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What we got right and wrong 2017

Just before we get into the festive spirit at 7IM, we like to reflect on the year that has passed. At the end of each year, we look back on the predictions that we made twelve months previously. Below, we try to take an objective look at how well we did at forecasting events in 2017, both right and wrong.

At the end of 2016 we wrote:
Our positive economic outlook for 2016 was pretty much correct, and at the end of the year, it looks as if markets reflected that growth – with almost all major equity indices in positive territory. The healthy growth of the UK and the US translated to the stock markets outperforming the slightly more sluggish Europe and Japan. By the numbers, 2016 seems to have been something of a conventional year…
However, you would be hard-pressed to find anyone, inside or outside of financial markets, who’d agree with 2016 being ‘conventional’. The prevailing theme was the rejection of the status quo in almost all popular votes – with a secondary impact being that ‘opinion pollster’ might not have been the best thing to list on your CV.
In addition to Brexit and the rise of President Trump, we also saw a bank bailout in Italy, a second interest rate rise from the Federal Reserve, the return of Iran to polite global society, and new all-time highs made in the Dow Jones and S&P 500 equity indices.
Almost all reviews of the year are looking to paint 2016 as a kind of turning point – for capitalism, for globalisation, for fixed income – the list goes on. In reality, it will be decades before anyone can even start to work out whether that is the case or not.
So rather than try to extrapolate the last year into a long term change in our world view, we will concentrate on the next 12 months – both the upcoming events and their possible interpretation by the financial markets.
2017 – Expecting the unexpected

Global economic growth is healthy. Now people need to start believing in it! Years of emergency monetary policy have left confidence near all-time lows, with any positive news being dismissed as artificially induced. We feel that there are enough widespread positives for the expansion to continue, even in a rising rate environment…

Review: Correct. In fact, not optimistic enough about the strength of the synchronised expansion. Economic growth in all major regions is positive and for the first time since 2012, global GDP growth forecasts are being revised upwards for the next two years. We have seen three rate hikes from the Federal Reserve, and no sign that this is stifling the world economy.
…but sentiment is still fragile. Investors are desperate to believe in a surging US consumer, but any evidence to the contrary could see violent market moves. It is almost a given that there will be one or two anomalous data points that see temporary doubt creep in – a weak jobs number, or a decline in house prices – something that will be taken badly with markets near all-time highs.

Review: Incorrect. Whilst overall data flow has been positive, there have definitely been potential market-moving moments where economic data has dipped. In the face of these disappointments though, markets have rolled relentlessly higher – volatility has been so notably missing from markets this year that its absence has started making headlines. The S&P 500, in particular, has been unstoppable, closing higher on 25% of its trading days!
The backlash against globalisation seen in 2016 will have repercussions in 2017. Whilst trade agreements are clearly at risk, it is the extension of similar policies to non-economic relations that is most worrying – a decline in the influence of conglomerate bodies such as the UN or NATO would give markets pause.

Review: Incorrect. The threat to globalisation has, so far, been more imagined than real. Existing trade agreements have remained in place, and no large international organisation has disintegrated (yet). And although Trump did back away from the Trans Pacific Partnership negotiations, discussions have forged ahead. In fact, a lot of the populist backlash seemed to have abated – in European elections for example.

In any given year, there are going to be wildcards – unexpected events that disrupt the perceived order of things. For 2017 though, surprise is the consensus. The political turmoil in 2016 has prepared the ground. There are thousands of different ideas of what these wildcards could be, but everyone is now basically waiting to be surprised. Does that mean the markets will be less, or more reactive? Our view is that whilst very short term volatility might increase, it will be more important than ever to look through to something approaching a sensible investment horizon.

Review: A bit of both. There were wildcards, but very little volatility. In terms of surprises: Macron winning the French election; Trump firing most of his close cabinet; North Korea firing missiles; Catalonia declaring independence; the list goes on. The real surprise, however, was that most risk assets seemed to take the same pragmatic view and looked through the political shenanigans.

