If 2016 is anything to go by, investors could be forgiven for feeling cautious about the new year.
No-one could have predicted the events of 2016 – not least the UK’s vote in favour of leaving the European Union (EU) and the election of Donald Trump as the next US president.
Markets have similarly surprised through the course of 2016. In January, the outlook was negative as global equity markets tumbled and the oil price fell to a low of $27 per barrel.
However, since early February markets have been surprisingly robust – regardless of what has been thrown at them. Trump’s election, the ‘Brexit’ vote, Italians voting against constitutional reform and a Federal Reserve interest rate hike have done very little to spook investors.
That is not to say that 2017 is set to be plain sailing. Here’s what the new year could have in store, according to fund managers and investment strategists…
Next: the rotation to value
The great rotation into value stocks
Very few commentators could have forecast that the FTSE 100 would breach the 7,000 mark by Christmas, six months after the UK voted to leave the EU.
Following a negative start to the year, mining stocks enjoyed the biggest gains across the FTSE 100. Anglo American (AAL) led the way, up 276.4% between January and 22 December. This rebound marked the start of an investor shift into more economically sensitive stocks, which gathered speed during the second half of the year.
Will this continue? Alastair Mundy, manager of the Temple Bar (TMPL) investment trust, believes the rotation has further to go. When you take the recent bounce for value stocks out of the equation, the discrepancy in the performance between value and growth stocks remains at extreme levels.
‘Historically, when such extremes have been reached, the subsequent outperformance of value has been both substantial and sharp,’ he added.
The fund manager is bullish on banks, where he says valuations look cheap. He also feels positive about another unloved sector – the supermarkets.
Simon Brazier, manager of the Investec UK Alpha fund, highlights protectionism as a concern for 2017, given the global nature of the UK market. As there are question marks surrounding the direction of interest rates and Britain’s future trade agreements, he suggests focusing on companies that can grow cashflows and reinvest them – regardless of the economic backdrop.
Next: will Trumponomics spur US rally?
Will ‘Trumponomics’ spur next leg of US rally?
Although Trump’s election as the next US president came as a surprise to many, a number of commentators expect his ambitious plans for infrastructure spend and tax cuts will spell good news for US equities and economic growth.
The US was selected as the country expected to deliver the strongest gains next year by investment trust managers, responsible for £25 billion of assets collectively, who were surveyed by the Association of Investment Companies.
Zane E Brown, strategist at investment firm Lord Abbett, is particularly positive about Trump’s plans to lower corporation tax and repatriate cash held by US corporates. When a similar programme was implemented in 2004, it created jobs and increased dividends and share buybacks – and he would expect to the same thing to happen this time around.
‘In the context of a Trump presidency, US-centric stocks, such as mid and small-caps, face fewer challenges than larger, more globally-focused firms,’ he noted.
However, Tilney Bestinvest’s managing director Jason Hollands says US equities are not a screaming buy, as valuations look expensive relative to history.
‘Current eye-popping valuations make an aggressively bullish stance feel uncomfortable at a time when central banks are going to be withdrawing vast amounts of liquidity,’ he added.
Next: a new era for central bank policy
A new era for central bank policy
The election of Trump and the Federal Reserve’s decision to raise interest rates in December has been hailed by some as the start of a new era for central bank policy.
Many fund managers believe that fiscal policy – which relates to government spending and tax rates – will now drive future interest rate decisions. It will become more important than monetary policy, which has been the key determinant since the financial crisis and focuses on the growth of money supply.
Since Trump’s election, US bond prices have tumbled as investors anticipate a faster pace of interest rate rises, eating into the value of the fixed coupons they pay. US 10-year Treasury yields have risen to 2.55%, up 0.32% over the year. Yields have an inverse relationship with bond prices so when they rise bonds fall in value.
Yields on 10-year UK government bonds, or gilts, have similarly moved upwards to 1.37% from 0.54% in August, as a result of higher inflation expectations caused by weaker sterling.
BlackRock’s team of strategists believe that we have seen the low in global government bond yields and the only way is up. Barring a big shock to the global economy, they expect to see this trend in the US and Europe.
Luca Paolini, chief strategist at Pictet Asset Management, agrees. He describes the backdrop for bonds and dividend-paying stocks as ‘pretty grim’.
Next: sterling recovery
In a year that has been marked by a depreciation in sterling and dollar strength, currency has played a role in driving returns. This is particularly relevant for FTSE 100 companies, which collectively derive 70% of their earnings outside the UK and have therefore benefited from sterling weakness.
Tilney Bestinvest points out that if you re-run the data for certain indices in local currency rather than sterling an ‘altogether different picture emerges’.
‘For example, instead of a stellar 20.7% gain from Japanese equities (Topix) in sterling terms, in local currency terms Japanese equity returns were actually negative (-3%) in total return terms,’ explained Hollands at Tilney Bestinvest.
Looking ahead, Hollands expects sterling to appreciate in 2017, especially against the euro. This could happen if there is a pick-up in bank lending, robust economic data and inflation coming through, which would cause interest rates to rise and quantitative easing to come to an end.
Paolini at Pictet Asset Management suspects the US dollar will strengthen in the coming months due to higher US growth and more interest rate hikes than are currently priced in.
Next: Europe faces political uncertainty
Europe faces political uncertainty
The future of the eurozone and the European Union faces challenges in 2017, as countries across the continent prepare to go to the polls next year.
Some commentators fear that the ‘Brexit’ vote is a sign of things to come in Europe, as populist, anti-EU parties continue to attract support. Meanwhile, Italy faces fresh political uncertainty after the public voted against constitutional reform, sparking the resignation of prime minister Matteo Renzi.
‘Radical or populist parties do not need to actually win elections to exert influence, as the threat insurgents pose can often result in established parties shifting their policies in response, as we are seeing in the toughening stances on immigration in France from establishment politicians,’ Tilney Bestinvest’s Hollands noted.
So what does this mean for European equities? Paolini at Pictet Asset Management, believes European stocks look attractive over the medium-term, but notes ‘there are good reasons why they look cheap’ right now.
He suggests that a market rally looks unlikely until the fog of elections has cleared during the second half of 2017.
Next: will the sun rise again in Japan?
Will the sun rise again in Japan?
BlackRock’s team of strategists highlight Japanese and emerging market equities as having the potential to perform in 2017 – as long as they are not affected by trade tensions.
Luca Paolini at Pictet Asset Management shares this view.
He rates Japan as a buy because the market looks cheap and the country has positive economic prospects.
‘Japan also historically benefits from a global reflation scenario. Some of the best opportunities can be found in Japanese financials as the improving economic outlook bodes well for credit demand,’ Paolini explained.
Meanwhile, he notes that emerging market equity valuations look cheap. When you throw in structural reforms, recovering commodity prices and improving investment flows the picture looks even more positive. However, he says selectivity is key.