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Year Ahead 2017 PDF

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Preview Year Ahead 2017

BECAUSE: The way to get good ideas StreetStuff YEAR is to go through LOTS of ideas, and throw out the bad ones… AHEAD … 2017 6. No More ‘One and Done’… in my view, December 30, 2016 the case for rate hikes will become more and more compelling as the year wears on. My policy outlook calls for 2017 calls for four quarter-point hikes, one per quarter, but I readily admit that the next move will be the hardest for the Fed… 7. There’s a New Sheriff in Town… Fri 12/23/2016 9:45 AM 8. Congress Comes Through… Year-End Review/2017 9. The Trump Administration Will Be Pro- Growth… Preview: Nap Time Is Over 10. Geopolitics Will Matter. There Will be Stephen Stanley Tension. I Am Watching China… Chief Economist Attached is my annual year-end review and preview piece, complete with 10 intrepid predictions for the New Year. 17 November 2016 Global Rates Quarterly …Renewing my annual tradition, here are Brave new world ten themes that I believe will be important next year, five related to the economic Global Rates Strategy: Brave new world 2 forecast and five related to the policy The US elections have changed the backdrop outlook and financial market developments. for global rates markets, and rates have likely bottomed. We maintain our recommendation to Economic Outlook short 2y US rates. Yield curves are likely to diverge at the front end, although inter-market developed economy spreads should stay 1. The Labor Market Is Going to Get contained at the long end. Seriously Tight… 2. Households Continue to Lead the Way… …Key Rate Views For now, our preferred way to position for the 3. Business Sector Finally Revives… sell-off is at the front end of the US curve. After 4. 3% or Bust. President-elect Trump and the US election, we recommended a short his camp have suggested that with the position in US 2y Treasuries (see A regime shift, November 10, 2016) on the basis that the Fed right policies, the economy should be will respond to overshoots on inflation and able to sustain 3% growth … unemployment, as well as lower recession risk, by hiking by more than is currently priced in. 5. Inflation Will Exceed 2% in 2017… …On the curve, the US 5s30s curve has already Policy Outlook steepened sharply, boosted by the sell-off in recent months in Japan and the UK, taper talk in Europe, and sharply higher US breakevens. At this point, the US curve should steepen only if …Supply/demand dynamics: Steady the Fed signals extremely dovish policy in the supply meeting domestic demand face of fiscal stimulus and improved economic …On the demand side, there has been a performance. However, global curves still have significant shift over the past few years. Figure 6 room to rise. With the ECB potentially reducing, if shows that over the one year ending June 2016, not eliminating, support to government bond foreign investors and the Fed did not increase markets, and the BoJ also providing less support their holdings of coupon Treasuries at all, even as to the super-long end via QQE with yield curve net issuance was close to $600bn; a year ago, control, we favour curve steepener expressions in they accounted for 30% and the year before Europe (through the Irish curve) and in Japan. 110%. Within foreign investors, it is essentially We see the BoJ reducing the pace of its JGB official investors who have been selling and purchases gradually, mainly in the super-long private investors are still likely adding (see Flows end, and expect the JGB curve to steepen slowly remain skewed toward spread products, 19 through H1 2017. October 2016). Regardless, it is the domestic investors who have been buying Treasuries. US Treasuries: Taking a breather 9 Investors have included mutual funds, banks and We believe 10y yields are likely to trade around those who have been displaced from the credit 2.25% until there is more clarity on the scale of markets as demand from foreign and the fiscal stimulus. We maintain our pension/insurance companies has exceeded net recommendation of being short 2y USTs and issuance in that sector. This is also reflected in the auction data, where investor allotment for short the 5s10s30s fly as markets should price domestic investment funds is close to the highs. in a more aggressive hiking cycle and an increased chance of an overshoot. We also We believe this shift in demand from foreign recommend going long the 10sUS30s fly. official to domestic private (and, to some extent, foreign private) argues for the cheapening of We believe 10y yields are likely to trade around Treasuries versus other asset classes (as foreign 2.25% in the near term until there is more clarity official investors typically do not lend in the repo on the scale of the fiscal stimulus. We maintain markets) and also a flatter curve as portfolios of our recommendation of being short 2y USTs and central banks tend