trumponomics or global growth prospects in general, optimism requires a degree of certainty in order to translate into concrete investments, hiring and, ultimately, growth. Persistent uncertainty, on the other hand, is negative for growth. In reality, uncertainty and optimism cannot both stay high. Something has to give.
Secondly, although inflation expectations have risen and investors increasingly buy into reflation trades (short bonds, long cyclical equities and growth sensitive commodities), markets are still only pricing two Fed hikes for 2017. If a regime shift in the direction of sustained higher inflation and higher real growth were to happen, the Fed would almost certainly be forced to hike more than two times over the next 12 months. Either the Fed is mispriced or too much of growth upside is priced into risk assets. It is difficult to see this scenario resolved in a way that is positive for markets (at least short term) because this would require either growth and inflation to disappoint or the Fed to tighten more than expected. One might be tempted to conclude that it’s just a matter of markets discounting more Fed hikes but we must remember the crowding out effects: Tightening more than expected would not go down well in equity markets and growth terms, as it would strengthen the US dollar further and raise long-term rates, amounting to increased tightening of monetary conditions.
Finally, equity market volatility has stayed surprisingly low although the range of outcomes both in economic and market terms has risen over the last few months. In other words, the tails of the outcome distributions are getting fatter. Even Fed members acknowledged “considerable uncertainty” at the latest policy meeting, with 6 FOMC members being more uncertain about growth, up from only one in September—not a sign of much confidence and not good for central bank credibility. We see a clear adverse relationship between central bank credibility and market volatility. Altogether, this should raise the demand and therefore the price for buying insurance against unexpected scenarios. Under such circumstances, the VIX (a proxy for the price of insurance and a market fear barometer) would normally rise. But it is currently at the lowest level in more than two years – clearly not consistent with the elevated policy and economic uncertainty we are seeing elsewhere. There might be some “volatility awakening” ahead.
2016 was a year of shock, relief, and hope: the year began with a growth shock and equity sell-off, followed by a relief rally fuelled by easing monetary conditions. After a BREXIT intermezzo, the second half of 2016 was about reflation hopes gathering pace, with risk assets getting an extra sugar rush after the US election. Now it seems markets are moving from hope to some kind of reality check phase as we head into 2017. Given wide-spread optimism and a crushing consensus on e.g. equity outperformance in 2017, this could lead to some disappointments. Potential triggers? The clearing of one or more of the above mentioned conflicting signals are obvious candidates. Each of these inconsistencies makes for a vulnerable macro- and market environment. This, combined with high valuation in most asset classes, gives us no reason to adjust return expectations for the coming 12 months upwards. In the same vein, safe assets have not lost their attraction despite the abundance of “regime shift” discussions.
About Nordea Asset Management
Nordea Asset Management (NAM, AuM 219 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 332 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.
Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.
Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.
*Source: Nordea Investment Funds, S.A., 31.03.2017
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