The Top Ten Financial Markets Questions for 2017

Some events are true black swans – for example, the September 11 th terrorist attacks or the tsunami in Japan – one-off events that create immediate financial panic, but may or may not exacerbate underlying economic vulnerabilities. However, political events that we saw in 2016 – Brexit, the election of Donald Trump in the US and the Italian referendum – are different in that these are manifestations of underlying forces of populism that have been building for years. Populist angst has been rising amid sluggish economic growth and loss of faith in traditional institutions, which have promoted liberal immigration and trade policies, let alone monetary policy that seems to have hit a wall. The resulting political upheaval creates a much wider range of possible outcomes, creating ever more uncertainty for the global economy and financial markets.

As 2017 gets underway, the immediate question on everybody’s mind is what happens next with respect to policies pursued by the incoming Trump administration, not to mention the impact of these, including the reaction function of the Federal Reserve and other countries. Whether China can manage its transition to a consumption-based economy while fighting capital outflows remains a key risk. Also, heavy clouds of political uncertainty hang over Europe just as several countries in the region appear to be making a cyclical recovery.

While we stay away from making forecasts and predictions, there are a number of things we are keeping a close eye on. We frame these as ten questions that we will continuously be seeking answers to.

1. Will fiscal spending by the Trump administration meet expectations?


Equity markets, and bond markets, are clearly pricing in significant fiscal stimulus from the incoming Trump administration, including major changes to the tax code (corporate and personal), regulatory upheaval, infrastructure and defense spending. However, the Trump rally is currently based on conjecture. The President-elect’s policy proposals remain opaque and the reality is that all of these policies will have to go through Congress. Even with a Republican Congress, any significant tax reform package is unlikely to pass before the summer, especially if they try to make the package revenue-neutral (which would remove any stimulus impact). Deficit-hawks in Congress have also begun to pour cold water on any major infrastructure-spending bill. It is an open question as to how much pressure the Trump administration can put on Congress to get its way. There is always the possibility that the final package could surprise to the upside, but with Congress’ role in crafting the various pieces of legislation, we are more than likely to see the opposite.

2. Will America look inward and reverse decades-long trade policies, perhaps leading to a trade-war?


Trade policy has been an area where President-Elect Trump has stood firm on throughout the campaign, and after. The fact that he is serious about trade is reflected in his appointees to set trade policy, including the Commerce Secretary, the U.S. Trade Representative, and the head of a newly created White House office that will oversee American trade and industrial policy – all of whom are highly critical of the U.S.-China trade relationship as it stands today, let alone globalization. The question is how the new administration will go about restructuring America’s existing trade relationships and upend decades-long policies that both parties in Washington have acquiesced to, and whether this will be done in concert with a Republican Congress that has traditionally been very pro-trade. Will they institute something like import tariffs – the President-elect’s team has floated a 10% tariff aimed at promoting American manufacturing – or remove expensing of import costs while restructuring the tax code, which are essentially tariffs?

While the Trump team’s goal is to raise GDP growth by reducing imports, it is not quite as simple since imports actually rise as the economy grows with higher consumption, resulting in more trade deficit. So it will not be easy to cut the trade deficit for an import-dependent country like the U.S. while also expecting it to grow above average.

Of course, none of this can be done unilaterally and we have to assume that other countries will retaliate as well. We could then be looking at significant consequences for companies in the U.S. that rely on global supply chains, and ultimately consumer prices. Not to mention the impact on countries, especially those in Asia, that play a critical role in these global supply chain routes.

3. How will the Federal Reserve react to increased fiscal spending?


Fiscal spending by the new administration will be carried out in an economy that is near full employment and is starting to see wages rise. This is clearly an environment in which the Fed believes fiscal spending is not required, as Fed Chair Janet Yellen noted after the Fed’s December meeting:

“ I would say at this point that fiscal policy is not obviously needed to provide stimulus to get us back to full employment ”.

While the Fed seems inclined to wait and see what fiscal policies will actually be implemented, they may look to normalize rates at a faster than expected pace (of three rate hikes in 2017) if inflation appears to be heading out of their comfort zone. In that event, we could see some tension between the Fed and the executive.

We could also see a flattening of the yield curve if fiscal policies fail to provide the expected boost even as the Fed continues along their current trajectory of rate hikes. Note that a flattening of the yield curve by itself is not indicative of future recession (unlike an inverted yield curve). Throughout the late 1990’s, when the economy was expanding at a rapid pace, the yield curve was considerably flatter than what it is today.

Is whether the U.S. is entering a period of political and economic uncertainty in 2017 with unclear policy administration and premature monetary policy tightening?

4. Will the US dollar continue to rise?


The Fed embarking on tighter monetary policy was always likely to push the dollar higher, especially with Europe and Japan still mired in negative and near-zero rates across the curve. With the Trump administration looking to promote “America First” policies, especially with respect to trade, the dollar could see a further boost.

Ironically, the rising dollar will only make it harder for American manufacturers to compete overseas, while providing ever more incentive for American companies to offshore operations. A rising dollar will also be negative for emerging markets, especially China, which we discuss below.

5. Will rising interest rates crimp US consumption spending?


Consumer spending has been the driving force behind the recovery since 2009, with housing, car sales and durable goods sales all benefiting from the low rate regime. Car sales have already begun to level off and durable goods may see a double blow if import prices also rise. Private residential investment, i.e. investment in new single and multi-family structures, home improvement and commissions, has historically been a strong contributor to GDP but has been weak during the entire recovery – a key reason behind the sluggish recovery. Residential investment slowed in 2016 and is likely to do so again in 2017 if interest rates continue to rise, putting an additional dampener on growth.

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6. How will China deal with its transition while fighting capital outflows?


