Easing Global Headwinds Point to Higher Equities in 2017: Populism and reflation make easy bedfellow
The political upheavals of 2016 caught many by surprise. That in itself is surprising, for the simple truth is that waves of populism are recurring features of economic history. Karl Marx predicted the first breakdown of globalization back in 1848, and Franklin Roosevelt was initially viewed as a very populist president. Today’s collapse of confidence in the political establishment became inevitable once the economic failure of the post- 2008 era was accepted as the “New Normal” and not just a transient phase.
In November, the U.S. electorate delivered a resounding message: Economic growth must be the preeminent priority. Monetarist dogmas are being abandoned in favor of fiscal, trade, regulatory and tax policies that will intervene directly in economic outcomes. While this regime may seem nebulous or precarious compared with its predecessors, the direction of things is clear. Populism has always been associated with reflationary impulses and reflation is good for equities.
For 2017, we expect:
» More upside than downside for equities, with the S&P 500 Index reaching 2400 by early 2018. Drawdowns of more than 5% or levels below 2150 are unlikely. Equities will be driven more by earnings growth than shifts in valuation. Consensus expectations for corporate profits (+11%) are realistic and assume modest recovery in nominal GDP. With tax reform and stronger economies overseas, earnings growth could surprise positively.
» President Trump will aggressively manage the U.S. economy, much like Jack Welch ran General Electric. Like the Chinese leadership, Trump is not afraid to intervene economically to create desired social outcomes. Fiscal stimulus, tax reform, a broad freeze in regulation and reparation of overseas cash will revive the “animal spirits” of which Keynes spoke so fondly. On the other hand, protectionism and immigration policy are risks to watch.
» Against this backdrop of sustained U.S. expansion, the upturn in the eurozone is gaining momentum. Coupled with brisk activity in Germany and Spain, the French economy appears to be emerging from its doldrums. Leading indicators across Europe are consistent with 2% GDP growth and imply this cyclical upswing will become self-sustaining. Politics are a wildcard, but European equities could comfortably outperform their U.S. counterparts in 2017.
» Fed policy is critical. Chair Yellen will remain patient in 2017 but the Fed is likely to over-hike and trigger a slowdown and bear market by mid-2018. Other concerns to monitor include whether U.S. bond yields overshoot on the upside, excessive U.S. dollar strength, and how well the Chinese manage their shift to slower growth.
Global headwinds are giving way to flickers of reflation (Figure 1). Fiscal austerity is ending, bank deleveraging is complete, and the decline in oil and gas capital expenditures is over. The emerging economies are bouncing off their lows, supported by stronger PMIs for commodity exporters (Russia and Brazil). U.S. inventories, which were a drag for five quarters, are adding to growth again.