Across the globe, protectionism and authoritarianism are on the rise … In a leaderless world, where political élites lack vision and power to coordinate key policies, economic co-dependence increases instability. As a result, the gap between the promises of globalization and the daily reality of average-citizens is growing larger. Joblessness, stagnating real incomes and rising inequality put pressure on welfare systems. Nationalism and protectionism threaten globalism. Populism is leading to authoritarianism via democratic principles, i.e.: the “one person, one vote” tenet. Immigration-without-integration erodes social cohesion.
… and growth is stagnant. Going forward, sustained growth accelerations are unlikely, as cyclical and structural factors hamper economic activity. The global economy is: 1) in the middle of “a lost decade” – i.e.: still suffering the 2008-crisis and its long-lasting effects on credit markets, output, and employment; and 2) undergoing a long-term transformation, as: a) aging populations reduce consumption; b) higher aggregate savings depress interest rates; c) services – less capital-intensive than agriculture and manufacturing – keep rising as shares of global output, employment and value added; and, as a result: d) investment, productivity, demand and trade remain weak, adding to structural unemployment.
In 2017, macro fundamentals will remain weak across the world. At the global level, gross domestic product (GDP) growth is projected to rise to 3.5 percent in 2017, from 3.1 in 2016. Yet, debt – both public and private – and unemployment will constrain investment and productivity growth, hindering industrial activity and trade. Stagnant wages and flat real incomes will weaken aggregate demand and keep inflation in check – at 1.9 percent in DMs and 3.7 percent in EMs. Oil prices will remain in the range of USD 50-60 per barrel (bbl), providing relief to oil producers. The US dollar (USD) will strengthen against other currencies.
- Burdened by debt and structural rigidities, DMs will stagnate – with the exception of the US. In 2017, the US economy will grow at 2.6 percent, lifted above its current trend by Trump’s tax cuts, fiscal stimulus and looser regulation; as a result, inflation will rise to 2.8 percent. The Eurozone (EZ) – hampered by unfavorable demographics, separatist politics, a heavy sovereign debt, inflexible labor markets, banking sector legacy-issues, a migrant crisis and religious divides – is expected to grow at 1.4 percent, with inflation at 1.2 percent. In Japan, a lack of structural reforms and a shrinking labor-force will keep growth below-potential, at 0.6 percent, and inflation at 0.4 percent. Across DM, the rise of income inequality and unemployment will strengthen political pressure to control immigration flows of unskilled workers.
- EMs will face low growth and risks of political volatility. In 2017, EMs growth will be hampered by political fragility, structural bottlenecks, sluggish investment, high domestic debt, a sizeable external debt, capital outflows and vulnerability to sharp currency depreciation. Interest rates will remain largely driven by monetary policy in the US and – to a lesser extent – in the EZ and Japan. In Latin America, Brazil is expected to grow at 0.5 percent, with inflation at 5.4 percent. In Russia, the economy will grow at 1.1 percent and inflation will stabilize at 5.1 percent. India will show robust growth at 8 percent, with inflation at 5.2 percent. China’s growth will decelerate to 6.3 percent – depressing the price of commodities and specialized manufacturing equipment – and inflation will decline to 2.2 percent, as the economy shifts from investment and manufacturing to consumption and services. Lower commodity revenues will hamper commodity exporters. In the Middle East and North Africa region (MENA), rising political risks and lower oil prices will keep growth subdued while fiscal consolidation, needed to face structurally lower oil revenues, will likely be put on hold.
Geopolitical tensions, trade wars, and market volatility remain key risks. At the global level, a few economic risks could take a toll on the outlook: a) geopolitical and social tensions; b) trade wars and competitive devaluations; c) a tightening of financial conditions; d) financial instability, market turbulence and volatility; e) lower oil prices and deflation; and f) weaker consumer and business confidence. Conversely, flat real incomes and rising inequality are major political risks and can lead to further instability, populism and authoritarianism.
