The Economy Resuscitates, Stocks Gain, Rates Rise, Inflation Grows -- Heightened Volatility and Potential for Big Market Swings Likely
In 2017, there is cautious optimism for accelerating U.S. and global economic growth, improving corporate fundamentals, modest stock gains, and higher yields on expectations of fiscal stimulus and regulatory policy easing.
Full-on optimism is tempered by the rippling effects of rising inflation, a stronger dollar, weak credit markets, uncertain commodity pricing, and game-changing political events that raise the potential for big market swings.
The outcomes of Brexit and the U.S. election have brought fundamental change, which equates to investor opportunity. If investors choose asset classes, sectors and stocks carefully, they can meaningfully outperform the market. 2017 could be the year of the active investor.
Topping the list of significant themes that will dominate 2017 is the political ground shift, reflective of a contagious backlash to globalization. Spreading populist influence, starting with Brexit, followed by the election of Donald Trump and now looming over the eurozone, raises questions about trade policies that would affect government debt levels, rates, commodity prices, and economic growth rates, particularly in emerging markets.
The overarching anti-globalization theme is setting the tone of a new economic and investment cycle now underway. Here are 10 macro calls for the year ahead.
- S&P 500: A 2017 year-end target for the S&P 500 Index is pegged at 2300, which assumes a 5 percent gain for the year and earnings growth of 9 percent, or a 2017 earnings per share forecast of $129. The case for a traditional, euphoria-driven end-of-bull-market rally could put the S&P 500 as high as 2700, in line with historic norms of 20 percent or greater annual returns. A bearish scenario, in the event of recessionary returns, could put the S&P as low as 1600.
- S. and global economic growth: Modest but accelerating. Nominal growth in the U.S. could rise from 3 percent to 4 percent, with a real GDP gain of 2 percent. Slower growth is expected in the first half of the year, picking up in the second half once fiscal stimulus measures kick in. In the rest of the world, nominal growth could near 7 percent, with a real economic gain of 3.4 percent, up from 3.0 percent in 2016. Global growth, however, will be driven by supply versus the demand side of the economy.
- Inflation: The party has started. Core personal consumption expenditures (PCE) inflation in the U.S. is expected to increase to 1.9 percent by the end of next year, approaching if not overshooting the Fed’s 2 percent target. Although the inflation party started elsewhere in the world, Europe didn’t get an invitation.
- Rates: Monetary easing gives way to fiscal easing.The history of populism is one of fiscal largesse. U.S. rates have backed up quickly after the election, driven largely by a repricing of inflation expectations. With long-term inflation break-evens closing on their historical averages, the next phase of the rates move will be led by the belly of the curve and real interest rates. The market expectation for Fed hikes in the coming years has sufficient room to increase relative to the current projections in our view.
- Foreign Exchange: Globalization of anti-globalization. While the U.S. fixed income sell-off is likely to continue spilling over into other bond markets, yield differentials are still likely to move in favor of the USD. Long positions in emerging markets remain crowded, liquidity conditions are poor, and downside risks remain in a strong dollar environment. USD/JPY will likely be the main foreign exchange beneficiary of U.S. fiscal expansion, given its high sensitivity to rates and the Bank of Japan’s 10-year JGB yield target.
- Emerging Markets: Hold on tight. Modest economic growth of 4.7 percent is expected in emerging markets, up from 4.1 percent, which is better than in the U.S. and the rest of the developed world. India is expected to lead, with GDP rising 7.6 percent, while China’s bellwether economy expands by 6.6 percent. U.S. rates will likely cast a shadow over emerging markets debt, with returns of about 2.6 percent for external debt and 0.7 percent for local debt.
- Metals and Mined Commodities: Coal and steel rise while gold loses luster. Mined commodities rallied as markets rebalanced in 2016, and the global macroeconomic environment should remain supportive, barring trade battles. Volatility in steel prices is anticipated – a potential anti-globalization trade – on factors driven not by supply and demand, but by raw material input costs.
- Energy: OPEC resets the bar. For the first time in eight years, OPEC agreed to cut crude oil production, marking a turning point in the price war at the center of cartel politics. As a result, 2017 forecasts are unchanged, leaving WTI crude oil at $59 a barrel and Brent to average $61 a barrel. Pricing forecasts embed a sequential 500,000 barrel-per-day increase in U.S. crude production, raising domestic output to 9.2 million barrels a day by the end of 2017.
- Credit: Farewell to utopia. After an extraordinary year for credit investors, total returns in 2017 will likely be a sobering 3.5 percent to 4.5 percent for U.S. high-grade bonds and 4 percent to 5 percent for U.S. high yield. On the other hand, high-grade corporate spread maturity curves may super-flatten as global credit investors sell shorter maturities and buy the long end. Corporate balance sheets are improving in the U.S. as earnings headwinds dissipate.
- Big rotation in global investment strategy: Domestically and globally, investments and policies that have done well in a low-rate, low-growth world have reached their peak. Long-term winners could be supplanted in 2017. Expect inflation rather than deflation; Main Street to prevail over Wall Street; fiscal winners to beat out zero-interest winners; and real assets to triumph over financial assets.
*Based on a December 7, 2016 BofA Merrill Lynch Global Research report.