2016 was chock-full of surprises, both in markets and in politics.
As Goldman's Allison Nathan explains, the year began with a perfect storm of worries that had become all too familiar already in 2015. Oil prices plunged and fears of faltering growth and a sharp depreciation of China’s currency escalated, driving disruptive sell-offs in credit and other risk assets. Confidence in global growth faltered, particularly after an anemic US GDP report for Q1.
But oh, how the world has changed. Today, the price of crude oil is almost exactly double its January low in the wake of announced production cuts by OPEC and key non-OPEC producers (Russia). We expect WTI oil prices to move higher to a peak of $57.50/bbl in 1H17 as the cuts push the oil market into deficit and whittle down the current large inventory surplus. But we also expect shale producers to respond to the higher prices, implying limited upside from there.
The rebound in oil prices led to a remarkable turnaround in credit markets, with HY Metals & Mining and E&Ps returning 49% and 36%, respectively, YTD; default rates normalizing; and spreads no longer pricing recession risk. We expect a further moderate compression of spreads in 2017 given expectations of a generally positive macro environment, gradual improvement in credit fundamentals, and, of course, our somewhat rosier oil outlook.
And fears about China have generally receded into the background as Chinese policymakers continued an ambitious stimulus program that helped stabilize growth. A more dovish tilt by the Fed in response to the tightening of financial conditions caused by the Q1 sell-off also assuaged market fears. But we warn that China risk is not far from the surface.
Capital outflow pressures have resumed amid the renewed strengthening in the US dollar. And policies that re-ignited growth in the short-term have just increased concerns about the future, particularly as credit growth has climbed. These potentially destabilizing trends merit watching next year, despite our mainline view of orderly currency moves and a continued bumpy deceleration in Chinese growth. (Side note: Meeting growth targets will be paramount next year amid China’s leadership transition.)
It was not long after the market left China, oil, and credit concerns in the dust that political uncertainty took center stage—a place where it has solidly remained since. Brazil had its president impeached amid one of the country’s longest recessions/depressions on record; French primaries established an unexpected presidential candidate in former Prime Minister François Fillon; and Italy will enter the new year with an interim government following the resignation of Matteo Renzi.
And we’ve not forgotten about one of the biggest political shocks of the year (decade, century?!): the UK’s vote in favor of Brexit. The now infamous Article 50, which needs to be activated to formally start the UK’s withdrawal process, still has not been triggered, and likely won’t be before March.
Meanwhile, UK and EU priorities for their future relationship remain at odds, leaving market participants closely watching “soft Brexit”/”hard Brexit” swings in the headlines. That said, UK growth has proved remarkably resilient, and assets have held up with the exception of sterling, which is 10% weaker than before the referendum. Next year, we expect a formal start to Brexit talks, a moderation in UK growth, and further declines in sterling as uncertainty over Brexit sinks in.
While it was hard to trump (sorry, we couldn’t resist!) the shock of Brexit, we dare say that Donald Trump defying almost all polls and betting markets to win the US Presidential election did just that. Trump’s cabinet and policy leanings are still being sorted out, but there appears to be potential for significant change ahead, be it in taxes, or environmental policy. There is no question that the policies of the new administration and their market implications will be Top of Mind throughout 2017.
The unexpected election outcome also super-charged the narrative around two themes already in train: the global trade slowdown and reflation. Trump’s protectionist rhetoric—and the considerable executive power he will have on trade policy—do not bode well for global trade growth, which had already slowed considerably in recent years, or for some multilateral trade deals on the table (think the Trans-Pacific Partnership or TPP). Although we are keeping an eye on potential protectionist measures (a particular risk for EM Asia and Mexico, but also a likely drag on US growth), we otherwise see signs of a moderate improvement in trade ahead. Key to watch: how countries respond to the apparent shelving of the TPP (e.g., bilateral vs. multi-lateral trade talks).
On reflation, we expect fiscal expansion and some further tightening in the labor market to sustain inflationary momentum in the US alongside moderately stronger growth, with US 10-year yields expected to end 2017 at 2.75%. This should be good news for equity markets at first: We expect the S&P 500 to rise to 2400 through 1Q2017, but then see the index settling to 2300 by year-end as rates rise further and investors recalibrate their policy outlooks. We still caution that equities are vulnerable should rates move too much, too fast, given stretched valuations following years of exceptionally low rates.
Lastly, despite recent market optimism about fiscal expansion providing more stimulus, central bank policy will never be too far from investors’ minds next year. (And let’s not forget that ECB and BOJ asset purchases in fact enable more fiscal spend, so the lines between monetary and fiscal policy continue to blur.) We expect an acceleration of divergence as the Fed follows last week’s hike with three more in 2017 while the ECB and BOJ continue their asset purchases under new and apparently more sustainable parameters.
Between this divergence, Trump, China, and a number of important European elections, 2017 is sure to be yet another interesting year for markets.
We wish you a happy, healthy, and prosperous New Year.
* * *
While you're relaxing on the sofa, full of food, and wine, here's Goldman's year-end crossword...