- In DMs, long-standing structural issues and migration will complicate politics and hinder growth. In the US, key risks are Trump’s ability to deliver on his electoral promises, the timing of his policy agenda, a build-up of social tensions, public debt – already at 2 percent of GDP – and the looming fiscal cliff, a faster-than-expected tightening cycle by the Federal Reserve (Fed), and a more than 20 percent USD appreciation. In the EU, elections in the Netherlands, France, and Germany (and, possibly, Italy, the United Kingdom and Spain) will test EZ’s cohesion while immigration flows and social strains will compound the consequences of Brexit. In southern Europe, political stalemate will put reforms on hold, while persistently low inflation could develop into deflation and unresolved legacy issues in the banking system – in particular in Italy and Portugal – could bring about bank failures and political tensions. In Japan, the chronic lack of structural reforms will hamper the outlook.
- EMs are fragile. In Brazil, a political crisis could lead to early elections and depress growth, while a rise in inflation could spur social tensions. In Russia, lower oil prices – along with the ensuing rise in budget deficits, fall in reserves and decline in real incomes – and frictions with the West are major economic challenges. India’s slow reforms, lack of infrastructure spending and rural-urban divide pose significant risks. China’s reliance on credit, investment and exports as growth drivers will lead to over-leveraging, financial bubbles and over-heating of the real estate sector, increasing the risk of a disruptive adjustment, capital outflows and a falling yuan (i.e.: a hard-landing); meanwhile, fast urbanization will keep increasing income disparities. In Turkey, political instability – likely to be enhanced by a referendum on the presidential system – and the middle-income trap risk hampering economic resilience. In MENA, the main risks are negative spillovers of the Syrian, Iraqi and Yemeni conflicts – increasing tensions between Saudi Arabia and Iran -, lack of job creation and low oil prices.
Fiscal and monetary policies are unlikely to strengthen demand and investment. The global economy needs growth-enhancing taxes and expenditures, but it might get them only in the US. Over-reliance on central banks (CBs) will continue buoying financial markets, and monetary policy normalization will take longer than expected.
- Fiscal policy is unlikely to turn expansionary, with the exception of the US. Now contractionary in many major economies, fiscal policies are unlikely to support consumption and investment. In 2017, led by Trump’s infrastructure spending, the US fiscal stance can turn expansionary. Yet – if other countries do not follow suit with significant fiscal stimulus – the US alone will be unable to support global consumption and investment.
- Monetary policy will diverge. In 2017, monetary policy divergence will grow, driven by a mild tightening cycle in the US and easing in the EZ, Japan and UK. Overall, the upcoming tightening cycle will be well below historical norms and negative policy rates will lead to further financial repression. As monetary policy normalization takes longer than expected, over-reliance on CBs will make their interventions ineffective. Additionally, CBs will risk making policy mistakes and lose their credibility.
Traditional banks remain under pressure. Increasingly stringent regulatory tightening – aiming at developing banking systems’ resilience to both uncertainty and turbulence – will force traditional banks to choose between lower profitability and sanction risks. Shadow banking will keep growing. International banks will keep selling loss-making franchises and moving away from retail; local banks will prosper. Technology-driven innovation will boost non-traditional competitors: block-chains, biometric authentication for payment transactions, and new “digital” banks – as consumers will increasingly refrain from going to branches. In the long run, only banks able to remain customer-centric ‘trusted advisors’ will prosper. In the EU, financial sector vulnerabilities will not be tackled head-on and – as much as in Japan – the negative-interest-rate policy will de facto tax banks that hold reserves, without encouraging bank lending.
Diverging growth and asymmetric monetary policies increase the risk of market dislocations. Repeated CB interventions will keep macro-liquidity abundant, prices elevated and unstable, and asset classes unusually correlated. In the first part of the year, liquidity will intensify asset inflation and keep the markets buoyant but jittery. Most markets are likely to suffer elevated volatility; over-bought and over-sold assets will create tactical exit-and-entry opportunities. Eventually, a rising disconnect between fragile fundamentals and elevated valuations will bring about a bear market (a drop of more than 20 percent from the 52-week high) – if not a full-fledged market crash (a more-than-40-percent plunge). With high volatility traders will perform better than fundamental investors.