Looking in more detail at the various regions:

US

Domestically – lots of talking, far less walking. A common analogy used to describe calm but effective people is that of a swan – serene on top, but lots of work going on under the surface. For Donald Trump’s presidency, an upside-down duck might be more appropriate (or a tortoise on its back) – lots of action, with very little achievement – at least in the sense of genuine policy being implemented.
Review: Correct. Although perhaps we could have used “tweeting” rather than “talking” in our first sentence. It is common knowledge that the US political system is built largely to prevent any serious decision being taken, and Donald Trump appears to be finding that out (although he might not admit it).
Overseas – talking may be enough. In a legislative sense, the President has more immediate control over US foreign policy than he does domestic. Yet given that much of international relationship management is conducted through the media, even that legal power may not be needed. As President-Elect, Donald Trump’s public statements have been… less than judicious. As President, some of the same statements may be more difficult for foreign nations to ignore. There is a worrying possibility that in 2017 one man’s Twitter feed will frame the global agenda.
Review: Correct. Clearly most of the diplomatic relations between North Korea and the US are now conducted via Twitter (except where Dennis Rodman is involved). There has been no appreciable decline in the President’s Twitter usage since taking office. It remains to be seen how seriously foreign politicians are taking these announcements. We have also seen worrying unilateral moves from Trump such as withdrawing from the Paris climate change agreement, and the recognition of Jerusalem as Israel’s capital.

Boringly stable growth. The US economy has been growing at an average of 2% a year since 2010. It is really very hard to impact an economy. Whilst there are doom-and-gloom predictions out there, most of 2017’s growth will be dictated by the forces that have carried over from 2016 – which means lower unemployment, higher wages and high consumer spending.

Review: Correct. The US economy hasn’t seemed to need much in the way of assistance from the White House; we are on track for a 2% GDP growth figure in 2017, driven by the forces mentioned above. As such, the Federal Reserve’s three rate rises look to have been sensible.

Inflation moves above the Federal Reserve target. If the oil price remains around US$50 a barrel, the mathematical impact will be to push inflation up throughout the first three months of 2017. Add into the mix the benign growth environment mentioned above, and suddenly the Fed target of 2% looks likely to be breached to the upside for the first time in two years. This should lead to the rate-hiking cycle beginning in earnest.

Review: Incorrect. In January and February, we did see the inflation figures rise as forecast. However, throughout the year, we saw healthcare service costs fall, which dragged the broader measures down. In addition, the continued rise of the influence of Amazon put pressure on retail prices across the US.

US Treasuries under pressure. With both inflation and interest rates rising, US Treasury yields are likely to join the club. In theory, this should be a gradual, gentle rise as the data continues to be positive. In reality, we expect sharp sell-offs, followed by periods of drift. It is likely to be the unexpected volatility of the bond markets that drives cautious investors to cash.

Review: A bit of both. The US 10-year yield seems likely to finish the year roughly where it started. Looking at a chart though, the period was indeed dictated by sharp sell-offs, and then long slow rallies, before another sell-off. Investors haven’t yet abandoned the asset class.

Europe

More populist portmanteaus. A portmanteau is “a word blending the sounds and combining the meanings of two others,” and is seemingly what Europe focuses on most when facing existential crisis – Brexit and Grexit being the most obvious examples. In 2017 Germany, France and the Netherlands all have general elections, all with candidates who have gained ground in recent months on anti-EU platforms. With most media outlets looking to build a narrative of popular discontent sweeping the Western world, expect more linguistic mangling to come.

Review: Incorrect. We don’t seem to have any impending departures from existing organisations – indeed following Emmanuel Macron’s election, the European political landscape appears to have settled down considerably. We did see Catalonia unilaterally declare independence, but no clever wording to accompany it – our suggestion was Cat-ALONE-ia.

No break-up of Eurozone. Anti-EU parties will do well next year, and as we saw with UKIP in the UK, outright victory is not necessary to cause dramatic change. Yet we do not believe that the Eurozone will split in 2017. On the continent, there is greater popular support for the European project than in Britain – populist victories are more likely to provoke change within the structures of the Eurozone, rather than an exit from them.
Review: Correct. Populism lost a little bit of momentum in 2017. Overall, polling of European countries shows slightly more support for the EU institutions compared to the start of the year. Perhaps the unedifying spectacle of the Brexit negotiations have had something to do with that.

Fiscal stimulus. A simple change in Eurozone policy would be to loosen fiscal deficit targets, allowing more borrowing (at ultra-low rates). Enough political turmoil could lead Eurozone authorities to acknowledge that this is the less ugly of their options – allowing pressured governments to buy off unhappy voters with increased spending or lower taxes.

