Some second thoughts after a solid start

Dave Mohr, Chief Investment Strategist at Old Mutual.

Izak Odendaal, Investment Strategist, Old Mutual Multi-Managers.

Following a strong December, global equity markets continued to rally in January on the so-called “Trumpflation” trade, i.e. the expectation of faster growth, lower taxes, deregulation and higher inflation. The benchmark US S&P 500 Index hit record highs and returned 1.9% in January.

The FTSE/JSE All Share Index delivered a higher return in January (4.3%) than during 2016 as a whole, thanks to another strong month for Resources and Industrials (Financials were negative). The global market sell-off in January 2016 led to particularly strong one-year returns on many indices. The S&P 500 was at 20% and the All Share Index at 10%.

The rand gained 1.9% against a softer US dollar in January, lifting the 12-month appreciation to 17%. In the first few days of February, the rand brushed off the latest Cabinet reshuffling rumours, remaining on the front foot.

The MSCI All Countries World Index returned 2.7% in US dollars in January following a 2% gain in December as global growth prospects improved. The softer dollar in January also boosted the index. Although the new Trump administration poses major questions for emerging market investors, January was a strong month for emerging market equities, with the MSCI Emerging Markets Index returning 5.5% in dollar terms, with 1.5% of that gain due to currency appreciation against the dollar.

The emerging market that is most exposed to changes in US policy is Mexico; the combination of exports to and remittances from the US is around 30% of its GDP. It is no surprise that the Mexican peso lost 14% against the US dollar over the year to end January. In contrast, the currencies of Brazil and Russia – both commodity producers – appreciated by more than 20% against the greenback over the same period.

An era of unpredictability

However, it seems that doubts are creeping in for investors. The outlook for the US economy remains positive, but policy uncertainty is high. The modern era has never before experienced such unpredictability from the Oval Office. The first few days of Donald Trump’s term showed that he was serious about implementing many of the controversial pledges he made on the campaign trail. He pulled the US out of two massive multilateral trade deals, threatened to impose a tariff on Mexican imports, ordered the construction of a wall on the Mexican border and instituted a ban on entry to the US from seven majority- Muslim countries. He also fired the acting Attorney General, a rare act.

Return to currency wars?

The US dollar in particular seems to reflect those doubts. It has lost some ground since Trump’s inauguration, and also poses a challenge to his agenda:

Faster economic growth and higher interest rates can be expected to drive the dollar higher, but a stronger dollar would harm US manufacturing and largely offset tariff increases. It has long been the US Treasury’s stated view that it welcomes a strong dollar since it reflects a strong US economy. This could be changing. In the past week, Trump accused China and Japan of devaluing their currencies, while his trade advisor, Peter Navarro, criticised Germany for benefiting from a cheap euro at the expense of the US. It is true that the euro is weaker than the old Deutsche Mark would have been, thereby supporting Germany’s export engine. But it is certainly not German policy to push the euro down as there is almost no nation on earth that is more afraid of inflation and places more value on stability.

The White House has not attacked the British for having a weak currency (yet!). The pound has made some gains over the past month, but remains at a 30-year low against the US dollar as the House of Commons passed a bill that would give official notice to exit the European Union, the first step in parliamentary approval. The weak pound has done wonders for the FTSE. But it is also resulting in a sharp increase in inflation that the Bank of England (BoE) now has to manage amid great uncertainty over the economic outlook. Against expectations of a post-Brexit recession, the UK economy turned out to be the fastest growing major developed country in 2016, with 2.2% growth. But this is unlikely to last, as the Brexit journey “is really just beginning”, as BoE Governor Carney noted.

Inflation rising but still low

Inflation is on the rise from very low levels elsewhere in the developed world, and not just due to currency movements. This is partly because of the higher oil price, but to the extent that it reflects improved corporate pricing power stemming from a better business environment, it is a positive development. Certainly, the deflation fears that stalked markets in the middle of last year have faded, and bond yields have moved up substantially since then, with benchmark German and Japanese 10-year bond yields no longer negative. There is a slight risk that central banks increase interest rates too early in response to the incipient rise in inflation. The risk is still small, because the lesson of the past eight years is clear: countries that hiked too early (such as Sweden and Israel) ended up having to cut much deeper. The European Central Bank is probably most at risk, since it has a history of premature rate hikes and pressure from Germany where unemployment is at record low levels (unemployment for the Eurozone continues to decline, but is still at a high rate of 9.6% ). The Federal Reserve kept rates unchanged at its policy meeting, and offered little by way of future guidance except to note that gradual interest rate increases are still warranted.