- 2016 will be remembered for political upsets, with the UK vote to leave the European Union and the election of Donald Trump highlighting voter dissatisfaction with mainstream politicians and parties. For investors, it will probably also go down as the year when global deflation fears came to an end, long-term interest rates finally started to rise, and central banks stopped being the “only game in town”.
- Faster reflation and reduced emphasis on monetary policy would both tend to increase the returns of equities relative to bonds in the future, and to point investors in the direction of cyclical assets over more defensive ones. Within fixed income, it would also tend to argue against holding long-dated bonds. But the structural and supply-side factors that are constraining global investment and productivity growth, and pushing up the relative demand for safe assets, have not gone away. These structural constraints, coupled with the fact that the US is much further along the reflationary road than other parts of the developed world, suggest the search for both income and new forms of “safety” will continue to be crucial for investors.
- Politics and policy are likely to dominate headlines again in 2017, with Brexit negotiations due to start and key elections in Europe. But for investors, we would argue that the real economy will continue to be the most important factor - especially supply-side dynamics in the US, the resilience of the eurozone and UK recoveries in the face of uncertainty, and the pace and extent of any further appreciation in the dollar.
I. A turn in the weather
Since the global financial crisis, growth has consistently fallen short of expectations, especially in the developed world. Globally, economic output is 9% lower than if it had merely returned to its pre-crisis trend, and for the advanced economies the average shortfall is closer to 13%. The US has done better than most, but with average growth of just 2.1% a year over seven years, this is the slowest economic expansion since World War II. As the governor of the Bank of England (BoE), Mark Carney, has pointed out, real earnings for the median worker in the UK are no higher than in 2006 - the worst performance since the 1860s.
The break with the past is even more noticeable when you measure demand in nominal terms, especially in the eurozone and Japan. Eurozone nominal GDP in the third quarter of 2016 was 11% higher than at the start of 2008. Over the preceding eight years, the cash value of the economy had grown by 40%. As Exhibit 1 shows, the UK and US have been more successful at sustaining nominal demand, but even in these economies, nominal demand has been consistently weaker than in the past.
Nominal growth since the crisis has been subpar across the developed world, but weakest in the eurozone and Japan
Exhibit 1: Nominal GDP growth