Review: Partially correct. France passed some extraordinary budget measures, but this was in response to a terrorist attack, rather than due to popular discontent – similar to Germany two years ago when it faced the wave of refugees.
(Also) boringly stable growth. It has been easy to miss the fact that Eurozone growth has been improving for three years now. Europe remains some years behind the US in terms of recovery from the Financial Crisis, but the trend is upwards. Quantitative easing, despite skepticism, looks to have been a success at buying time for the financial system to stabilise and genuine growth shoots are coming through. We expect to see another year of expansion at around 1.5%.
Review: Incorrect. We were too pessimistic – Eurozone growth looks like coming in at around 2 to 2.5% in 2017. Continued consumer optimism in Germany has started to be matched in some of the peripheral nations as the unemployment rate kept falling. A positive global trade environment has also added to the upward momentum.
No deflation and no tapering. The European Central Bank (ECB) has shown its willingness to keep the taps firmly open in a bid to restore inflation to the economy, regardless of pressure from German economists to tighten policy. With asset purchases in the pipeline until at least September 2017, we have no expectation of materially tighter policy in the Eurozone.
Review: A bit of both. We haven’t seen deflation in the Eurozone, with the figure remaining above 1% all year. However, we have seen some adjustments in the ECB asset purchases, with the amount being cut from €60bn a month to €30bn from January 2018. However, Mr Draghi was also very careful to emphasise that the programme remains open ended, and could continue for longer than people expect. So it’s tapering of a very gentle sort.

Japan

A winner in a Trump trade war? For some reason, Donald Trump does not seem to be targeting Japan in his trade renegotiating rhetoric. It may be because he believes the US won that particular trade war at the end of the 1980s, and therefore there is nothing left to be proved. Regardless, it seems that Japanese exporters would be relatively immune from a trade ‘war’ – despite the Yen weakening once more.
Review: Incorrect. We haven’t really seen a trade war in 2017 – just a lot of rhetoric. Japanese exporters have done well this year, but this has been down to the benign global growth environment and trade helping to generate decent corporate profits.
Weaker Yen. For many Japanese investors, the rise in US bond yields has prompted a shift from Yen based assets to US Dollars. In fact, Japan has recently overtaken China once more as the largest owner of US Government bonds. Should this capital flight continue, we would expect to see the Yen continue to depreciate throughout 2017.
Review: Incorrect. The Yen has largely remained stable in value against the US Dollar in 2017. Part of the reason for this may well be that foreign investors are finally returning to the Japanese equity market, enticed by high earnings and attractive valuations.
Economic growth sluggish, but positive. Once again, Japanese economic growth is likely to underwhelm relative to the rest of the developed world – although the weaker Yen should help. However, even coming in at 1% expansion would be in line with the 10-year average.
Review: Incorrect. Japanese GDP growth estimates have been continually revised upwards throughout the year, and the final figure for 2017 is likely to be around 1.5%. Inflation is still stubbornly refusing to come through.
Abe needs to produce something special. Should Prime Minister Abe wish to be at the 2020 Olympics (as PM, rather than in a Super Mario costume), he needs to change his internal party rules to allow him to lead for a third term. However polls show that a majority of the Japanese people would not support such a move. Although Japan is historically less likely to see the kind of populism seen elsewhere in the world, without a dramatic policy announcement sometime this year, Abe could well finish 2017 with a political battle on his hands.
Review: Correct. Abe did indeed face a political battle, with the Governor of Tokyo, Yuriko Koike, resigning from Abe’s Liberal Democratic Party to stage a populist-style challenge. However, the opposition parties became so fragmented that Abe ended up increasing his share of the popular vote. Bring on the Olympics!

