Investment Outlook 2017
January 25, 2017
by Reams Asset Management
2016 showed the peril and futility inherent in economic forecasting. Global interest rates confounded innumerable years of historical data with sovereign rates of many developed nations at negative levels, an entirely unprecedented event. Unorthodox central bank policy accelerated once more, with increased equity and fixed income market interference failing to generate tangible impact on global GDP growth or CPI inflation rates. The outcomes of the U.K. European Union referendum in June and the U.S. presidential election in November portend more unknowns than knowns, yet nevertheless led to a second half global rally in risk markets.
Against this backdrop, we enter 2017 in a world with even more questions than a year prior and, perhaps, fewer obvious answers. Unsurprisingly, economic forecasts run the gamut for the year ahead and yet fail to consider events or risks that will only be too obvious in retrospect.
The U.S. election results that elevated business magnate Donald Trump to president-elect, and the ensuing market euphoria, crystalize the need to lay out precisely what market participants are now anticipating in terms of the economic possibilities of a Trump administration. Most pressing is the re-introduction of potential fiscal stimulus referenced often by Mr. Trump, most notably in his acceptance speech immediately post-election.
Rather than throwing yet another jaded dart on the board to predict interest rates or GDP growth, the following analysis attempts to encapsulate the economic hot button issues we will be tracking, understand where the market consensus lies and identify where deviations from that consensus—and perhaps ensuing opportunities—may occur.
What are Reams’ Key Areas of Focus?
Fiscal Stimulus: Can it succeed where monetary policy has not?
- A combination of infrastructure spending, tax cuts, cash repatriation and regulatory reform could power additional near-term GDP growth
- Headwinds include Congressional willingness to pass reforms as advertised and in a timely manner
- U.S. dollar strength vs. global currencies could limit efficacy and dampen GDP growth
- Unprecedented use of fiscal stimulus so late in a business cycle and limitations of extensive debt growth are valid concerns
Monetary Stimulus: Waning appetite could remove the safety net of recent years
- The ECB and BOJ are questioning the efficacy of quantitative easing (QE) / bond buying programs
- Unconventional monetary policy has acted as a de facto “volatility dampener” by lifting asset values
- Absent this safety net, future expected volatility may be meaningfully higher than what has been witnessed in recent years
Tail Risks: Increased probability of downside risks as stakes are elevated
- Downside scenarios on either “tail” of the distribution of economic outcomes are increasingly plausible
- Heightened inflation growth and renewed bank lending could overshoot intended targets as fiscal stimulus and labor shortages lead to increasing prices in an “overheated” economic scenario
- Additionally, potential restrictive trade policies and/or tariffs could reduce the trade deficit at the expense of sharply higher rates
- Alternatively, if a recession or worse were to arrive globally, via a GDP collapse in China or elsewhere, central banks would have few tools to adequately combat the problem
- Baseline expectations, specifically in sanguine volatility as measured by the VIX Index, suggest that any deviation from the norm could lead to a meaningful shock to the financial markets
Globally: Exogenous factors have the ability to exert major influence on the economic trajectory in the U.S. and abroad
- China’s consistent GDP growth is suspect in both veracity and durability. The country’s tightly controlled economic levers have been used in unprecedented means to perpetuate growth, despite mounting evidence of asset bubbles in areas such as real estate
- U.S. dollar currency appreciation has been considerable since the election and, coupled with potential trade restrictions, may undermine U.S. multinational corporations who rely heavily on international sales
- Though unlikely to repeat the violent changes of 2015/16, global commodities could endure more volatility in the event of supply shocks or an economic downturn in China
What is the Consensus Viewpoint?
Per Bloomberg Survey Results (see table) economists collectively forecast a 2017 GDP growth rate of +2.2%. In spite of optimistic forecasts, generating consistent GDP growth above 2% has proved elusive the past five years. The 2017 GDP growth rate incorporates the U.S. election results and hopes for a fiscal stimulus that could propel additional growth next year. However, based on timing, size, lack of “shovel ready” projects and other factors, many of the Trump administration’s initiatives may not contribute materially to GDP growth until 2018.
