22 December 2016
Where should we invest in 2017?
by Frank O’Nomics
This time last year I was rash enough to discuss what we should do with our savings with a view to making the best returns over 2016. It would be easy to brush this under the carpet and try to pretend that I had not missed some key trends. It is also too easy to use the number of unpredictable events (Brexit and the Trump election, to name but two) as excuses. What I did possibly get right was that the outlook at the start of last year was very uncertain, and for this reason I was very cautious about the prospects for many asset classes, especially given that most looked somewhat overvalued. You might then suggest that, with a similar degree of uncertainty facing the world again, coming up with investment suggestions is an exercise in futility. However, there are signs that some long-term trends, notably those for inflation and hence interest rates, are starting to turn and, if this is the case, there are some implications for what we should do with our cash. Yes, as with last year, equities, property and bonds all look very expensive, but the beginning of a re-steepening of yield curves points to a potential “great rotation” out of bonds into equities (at least for some sectors), especially if you believe that the pressure on interest rates is part of a broad global economic recovery.
The argument goes that with inflation returning (and we could see a level of 3-4% in the UK next year), even if the Bank of England decides to keep base rates unchanged through most of next year, longer-term interest rates will have to rise. We have already seen some steepening of yield curves, but so far this is just a small reversal of a fall in yields that has been a trend for several decades. If the rise in long yields continues, then the attractions of bonds and property will be very limited until the process has run its course. For equities there are some negative implications, particularly for those stocks that have been bought as bond proxies due to their attractive dividend yields. Indeed, the level of price-earnings ratios for most developed equity markets are towards the higher ends of their historic ranges. So why should we consider buying equities rather than bonds or property?
As always the key driver of equity markets should be the economic outlook. While historic price-earnings ratios may be high, if earnings are expected to grow, the prospective p-e ratios will still leave stocks looking attractive. If part of the pressure on inflation is a function of increased demand, which in turn has partly been helped by the cheapening of sterling, then we should be positive about equities. In the current scenario, the sectors of the equity market that should perform well will be the cyclical stocks, such as miners – who will benefit from an increased demand for resources – and financials. Banks make their money from borrowing short-term and lending longer-term, and have suffered for a long time due to low rates and a flat yield curve. If we are at the end of the period of heavy bank fines for past misdemeanours, then their earnings should start to be rebuilt quite quickly by a steepening yield curve. Perhaps a more important factor for corporate UK overall, a rise in long-term yields can have a particularly strong impact by cutting the size of pension fund deficits. These deficits have been largely the product of low long-term yields. As this pressure reverses, companies will have more money to invest in their businesses, thereby creating the capacity for long-term growth.
At this point it is quite correct to raise the spectre of continued uncertainty, and I see 3 areas of note. Firstly, we have to go through the lengthy process of Brexit, a process about which we still know very little. However, the market has recovered all of its summer losses and more, and the economy has yet to suffer to any great degree. Indeed, you could argue that many of the corporate deals that have been held in abeyance since the referendum have not gone away and, if confidence develops further, some of these will come to fruition. There are those who argue that the EU is ultimately a flexible entity that has always made exceptions when needed, and that the prospect of a bespoke deal for the UK is quite high. There will undoubtedly be some market wobbles concerning Brexit over the next 12 months, but these may just provide a buying opportunity. The second area of uncertainty surrounds the incoming US President. The markets may be looking too much at the short-term, but the current sense that tax cuts, to encourage the repatriation of US corporate cash, along with increased infrastructure spending, will be a positive for the next couple of years. This is likely to be inflationary, but still supportive for US stocks, even at the current record highs. The final key uncertainty is China, where we have been worrying about the consequences of an economic slowdown for some years. However, economic management in China seems relatively sound and a 6% growth rate might be a lot slower than it was, but it is still the envy of everyone else. For those that feel I have put too strong a spin on these risks (and I have), there is always recourse to buy the “fear” index, or VIX, which measures the level of volatility in markets. In the US this index has actually been falling since the US election, which suggests that the fear factor was previously overstated.
Markets are efficient to some degree, and there is a danger that many of these arguments are already priced in. The counter to this is to look at just how far they could move. Yes: US and UK financials have rallied 15% since the election, but this is a small part of the extent to which they fell after 2008. A stock such as Barclays may be 5% up on the year, but is still 10% down on a 3 year view and is one third of its level 10 years ago. The tentative conclusion then is to favour stocks over bonds (where you are paid little given a risk of rising rates) and property (where you risk getting trapped in a falling market), but to be very selective regarding the sectors that you favour. On that positive note, it just remains for me to wish you a prosperous, but more important, happy New Year.
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