Portfolio approach: lower expected returns, greater exposure to alternatives. For most asset classes, expected returns are likely to be lower than in past years – because: a) valuations are elevated by historical standards; and b) aging societies, insufficient investment, and weak productivity constrain potential growth and corporate earnings (in other words: fundamentals will determine asset values). On a multi-year horizon, unusual, less liquid portfolios are likely to perform better than conventional ones. Priorities are: 1) capital preservation via a defensive asset allocation; and 2) broadening exposure beyond conventional stocks and bonds, identifying opportunities in the illiquid space. As a result, only 60 percent of the assets should be liquid, and as much as 40 percent should be kept illiquid. In the liquid space, the allocation should privilege stocks (20 percent) and bonds (20) over commodities (15) and cash (5). In the illiquid space, alternative investments should be split between real estate (20) and private equity (20).
Stocks (20 percent) – Investors, so far satisfied with the “buy on dips” strategy (as long as liquidity-driven markets keep achieving new highs), lack viable alternatives and, given limits on cash holdings, will keep buying equities. In DMs, corporate cash will keep supporting share buybacks. The whole allocation should go to DM large caps with cash flow. In particular, dividend-paying blue chips are preferred – better if multinational brands with exposure to EM domestic demand. Volatility will remain elevated and small caps are better avoided, as much as EMs, where earnings growth will soften and currency risks will rise. If Trump’s policies veer toward pragmatism, US equities are likely to over-perform. Japanese and EM equities can be hampered by trade restrictions.
Bonds (20 percent) – Bond prices are likely to decline, and yields to be pushed up by: a) rising fiscal deficits and debt; and b) a higher growth differential (i.e.: the US economy will expand faster than other DMs). High-quality credit and inflation-linked securities are likely to do better than nominal bonds. Held for capital preservation purposes, bonds should follow a “buy to hold” strategy, with profit-taking in case of yield-reducing risk-off episodes, liquidity-injections by CBs, and further reductions in long-term interest rates. The allocation should privilege corporate (15 percent, DM only) over sovereign (5 percent, EM only). In DMs, where the regulatory and institutional setting is stronger, the whole 15 percent should go to corporate, but only to high quality, high-yield blue chips, better if multinational brands. Overbought sovereign should be avoided; US yields will rise, but remain subdued – supported by the ongoing shortage of safe assets, global demand, and the quest for financial safety. In EMs, corporate should receive no allocation, given currency risks and a weaker regulatory framework in case of insolvency; once country risk has been assessed, 5 percent should be allocated to sovereign bonds, only if USD denominated, investment grade and with above-inflation yields.
Commodities (15 percent) – Weak global demand and abundant inventories will keep commodity prices subdued. Low global inflation and USD strength will remain headwinds for performance. Price increases will only depend on supply shocks. The allocation should privilege energy (10 percent), to capture the expected rise in oil prices. While rising interest rates will diminish safe-haven buying, precious metals should be allocated 5 percent, as an insurance against: a) currency debasement; b) sharp downturns; and c) periphery-to-core runs.
Cash (5 percent) – Cash is required as: a) seeding-capital to quickly seize opportunities; b) insurance against sharp downturns; and c) protection against negative rates. The 5 percent allocation should be held in money market funds, cash ETFs and hard cash. Given depreciation pressures on EM currencies, the USD and the Swiss Franc (CHF) should be favored in DMs, and the Singapore Dollar (SGD) in EMs.
Alternative investments (40 percent) – The allocation should be equally divided between real estate (RE, 20 percent) and private equity (PE, 20 percent). The whole 20 percent invested in RE should be allocated in DMs – as a fixed-income play, based on rental income and should go to: a) undervalued “trophy” assets; and b) distressed properties in rapidly growing cities. In EMs, a capital appreciation play based on fundamentals is unlikely to materialize soon, certainly not in 2017. The whole 20 percent allocated to PE should also go to DMs only, invested in undervalued firms with positive cash-flow, able to produce non-replicable or luxury products in high demand in EMs. No allocation should go to EMs: regulatory and currency risks are too elevated, despite fair fundamentals.
The indicative portfolio is shown here below.
I thank Eduardo Eguren, Pablo Gallego Cuervo, Mert Yildiz, and Francisco Quintana for their comments and suggestions. All errors are mine.