Unemployment is expected to stay low at 4.7%, but not improve materially from current levels. Inflation has started to climb off of zero and is anticipated to rise to 2.3%, slightly above the Federal Reserve’s 2.0% target. It is important to note, the potential range on CPI is fairly wide, and the actual number will influence interest rates, GDP growth and other critical economic factors. After the December 2016 hike to a high-end range of 0.75%, consensus is that the Fed enacts two or three additional hikes for its key lending rate, ending 2017 at 1.30%. The 10-Year U.S. Treasury Note is expected to finish at 2.43%, 4 basis points wider than 2016. Also notable is the VIX Index, which is nearing its cycle lows. A further reduction in volatility is hard to envision, but meaningful downside (increased volatility) in the VIX at some point in 2017 is certainly possible if not probable. In international markets, China’s important growth rate is forecast at 6.4%, once again modestly lower and, perhaps, not encapsulating meaningful downside risk to that estimate. The European Union continues to track slower than the U.S., with a +1.48% GDP estimate for 2017.
Consistent with Reams’ traditional approach to scenario analysis, we prefer to focus on what factors would cause results to disappoint from the consensus, either to the upside or downside. It is ordinarily the disappointments which cause the most pronounced market repricing.
What is the Downside to Consensus?
As discussed earlier, the consensus forecast has risen and is a generally sanguine world view. While this may persist, outcomes on either side of the consensus are real and troubling. In our view, the probability of realizing either distribution tail has escalated given the late 2016 rally in risk assets.
On the downside end, the “hard landing” concern remains paramount: China (or another major economy) experiences slowing or negative GDP growth. This was the primary downside concern a year ago as well, but China’s GDP picture fell quickly to the backburner in the wake of the first half 2016 commodity rally and subsequent Brexit vote and U.S. election. Unfortunately for market participants, what did not go away were China’s problems: namely, increasingly desperate measures to continue to perpetuate robust GDP growth.
Recently, growing evidence has emerged of valuation “bubbles” in a number of areas in China, primarily housing. Debt accumulation has climbed to more than 275% Debt/GDP, a worrisome level and reflective of rapid balance sheet deterioration the past five years. Now, top officials have commented that GDP growth below 6.5% would be tolerable, a previously unthinkable position. This comes despite heavy-handed government interference in devaluing their currency and mandating capital retention. It is important to keep in mind, any substantial decline in China is unlikely to be offset by gains elsewhere. More likely, the outsized influence of China in global markets would have major negative ramifications everywhere.
Given recent remarks from members of the ECB and BOJ, acknowledging the limitations of their own central bank intervention, as well as the still very low global lending rates, there is an open question as to what potent solutions central bankers could provide in an event of a global recession or serious economic dislocation in China or elsewhere. The “Don’t Fight the Fed” mentality that has inserted central bankers as a de facto “backstop” to backsliding asset valuation may not only be deemphasized, but also may be impotent from this point forward.
In such a scenario, the Fed would quickly halt if not reverse recent rate hikes. U.S. multinational corporations, at minimum, would be impacted by problems abroad and the U.S. dollar would continue its ascent as a “last bastion of safety” for global investors, causing already considerable currency headwinds to intensify. In this picture, rates stay quite low, inflation lies dormant, GDP and economic data disappoints, credit widens and U.S. Treasurys are probably one of the few asset classes that performs well.
What is the Upside to Consensus?
The upside tail risk to consensus opinion is the possibility of an overheated U.S. economy, where rising inflation and rates places enormous burdens on the U.S. economy. Entirely absent in practice the past decade, inflation concerns were previously more theoretical than true concern. That has changed abruptly post the U.S. election as rates have risen sharply, alongside inflation expectations, as fiscal stimulus talk—particularly a renewed emphasis on infrastructure projects—has emerged as an economic stimulant. Assuming the fiscal stimulus is delivered in short order and on a meaningful scale, labor shortages and increased “animal spirits” could push wages and prices higher. Moreover, deregulation and tax reform to the financial sector could unleash lending as banks move aggressively to take advantage of more benign environs. The impact of this lending would be increased money velocity on a mountain of excess reserves that global banks have accumulated the past decade—surely an inflationary driver from a traditional standpoint.