Equity markets cratered during the first week of 2016 after Chinese authorities fixed the yuan reference rate at a five-year low on January 6 th . Concerns continued throughout the year, with China spending nearly $329 billion of its reserves, on top of $513 billion in 2015, to defend its currency amid capital outflows. This is despite an uptick in economic data – third quarter GDP growth came in on target at 6.7% but it was primarily driven by local government debt. The Chinese have made advances to transition their economy away from export-led manufacturing but the service sector still makes up about 50% of the economy. Sectors like telecom, healthcare and education continue to be tightly controlled by the state. The question is how long the Chinese can continue to provide short-term support on the back of a rising debt load that is already close to 250% of GDP.

While the yuan caught a break mid-year as the dollar stabilized at a lower level, it came under renewed pressure as the dollar resumed its rise after the U.S. election. Reserves fell to a six-year low of $3.01 trillion in December 2016 even as the country saw $82 billion of capital flows just in that month. In addition to fighting capital outflows with its foreign reserves, the Chinese also introduced stricter capital controls recently. Chinese authorities may come under renewed pressure to stem outflows if the dollar continues to rise in 2017. The problem is that stricter capital controls will depress business sentiment, especially foreign direct investment. The other option is to raise interest rates, which will hurt their heavily indebted borrowers. As we wrote at the beginning of the year, the overseers of the world’s second largest economy may be forced to resolve their way out of the impossible trilemma by letting go of one of the following – low interest rates, a stable exchange rate or ending the free flow of capital – and how they go about doing this remains one of the biggest known-unknown risks.

7. How will China retaliate if the Trump administration starts a trade war?


This question arises if the new administration decides to act on its rhetoric and slap tariffs on imports, especially Chinese imports. It is an open question as to what retaliatory actions the Chinese will take if this occurs. China’s own problems, not to mention the fact that it runs a huge trade surplus with the U.S., narrow the space within which it can act. They could, however, make it difficult for U.S. entities to do business seamlessly in China, with more taxes and investigations. Access to Chinese markets is critical to the growth trajectory of large U.S. companies like Apple, Boeing and General Motors.

8. What will be the impact of rising anti-EU populist sentiment in Europe?


The major European countries like Germany are seeing a backlash against a core EU principle, the free movement of people across borders, in the face of refugees streaming in from a war-torn Middle East and terrorism. Furthermore, 2017 will see elections in some of Europe’s major countries, including the Netherlands in March, France in May and Germany in the fall. At this point it looks increasingly likely that the populace in these countries will move further towards parties that are antagonistic toward the union. Note that his does not imply a breakup of the common union. Instead, Europe is likely to muddle through as it has over the past seven years.

However, rising populist and nationalistic sentiment will constrict the space within which EU governments can ease the ever-increasing pressures of remaining in a monetary union (especially for countries on the periphery like Italy and Greece) – like creating a fiscal union, joint debt issuance or continent-wide fiscal stimulus. Weakened leadership across the union also raises the possibility that Europe may not be able to act deftly to deal with, say a continent-wide banking crisis, which would only make the region even more susceptible to anti-EU populist movements.

9. How will the United Kingdom manage Brexit?


Prime Minister Teresa May of the United Kingdom (UK) has said that they will begin the divorce process from the EU by invoking Article 50 of the EU treaty by the end of March. The hard work of Brexit then begins. The Prime Minister has reiterated that Brexit will in fact be a “Hard Brexit” – meaning Britain will regain complete control of its immigration policies, laws and regulations, at the price of losing access to the common market.

The Brexit vote in June did not sink the British economy but uncertainty will rise as negotiations begin. The big question is how the government manages the transition period while negotiations are underway, which could take years. For instance, while remaining part of the EU’s customs union, which allows free flow of goods and services across borders, the UK cannot negotiate new trade deals with other countries outside the EU. It is against EU law for a member to negotiate its own trade deals with outsiders. So the UK can only start this process after it has left the EU – which essentially means that they cannot conduct separate trade talks for up to two years. If they do immediately exit the customs union, the hope would be for a transition arrangement, but as of now, the remaining EU members appear unwilling to extend such accommodation.

The UK government also appears to be underestimating how long t will take to negotiate bilateral trade deals once it leaves the EU. Trade negotiations take years because these deals almost always include the service sector, which is harder to sort out than the exchange of physical goods. Each country, including the US, has only a limited amount of staff that can simultaneously work on several trade negotiations. In fact, the UK is even more at a disadvantage since all its existing trade agreements were done under the auspices of the EU and negotiated by teams from Brussels. This means they will have to cobble together an entirely new team of trade negotiators with the requisite skills to create its own sovereign trade regime, all in rather quick order.

10. Will crude oil prices stabilize around $50 a barrel?


Equity markets began 2016 tightly correlated with oil prices – the correlation between the S&P 500 index and oil prices hit 0.88 during the first twelve weeks of the year. However, this correlation reduced after oil prices stabilized in the latter half of 2016, even as equity markets closed the year at record levels. While the price of crude was given a significant boost after OPEC reached a deal to make production cuts beginning in 2017, there are several factors that could prevent it from going much higher.

  • OPEC countries cheat their production quotas often and it is an open question whether Russia (a non-OPEC member) will abide by the cuts.
  • Prices are currently in contango, indicating short-term over-supply.
  • US shale companies produced an additional 300,000 barrels per day (bpd) in 2016 and this could rise to a million bpd in 2017 as more rigs start coming online. That would make them the marginal producer – and there is no deal that requires shale companies to cut back production, except market prices.
  • A rising US dollar could also impact worldwide demand if it makes oil, which is priced in dollars, more expensive.
  • Demand could also slow if China continues its slowdown. The International Energy Agency projects demand to rise only 1.3 million bpd in 2017, down from 1.4 million bpd in 2016.