The world’s long-term economic problems are well known – rising debt, aging populations, and muted growth. But it is not these problems alone that will drive markets in 2017. As in 2016, policy is likely to prove the decisive factor.
Many investors we speak to believe that a “reset” for financial markets is overdue. The case seems simple: everyone can see that markets have risen consistently, yet so have inequality, debt, dependency ratios, and social tensions. Meanwhile, growth, investment, and productivity are weak. It looks like something’s gotta give.
However, we have to remember that the “everyone” who can see the global economic problems includes policymakers and electorates worldwide. And they have shown they are willing to pursue increasingly extreme measures to solve the issues at hand. Here are some simple thought experiments: faced with a lack of growth, will a central bank that has already distorted the local bond market choose to stop, or start buying equities? Or, faced with rising overseas competition, will voters stick with the status quo, or turn to protectionism?
The answers to these questions, and many more like them, will matter a great deal for your portfolio.
The Year Ahead
In 2017, policymakers and voters will again be faced with a series of such trade-offs. Developed market central banks have noted that inflation is beginning to rise, but also that employment is still below pre-crisis peaks. China’s leaders know the country needs to maintain growth and employment, but rapidly rising debt ratios and house prices suggest growth may come at a cost. Elsewhere, politicians facing elections in 2017 may believe that trade and immigration are helpful for growth, but Brexit and the election of Donald Trump demonstrate that protectionist policies are becoming more popular among voters.
In 2017, policymakers will be faced with a series of such trade-offs.
The issues policymakers choose to focus on in the year ahead, and how they choose to address them, will heavily influence market performance. Therefore, understanding their most likely choices is a critical part of our investment process. We need to ask ourselves the right questions: “what does policymakers’ past behavior tell us?”, “what are they trying to achieve?”, “how are they incentivized to act?” In our base case, we believe that central banks in the US and Europe will continue to err on the side of loose monetary policy, even if it comes at the cost of higher inflation.
The behavior of central banks since the financial crisis suggests that growth, employment, and near-term support for the economy have a higher priority than concerns about potential longer-term consequences of their actions. Recently, Fed Chair Yellen has re-confirmed this by discussing running a “high pressure economy” (i.e. above-target inflation) in order to stimulate employment growth. And ECB President Draghi has dismissed some of the claims of negative side-effects to his policies.
We will be alert for a change in this modus operandi in the year and years ahead. But as we enter 2017, we believe this means equities can remain supported, mostly in the US, and investments with a decent yield will remain sought after. Investors will also need to consider means of hedging portfolios against rising inflation.
Meanwhile, for the Chinese government, maintaining high levels of employment and social stability are crucial. It has consistently shown its ability and willingness to intervene in favor of short-term stability, at the cost of longer-term reform. We see no reason for 2017 to be different. Medium- term risks and debt-to-GDP will continue to rise, but we expect China’s demand to remain relatively stable, and assets exposed to that growth will be supported. Two of our top 10 ideas are exposed to emerging markets.
Like in 2016, the direction of politics is perhaps the most uncertain factor in 2017. Brexit and the election of Donald Trump showed how the political “center ground” is not fixed, and investors need to remember that politicians are incentivized first by electoral success and (by extension) popularity, not GDP and corporate profit growth. Against this backdrop, investors will need to monitor the impact of a Trump presidency on markets, the UK’s increasingly complex Brexit process, elections in France and Germany, and a rising global trend of protectionism. To cope with this political uncertainty, we believe investors are best served by diversifying across countries and regions, to avoid overexposure to the experimental policies of individual regimes.
Looking longer term
Over the longer term, the only certainty is that different countries will choose different paths and see different outcomes. Therefore, we believe diversification across regions and asset classes provides investors with the best way to protect and grow wealth in a world of increasingly complex and difficult choices. Investors will also need to consider investing in trends and asset classes that are less affected by policy.
For instance, urbanization, population growth, and aging are contributing to increased demands for education, healthcare, and energy efficiency. For longer-term investments, sustainability is a critical consideration. Alternatives may also provide a means for investors to reduce exposure to diverse political outcomes, while seeing capital growth through the cycle.
The end game
To demonstrate how changing monetary, fiscal, and social policies interact to affect economies, markets, and portfolios, we have created the end game, an interactive game. Since the financial crisis, we have consistently run simulations as part of our investment process. The end game offers you the opportunity to play global policymaker and walk through a simplified version of our scenario analysis. I think it helps us understand the policy choices, interactions, and iterations that will impact portfolios.
I hope it leads you to a deeper discussion of your investments and diversification.
Solving the world’s myriad economic problems is about trade-offs, and the choices that both policymakers and electorates make will matter a great deal for your portfolio. The only certainty is that different countries will make different choices. Diversification is the best way to protect and grow your wealth in an increasingly complex world.
UBS House View: Year Ahead
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