Also of particular importance to inflation, year-over-year wage growth has been in the +2.5% area the past few months. While not massive, this does represent an increase and now is occurring with low overall unemployment of just 4.7%. This is natural that insofar as unemployment drops, wage pressure should increase as employers struggle to find or retain talent and are willing to pay more in order to do so. That unemployment has fallen so dramatically in this seven-year recovery without a corresponding increase in wages to date is one of the perplexing dilemmas of the “new normal” economy of 2% GDP growth.
One final concern on the upside is the incoming administration’s rhetoric on trade agreements. Mr. Trump has stated that companies moving offshore could be subject to a sizeable tariff. If any trade wars are provoked, this could close the U.S. trade gap deficit, but taking protectionist actions could cause a capital flight out of the U.S. and support for U.S. Treasury issuance would dissipate. The Fed would certainly be hard pressed to raise its rates fast enough to keep pace if these impacts are pronounced.
In the overheated scenario, inflation would overshoot the 2% Federal Reserve target, interest rates could spike in response, and the onerous debt burden would be stifling to GDP as debt service at higher rates would consume government expenditures. This last effect could procure the worst of both worlds: an economy with surging inflation, but thanks to rising rates and ever higher interest expense, no material GDP pickup to offset.
Corporate Sector Outlook
While credit had another excellent year in 2016, and baseline expectations factor the trend to continue in the year ahead, we remain cautious on the credit sector as a whole. We are now entering the eighth year of an expansionary credit cycle. Historically, the typical credit cycle has a tenor of five years. During this particular cycle, many companies have increased their use of leverage, undertaken shareholder friendly activities and engaged in speculative mergers and acquisition transactions that may or may not add value. Now, nearly 30% of all investment grade debt has leverage above 4.0x EBITDA, up significantly from just 10% six years ago.
Moreover, the environment for large scale merger and acquisition activity remains robust. Companies with large cash balances and few attractive internal investment opportunities will be active buyers, as will a hungry private equity community that is no friend to the debtholder.
Away from credit fundamentals, we have also witnessed increased desperation by the investor community in seeking any income-producing vehicles, regardless of risk profile. The scarcity of meaningful income-producing product is due to the alternative monetary policy that has been pervasive globally since the 2008/09 recession. The result has been an increase in very low quality (“B” or “CCC”-rated) debt as well as poor underwriting standards and weak covenant protection for debtholders. Typically, these speculative investments are the worst performers when risk aversion finally returns.
Additionally, our concerns over credit liquidity have not abated and, in fact, may be even higher than a year ago. The broker-dealer community is smaller and has less ability to take on risk positions as was the case a decade ago. Thin markets such as high yield and emerging markets could be subject to exacerbated liquidity challenges in a market downturn due to a crowding out effect.
All this portends a cautious continuing outlook on credit absent a meaningful repricing of risk and a more sober appraisal of deteriorating underlying fundamentals.
Securitized Sector Outlook
We expect the agency MBS pass-through market to struggle in 2017 relative to U.S. Treasury securities. An increase in interest rate volatility will negatively affect returns from this negatively convex part of the market. Spreads, at the present time, are not sufficiently wide enough to protect these securities from interest rate volatility. Additionally, the Fed will eventually cease reinvesting the principal paydowns of their holdings, which will remove a technical support for this market. An area of the agency MBS market that we do favor is bonds backed by multi-family collateral. These bonds have solid call protection and should outperform single-family collateral in a volatile rate environment.
The CMBS market continues to successfully work through balloon maturities resulting from large issuance in 2006 and 2007. Net supply will remain negative through mid-2017, a positive technical for the market. Although current spreads are not attractive on a risk-adjusted basis we continue to favor the credit protection and good convexity found in the CMBS market and will add opportunistically in this sector.
ABS spreads are attractive on a risk-adjusted basis. Auto ABS should steadily perform well due to their short average life and stable cash flows.
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