2017 global investment outlook updates
Thomas A. Nelson, CFA, Senior Vice President, Director of Investment Solutions at Franklin Templeton Solutions.
“We believe financial markets will begin to recognize tailwinds to inflation going forward. Improved employment indicators, along with proposals in the United States for increased infrastructure spending and trade protectionism, support a rise in US inflation expectations in the medium term, in our view. Our outlook is most favorable for assets we view as having attractive relative valuations, such US Treasury Inflation-Protected Securities. Given what we have viewed as excessive developed-market government bond valuations, in particular those outside the United States, we favor cash as a way to remain moderately defensive and tactical in 2017.”
Macroeconomic overview
A number of macro events in 2016 had meaningful impacts on financial markets, and each event has contributed to our outlook across asset classes. After being overwhelmed by deflationary pressures over the past few years, developed-market (DM) central banks have, in our opinion, exhausted operational tools. Low global growth has sparked ubiquitous support for fiscal stimulus in DMs, which was expressed in promises from both the US Republican and Democratic 2016 presidential candidates for increased infrastructure spending. We believe that financial markets will recognize tailwinds to inflation in 2017. Improved employment indicators, along with potential proposals in the United States for increased infrastructure spending and trade protectionism, support a rise in US inflation expectations in the medium term, in our view. In contrast, we believe subsiding inflation from elevated levels in emerging markets (EMs) leaves room for greater monetary policy flexibility in contrast to DM peers. Evolving policies suggest to us that the current market cycle is likely to extend for several more years.
Cross asset
Our outlook is most favorable for assets we view as having attractive relative valuations, such US Treasury Inflation-Protected Securities (TIPS) and EM equities to a lesser extent. Meanwhile, our outlook is bearish for assets that we find the most overvalued, such as DM government bonds outside the United States. We held a moderately defensive view of risk assets leading toward 2017. However, given what we viewed as excessive DM government bond valuations, in particular those outside the United States, we favor cash as a way to remain moderately defensive and tactical in 2017.
Global corporate profit margins and economic sentiment as of November 2016 both suggested to us challenging performance potential for global equities. Falling global real credit growth and elevated global equity valuations relative to history each have historically been negative indicators that we believe support a modestly defensive stance. While negative macro indicators have left us moderately bearish on equities, select indicators improved in 2016 and tempered our defensive positioning. Sideways-moving but positive global purchasing managers’ index readings and earnings-per-share momentum in 2016 have each been bullish growth indicators for global equities and global bonds, in our view. In addition, supportive financial conditions in the United States and a large pickup in narrow money growth have also supported risk assets. While equity valuations relative to history were elevated as of November 2016, valuations relative to DM government bonds supported equities, based on our analysis. US President-elect Donald Trump’s proposed initiatives regarding infrastructure investment, increased defense spending, tax reduction and simplification, and deregulation may, in our opinion, warrant selectively heavier exposure to risk assets going forward.
Global equities
Consistent with our long-term capital market expectations for different asset classes for the next five to 10 years, we feel that within global equities, there is opportunity in EMs relative to DMs. This view reflects economic trends, flexibility in monetary policy, corporate fundamentals and valuations as of November 2016. However, in the short term, there may be headwinds for EM countries, given greater macro uncertainty with the incoming US Republican administration. Leading economic indicators in EMs have been showing improvement, both on an absolute basis and relative to DMs. In contrast, such indicators have shown significant slowing in DMs in late 2016. For example, the Organisation for Economic Co-operation and Development leading economic indicators for EMs were stronger relative to DMs. The combination of positive interest rates and positive-but-falling inflation led us to conclude that EM central banks have more flexibility in monetary policy than many DM peers. In our view, central banks in DMs appear more constrained and have largely exhausted their operational tools. Donald Trump’s campaign promises and policy proposals, such as trade protectionism, may pose risks toward emerging markets, but as of this writing these policies still would have to overcome checks and balances in the US Congress, even with a Republican-controlled Senate and House of Representatives.
The path of corporate fundamentals diverged for the 12-month period ended November 2016, and we see this trend continuing. EM corporate fundamentals generally have been poor but stabilizing, while DM fundamentals have been deteriorating. In broad terms, EM companies demonstrated improvement, albeit from an extremely low base, across many fundamental metrics, including revenue growth, earnings growth and earnings revisions. From a valuation standpoint, EM equities had significantly lower valuations across several key measures, including price-to-sales (P/S), price-to-book, price-to-cash earnings, and trailing and forward price-to-earnings (P/E) ratios as of mid-November. Given the increased level of share buybacks in DMs, we believe P/S ratios provide the most potent measure of value. Based on our analysis, gains for DMs have been driven largely by expansion of P/E ratios, rather than growth in earnings.
Fixed income
We hold a favorable outlook for US inflation-protected assets as we approach 2017, primarily due to what we view as attractive valuations, improved employment data and increased inflation expectations. From our perspective, the US Treasury market has been excessively pricing in sluggish growth and a conservative path of interest-rate hikes in the medium term. Therefore, we view valuations for US TIPS breakevens, which reflect the difference between the yield on a fixed-rate bond and an inflation-linked bond, as attractive. US employment indicators have been improving and should bode well for wage gains going forward, in our opinion. We believe some of the sluggishness in wage gains in 2016 can be attributed to low-skill workers reentering the labor market. One of the more comprehensive measures of wage data, the Atlanta Fed Wage Growth Tracker, revealed in late 2016 a more precipitous rise in wages than average earnings. As the tracker is not impacted by the changing composition of the labor market, we believe it represented a more reliable indicator of wage growth.
While shelter and core goods inflation remained relatively stable year-over-year in late 2016, core services inflation, excluding shelter, was trending up, which supported TIPS breakevens. The potential trends for higher oil prices and a more stable US dollar also suggest to us that inflation could pick up, as the direction for both has tended to precede Consumer Price Index performance by six months. Although select economic indicators have weakened in recent months, third-quarter US gross domestic product growth improved, reflecting increased exports and inventory investment. However, consumer spending slowed. Globalization is an inherently deflationary force. Rising protectionism, greater infrastructure investment, increased defense spending, tax reduction and simplification, and deregulation would all likely be inflationary. Increased fiscal spending is a policy proposal that has been advanced by both US Democrats and Republicans that is also gaining traction among DM peers.
We have an unfavorable outlook for non-US DM government bonds, such as German Bunds. As of November 2016, what we viewed as high valuations and stretched technical conditions supported our view that non-US DM government bonds could face performance headwinds. For example, we believe yields on five-year German Bunds were extremely overvalued, which indicated to us asymmetrical risk and reward. The European Central Bank (ECB) stated in 2016 it will not buy German Bunds with a negative yield lower than -0.40%, and we believe the ECB is unlikely to cut rates further, which in our view limits a continued rally going into 2017. The transmission mechanism of monetary policy in Europe has been showing gradual improvement, which may lead to an upside surprise in growth and inflation, and leave German Bund yields vulnerable to spread widening, in our view.
