11 January 2017

Relative optimism prevails

Equity markets finished 2016 in optimistic mood, contrary to early expectations and a series of adverse political events.

The FTSE All Share delivered a 12% price return over the year, ahead of the long term average, while US equities achieved a “triple top” in December, as each of the three major American indices hit all-time highs. Few investors (ourselves included) could have hoped for such a result after stock markets suffered one of the worst Januaries on record, amidst collapsing commodity prices and fears of global recession centring on a Chinese slowdown.

There are reasons to be confident entering 2017, as the global economy has gathered momentum since th is shaky start to last year. December data points showed US manufacturing sentiment at the highest it has been in two years, employment levels strong and consumer sentiment much improved. China has defied its critics, with growth rates picking up and, closer to home, the UK economy has not crumpled under the weight of Brexit worries. UK exporters have enjoyed a particularly strong last few months thanks to sterling devaluation and order books look healthy.

This improved outlook has been a catalyst for change and has not been good news for all asset classes. It is easy to point to Mr Trump as the watershed moment this year but, at least from a market perspective, it seems that change was underway before the US election in November. Debt markets have been strong for many years as interest rates fell, supported by central bank purchases and low inflation. This may have turned during the summer, peaking with German and Japanese sovereign yields turning negative (effectively investors paying governments to take their savings!) and a string of large corporates refinancing at historically extreme low levels. The subsequent improvement in growth outlook and signs of a pickup in inflation have since undermined bond markets and should not be ignored by central bankers. The Federal Reserve raised rates twice in 2016 and it will be interesting to see how Mark Carney reacts to inflationary pressures rising in the UK due to higher import costs – maintaining the lowest bank rate in history during a period of rising prices would appear difficult.

By historic standards, bond yields and bank interest rates remain unusually low. There should be scope for both to rise without causing upset in equity markets, but there may of course be bumps on the road to “normal” conditions. Markets dislike surprises and the current generation of central bankers seem to dislike hawkish action. In the event that inflation does continue to increase (it is a lagging indicator and could easily surprise us) then Governors Yellen, Carney, Draghi et al may be forced into precipitate action.

Valuations remain generally high and volatility is low at present, highlighting the fact that markets are relatively optimistic heading into 2017. The year ahead holds the potential for plenty of macro hiccups, from Brexit negotiations, to European elections and ongoing capital outflows from China. History tells us that the best returns are made from a starting point of high volatility and low market confidence. While we are not beginning 2017 in such an environment, the global economy does appear to be enjoying a cyclical improvement, for now this should provide a tailwind for markets in coming months.

Fred Mahon is the fund manager of JM Finn’s Coleman Street Investments service. Click here for more information.

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