2016 was another year of thrills and spills for global financial markets, and 2017 is likely to prove just as tumultuous.
This year began with great fear and trepidation over potential interest rates hike in the United States. But we’re now finishing the year relaxed and comfortable (at least for now) about US interest rates, and – even more importantly – buoyed up about potential US fiscal stimulus under President-elect Donald Trump.
Australia’s S&P/ASX 200 Index, for example, ended 2015 at 5,295 points. By 10 February, however, the market had already shed 10% to be down to 4,775 points – in what was one of the worst starts to a calendar year in history. As is usual, we had followed Wall Street down, with the S&P 500 also dropping by just over 10% over the same period.
What had the market worried was that the Fed had indicated – after it hikes rates in December 2015 – that it planned to raises rates four more times in 2016. In turn, this has led to US dollar strength and fears of capital flight from vulnerable emerging market economies.
But then things changed.
Fearing a market bloodbath, the Fed quickly backed away from its threat to raise rates anytime soon. China also unleashed more policy stimulus to support its flagging economy – which, along with a weaker US dollar due to a more dovish Fed, set us up for a year-long rally in commodity prices.
And following further (momentary) market upheaval in the wake of the United Kingdom’s “Brexit” decision in June, the Fed became even more dovish, while other central banks also quickly promised to flood their markets with liquidity if need be. As it turned out, the floodgates did not need to open as markets soon concluded Brexit, while possible a huge challenge for the UK, was no big deal for the much larger global economy.
The only other time markets were tested in 2016 was in the lead up to the US Presidential election, when polling indicated the “loose cannon” Trump had a shot at victory. The received wisdom at the time was that, while a Trump victory remained unlikely, there was a risk of a major market meltdown if he did.
As it turned out, of course, Trump not only won – but markets quickly rallied rather than collapse, as investors started to focus on his promise of fiscal stimulus through tax cuts and increased spending on defence and infrastructure.
And in a nice bookend to the year, the Fed finally did raise rates only a week ago, and is now promising to raise rates a further three times in 2017. And so far at least, the market seems to have taken the Fed’s intentions well in its stride. Fed action and the promise of fiscal stimulus has also caused a major rebound in bond yields, with US 10-year bonds yields lifting from a low of 1.4% mid-year, to a recent high of 2.6%.
All up, based on recent pricing, the S&P/ASX 200 has managed to edge up just under 5% so far this year – reflecting a modest 1.5% gain in forward earnings (largely reflecting a rebound in resource sector earnings expectations), and a lift in the price-to forward-earnings ratio from an elevated 15.6 to an even more richly priced 16.1. America’s S&P 500 has done even better, rising so far by 10% – reflecting a slightly better lift in earnings, and further gain in already rich price to earnings valuation from 16 to 17.
Reflecting the rebound in bond yields since mid-year, we’ve also seen important sector rotations take place – namely investors switching from “bond proxies” such as listed property and utilities, to more cyclically orientated sectors like resources, together with financials.
Where to from here? First and foremost, bond yields seem likely to rise further – with US 10-year yields possibly breaking through 3% at some point. This should also be associated with a rising US dollar.
Given US-led rising bond yields, still high valuations pose a challenge for equity markets heading into 2017. Indeed, markets are counting on a decent upturn in earnings – via the “Trump stimulus” in the United States, and sustained higher commodity prices in Australia. It’s this hope that so far at least has markets not worrying too much about what the Fed is planning to do.
My fear is that earnings won’t show the strength the market is hoping for. In the United States, a tightening labour market is already causing wage inflation to rise, which could squeeze profit margins, while US productivity growth remains abysmal.
Indeed, the risk is that US inflation may heat up more quickly than expected, especially if Trump ushers in a quick round of tax cuts.
In Australia, meanwhile, economic growth remains relatively more sluggish, and there’s a good chance the RBA may in fact cut rate again by May next year – which would favour bank stocks and should help lower the Australian dollar. The commodity price rally, however, seems unlikely to be sustained, due to both an ongoing lift in supply, and a likely winding back of Chinese stimulus in the face of renewed price pressures in the housing sector.
Investors also have to deal with potential new shock waves in Europe, given several important national elections in France, Germany, the Netherlands (even possibly Italy) which could see populist anti-EU parties take on added power. There’s also uncertainty around a Trump Presidency, especially the potential risk of a tit-for-tat trade war between the US and China under his belligerent leadership.
Heading into 2017, investors can be sure of one thing: the thrills and spills seen this year are likely to continue.