2017 – The year of reflation, says NN IP
Political uncertainty will be a dominant theme on financial markets in 2017, but it does not need to drag down the real economy. In fact, a mild improvement in global growth momentum is in the cards.
The shock waves triggered by the tectonic shifts in commodity prices and exchange rates are slowly dying out. As a result, the drags on earnings growth are waning, while earnings should be further supported by stronger global demand and higher oil prices, believes NN IP.
With Donald Trump becoming the next president of the United States, elections in the Netherlands, France and Germany coming up as well as the UK being expected to trigger Article 50 in March, the global policy and growth outlook is clouded by a high degree of political uncertainty.
A political risk premium will thus be priced in markets, but a moderately positive trend in fundamentals is surfacing. Global consumer spending has been increasing in the past quarters, driven by improving labour markets and higher confidence. The improving earnings outlook has a positive impact on business confidence, as reflected in a broad based improvement in PMI data. Improving earnings growth and confidence, combined with higher commodity prices, should support a moderate improvement in global capital expenditure (capex).
NN IP expects a pick-up in global nominal growth next year and a more balanced economic policy approach: less monetary and more fiscal policy stimulus. Markets have been anticipating these trends, reflected in the rise in bond yields in developed markets and the rotation from defensive and yield-sensitive sectors towards cyclical sectors. We expect this reflation theme to persist in both equity and bond markets in the coming quarters.
While we live in uncertain times, it does not mean that opportunities are absent. Risk premia are still decent while investors hold on to a cautious positioning and relatively high cash levels. These factors act as a cushion against the impact of unexpected events such as we have seen after the Trump election. The political uncertainty can lead to occasional bouts of volatility, which means that a flexible investment approach is a necessity.
We believe that the cyclical rotation which has been taking place since the summer will persist. This rotation is fuelled by the anticipation of a more balanced policy approach, the improvement in oil and industrial commodity prices and the turn in bond yields.
Hints of substantial fiscal stimulus, for example by Donald Trump but also by other policy makers, leading to higher budget deficits and rising inflation expectations, might well add to the upward trend in global bond yields we have seen in the past few months. Higher bond yields and steeper yield curves favour cyclical sectors and the financial sector in particular, while they negatively impact yield-sensitive sectors like real estate and utilities. This would further fuel the rotation towards cyclicals. Our favorite sectors are financials and materials.”
Furthermore, we should not underestimate the impact of higher oil prices on corporate earnings. The fall in the oil price in the second half of 2014 and again in the second half of 2015, early 2016, has acted as a significant drag on the earnings and capex of energy companies, a sector which historically has a large contribution to global earnings. A stabilisation in the oil price around current levels will push earnings growth higher thanks to the bigger contribution from the energy sector. Currency developments are an additional driver of earnings where a strong USD could enhance earnings growth of non-US companies.
If the above mentioned drivers persist, we think this reflation theme has further to run. This means that cyclical sectors can continue to outperform their defensive peers and that the value style will outperform the growth style. What’s more, the relative valuation of value versus growth is attractive. The discount based on price to book is 55% in the US and even 60% for the Eurozone. In both cases this is some 5-10% below the long-term average discounts. In our allocation we have a cyclical bias.
Regionally, we think the markets most sensitive to the reflation trade are Japan and the Eurozone, given the importance of cyclical sectors (ex IT and financials) in their market benchmarks. If the US dollar would appreciate following a rise in US interest rates, non-US developed markets could get an additional boost. We prefer Japan for two reasons: Japanese profitability is at comparable levels with the Eurozone, but the market is 20% cheaper based on price-to-book. Secondly, the Eurozone is facing a lot of political and institutional challenges.
Emerging markets have staged a remarkable – though moderate – growth recovery in 2016, to a large extent to an easing of financial conditions as a result of improving capital inflows and looser monetary policy. The recovery in commodity pieces also helped.
The EM growth pick up has been primarily driven by easier financial conditions. Meanwhile we have seen greater divergence between countries with reforms and improving governance and countries with populist/unorthodox leadership. Reforms are still key for a sustainable growth recovery, given the high leverage in emerging markets and weak global trade.
Regarding the latter, the election of Trump is a risk factor. EM exporters have been struggling due to weak global trade growth. A more protectionist policy course in the US will make it even more difficult for EMs to get back to positive export growth. Financial markets are likely to price the uncertainty and increasing risks for EM trade. This could lead to a decline in capital flows to EM.
We therefore have a preference for markets which do not rely too much on exports and where structural change and better policy execution are producing higher growth. We like India, Indonesia, Colombia, Argentina and Vietnam, while we underweight Turkey, Brazil, Malaysia, South Africa, Russia, Egypt, Philippines and China.
Valentijn van Nieuwenhuijzen, chief strategist and head of Multi Asset at NN Investment Partners, Patrick Moonen, senior strategist Multi Asset and Maarten-Jan Bakkum, senior Emerging Markets strategist at NN IP