UK

Article 50 is triggered… Second-guessing explicit government policy is tempting, but it seems most sensible to assume that Theresa May will stick to a declared date – why run the risk of being called incompetent?
Review: Correct. And after that it was smooth sailing…oh…wait.
…but will Brexit mean Brexit? And what does that phrase actually mean?! With Article 50 triggered, the main focus for 2017 will be on the negotiations. Unfortunately, trade negotiations take place behind closed doors, so there will be a large amount of supposition and guesswork on the part of the media, very little of which will give any real guidance as to how Britain’s relationship with the EU will look once the two year exit period has elapsed. Our best guess is that once discussions actually begin, business interests will begin to form pressure groups – similar to lobbyists in the US. The finance sector will need to find a spokesperson who can be trusted by both the UK government, and the UK public. Justin Urquhart Stewart?!
Review: Correct (but a cop-out prediction). Some progress has been made, in that the UK and the EU have now entered the second stage of negotiations. The business groups mentioned above have only been sporadic in making their views felt this year, but it may be that the trade negotiations give them the chance to become more vocal more often.
Inflation certain, at least on a temporary basis. For three years inflation has been well below the Bank of England’s 2% target – something unlikely to be the case in 2017. Over the long term, currency movements do not affect inflation. However, on a year-on-year basis, the 15% fall in Sterling since 23 June is going to be important. As most producers hedge their prices at least six months out, the first half of 2017 is likely to see CPI inflation continue to rise.
Review: Correct. Not a hugely difficult prediction, given the base effects. CPI inflation is now at 3%, a level not seen since 2012. The impact on consumers was not hugely noticeable throughout the year – perhaps due to the same suppression of prices as retailers suffer under competition from one another.
Growth dependent on consumer confidence. In a service led economy like the UK, most economic sins can be paid for as long as the man in the street continues to feel good about life. Around half the country are demoralised by Brexit, but remember that just over half of the UK have had their wish granted! Consumer confidence is hardly an exact science, but there is a decent chance that Brexit should be neutral for sentiment overall. If this proves to be the case, then GDP growth should surprise to the upside in 2017 – admittedly not a huge feat given current expectations of 1.2%.
Review: Correct. Throughout 2017 we kept hearing that official bodies were downgrading growth forecasts, and it is easy to forget that at the start of the year, the view was that 1.2% growth would be quite a feat. As it stands, UK GDP is likely to be around 1.5%, powered, as we said, by the consumer.

Emerging Markets

China internally stable, externally less so. The Politburo Standing Committee is responsible for most of Chinese government policy – and in autumn 2017 will undergo a reshuffle. With President Xi keen to maintain stability ahead of this change, economic bad news will not be allowed to disrupt events – bad loans will be rolled over, equity markets will remain supported by government funds and economic growth targets will be hit on the nose. President Xi may also be thankful for the fuss caused by the incoming US President. Any political discontent in China can be easily channelled abroad – fostering a sense of national identity coming under threat from Donald Trump.
Review: A bit of both. Absolutely right on Chinese economic and market stability. President Xi demonstrated at the National Party Congress that he is looking to consolidate power, and continue pushing China to escape the middle-income trap. In terms of external politics though, China has had a very good year; making a huge effort at Davos and at other regional summit meetings. Perhaps it is just relative to the mess that is US foreign policy at the moment, but China is coming across like the experienced diplomat.
China unites Asia? A move towards regionalisation around Chinese leadership is feasible. China is already looking to increase unity in the region under its ‘One Belt One Road’ policy. Pitched in the right way, this process could be accelerated if it is seen as a way of combatting anti-Asia US policies. For Taiwan and South Korea, this means choosing between a rock and a hard place; protecting growth at the expense of joining an age-old enemy.
Review: A bit of both. The US political withdrawal from Asia hasn’t yet occurred in a significant way – for now it is probably easiest to say that the approach is confused… China hasn’t particularly pounced on the opportunity; the Chinese-led Asian Infrastructure Investment Bank is lending money, but only US$3 billion over the past two years. Too soon to call.
India immune from Trump. We believe that India is well positioned to continue its strong growth. India’s economy is service led – particularly focused on information technology. This is not a sector that Donald Trump has paid much attention to, perhaps because there are very few disenfranchised US IT workers claiming that Indians have taken their jobs – and if there are some, they lack the unionised punch of the auto or steel industry. India, therefore, should be able to function reasonably freely, allowing the positive domestic story to play out.
Review: Correct. The Indian economy weathered the impact of both demonetisation and the Goods and Sales Tax introduction. Part of the resilience is due to the optimism inspired by Prime Minister Modi – recently voted India’s most popular leader. Belief in the government’s ability to change the economic fortunes of the lower ranks of India’s society has kept consumer confidence at around five year highs throughout the year.

Mexico to suffer, but then rebound. Mexican equities to be one of the top performers in 2017? This one might seem a bit unlikely, but eventually Pesos will be cheap enough for investors to start becoming interested. Any sign of conciliation from Donald Trump would also help improve sentiment.
Review: Incorrect. A punchy call to be fair. Mexican equities were one of the year’s worst performers, but they still finished comfortably in positive territory. The Peso has rallied back to the same levels as before the US election last November, and business confidence is near all-time highs. Again, Donald Trump’s bark has seemed to be worse than his bite with regard to trade sanctions and wall building.

This commentary has been produced by Seven Investment Management from internal and external data. You should not rely on it as investment advice or act upon it and should address any questions to your investment adviser. The value of investments can vary and you may get back less than you invested.

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