In the third extract from BNP Paribas Investment Partners’ informative overview of the investment outlook for 2017, Daniel Morris, senior investment strategist, outlines how the major asset classes are likely to perform in view of two key factors that he believes will make 2017 a very different year for investors:
- the election of Donald Trump as president of the US has the potential to dramatically change the direction of US inflation, interest rates, equity markets and GDP growth
- some central banks may begin to soften their quantitative easing (QE) policies, meaning that the long downward march in core government bond yields could finally be ending.
Looking at the broad asset classes, these are our expectations:
• equities should outperform fixed income
• corporate credit should outperform sovereign bonds
• inflation-linked debt should outperform nominal government bonds
• developed market debt should outperform emerging market debt
• particularly in the US, small and mid-cap stocks should outperform large caps and cyclical and value stocks should outperform bond proxies (equity sectors such as real estate, telecommunication services, consumer staples and utilities).
Developed market fixed income
The size, scope and funding of a US stimulus package under the new administration remains unclear. But even before November’s election, US Treasury yields had been expected to rise in 2017 thanks to increases in the federal funds target rate and rising inflation. The scope for higher inflation expectations is significant, in our view, as both core personal consumption expenditure (PCE) inflation and the core consumer price index have risen since 2015, while current inflation expectations are still below the average of 2014.
Any increase in Treasury yields should to an extent be moderated by foreign demand given the significant difference in spreads between US Treasuries and core European and Japanese bonds. At the same time, rising US rates typically pull European and Japanese interest rates upward.
As US interest rates rise, agency mortgage-backed securities could be one area of potential outperformance. Historically, when rates rise slowly, MBS have tended to outperform Treasuries given their typically shorter duration and higher yield. Security selection would offer opportunities to boost returns further.
The outlook for core eurozone government bond yields depends on the balance of power between rising US rates, modestly rising eurozone inflation, investor concerns about the sustainability and impact of quantitative easing, and European political risk. We expect the balance to tip towards higher rather than lower yields. ‘Peripheral’ market government bond spreads will likely reflect the ebb and flow of populist sentiment in each eurozone country; while we believe the political and financial risks in Italy, Spain and Portugal are meaningful, bond purchases under the ECB’s quantitative easing programme should cap any significant sell-offs, meaning that investors should look to buy on the dips.
Developed market equities
Given rising interest rates, the high valuations of bond proxies have become more of a worry to investors, although these sectors should eventually stabilise as dividends will still be attractive compared to what remain historically low bond yields. Although any correction in these valuations would restrain broader market returns, this could be more than offset by an equivalent bounce in the valuations of out-of-favour, lower ROE stocks. Volatility spikes due to monetary policy or political surprises will likely open up opportunities for active investors.
On top of monetary policy favouring European equities, the scope for earnings growth looks better in Europe over the medium term. In the short term, US equities could benefit from rising inflation, a government stimulus package, lower taxes and reduced regulation. In Europe, investors will be focusing on political risk with elections due in several major countries. While the fundamentals favour European equities outpacing the US, the eurozone recovery may yet again be delayed.
Emerging market fixed income
The siren call of emerging market (EM) debt yields has fallen silent as the prospect of higher US interest rates makes the extra yield in EM debt less attractive relative to the risk. A stronger US dollar will likely eat into the returns of local-currency EM debt. With spreads currently below average for the Emerging Markets Bond index (EMBI) and US yields rising, EM sovereign debt is unlikely to do as well in 2017. Investors may see better gains in corporate debt.
In our view, local currency sovereign bond yields are attractive relative to core developed market debt, but a rising dollar means some central banks may need to raise policy rates to defend their own currencies. Ultimately, there is still the scope for EM currency appreciation given how far many EM currencies have fallen since 2013, but investors may wish to hold off on buying.
Emerging market equities
The US election result presages trade concerns and a stronger dollar, which may offset equity gains, but we believe the gains will be enough to leave investors with positive relative returns at the end of the year. If the current worries about restrained trade prove unfounded, emerging markets could rebound sharply.
Emerging markets are still more attractively valued than developed markets. Margins are well below average for EM companies, in contrast to high margins in the US and, at best, average margins in Europe. However, any margin expansion appears likely in only two non-commodity sectors: information technology and utilities. It will need to expand beyond these for the market as a whole to sustain its appreciation, but barring a more sustained rise in the US dollar, EM equities should be able to outperform by the end of the year.