to have low average maturity short the 5s10s30s fly as markets should price in of about 4 years. a more aggressive hiking cycle and an increased chance of an overshoot. We recommend going EGB Market Outlook: ECB to tread carefully 13 We see the ECB’s reaction function, especially following the long the 10sUS30s fly to position for a pickup in US election outcome, and European politics as the key drivers the liquidity premium and the potential for an of EGB market price action over the coming months. We increase in auction sizes in response to widening believe a “hawkish” tapering as unlikely from the ECB at this budget deficits… stage and recommend easing into bullish biased trades in EGBs opportunistically. …We believe 10y yields are likely to trade around UK Gilts: Between Scylla and Charybdis 16 2.25% in the near term until there is more clarity A slowing growth profile, a prolonged period of above-target on the scale of the fiscal stimulus, and then drift inflation, fiscal weakness and the uncertainty of the details of higher to 2.4% by mid-2017 (Figure 1). Below, Brexit leaves gilts in an unenviable position. Outright duration we discuss some of the likely drivers of the price remains treacherous and we see better value in 10y ASW and action over the coming months. In terms of money market curve steepeners. trades, we maintain our recommendation of JGB Market Outlook: Curve to steepen gradually through going short 2y USTs, short 5s10s30s fly and H1 17 p19 recommend going long 10sUS30s fly (see the Key Under quantitative and qualitative monetary easing with yield Trades section below). curve control, JGB yields across the curve have remained near levels seen prior to the September MPM. Although the …Debt limit: Not binding in Q1 but T-bill BoJ could still come under pressure to ease further during phases of rapid JPY appreciation, we believe additional action universe to shrink is unlikely to be up for discussion until mid-2017 or later. …Liquidity premia: Likely to rise heading Derivatives: Volatility makes a comeback 22 into year-end and the second hike In the US, we recommend selling USD 3m*5y straddles hedged for a sell-off by buying 3m*5y ATM+25 payers. In EUR, we suggest taking advantage of cheap vol levels to sell EUR 2y*5y 1x2 payer spreads. In the UK, we recommend buying  The rally in high beta was partly a product of GBP 6m*30y payer spreads versus selling 6m*5y ATM+25 a difficult 2015 and lower quality still trades payers. wide in a historical context. As long as growth remains positive and the hunt for yield is a US Money Markets: Debt ceiling major flow factor, we believe investors will disturbances 27 trail the market if they move to fully It is unclear if Congress will approve a re- conservative positioning considering the suspension in the debt ceiling ahead of its premium that exists in higher beta assets. March 15 expiration. If not, the resulting  For US investment grade we believe contraction in bill supply in early Q1 would pull spreads are at the tighter end of the bill and repo rates lower relative to OIS. range, particularly in the higher Government-only money fund demand may quality parts of the market, and exacerbate the rate decline. Separately, we therefore would advocate an expect LOIS to remain at 35bp. overweight to BBB’s. We also believe financials can outperform post- Euro Money Markets: Collateral is king 29 election. Collateral scarcity remains an important issue, but we do not  The European credit market will once again expect the ECB to intervene. In the repo market, core GC rates take its cue from the actions of the ECB, should remain expensive. Euribor fixings should continue to creep down. Market focus will be on details of Euribor and where we believe 2017 is unlikely to pass MMFs reforms, likely to be announced in Q1, that have the without widespread anticipation – or actual – potential to fuel some volatility. tapering of the pace of QE. With spreads tight and compressed compared to macro US Agency MBS: A look ahead 32 indicators, this makes us cautious on After underperforming following last week’s European credit, and we look to sell into election, mortgages now look significantly more rallies. attractive. Technical factors, including a  Default rates are either decreasing or deceleration in net issuance, slower remaining low depending on the market, and spreads are less stretched down the prepayment speeds, and a stable investor credit spectrum. This should set up high base, should also be supportive of the basis yield assets for another year of solid next year. Housing policy remains uncertain, returns despite the potential for short- but likely will become clearer in early 2017. term flow-related volatility due to interest rates. Global Bond Yield Forecasts 36  Our hesitations from recommending a full on down-in-quality trade stem from the 2 December 2016 commodity risk associated with the highest Global Credit Outlook 2017 yielding assets and increased uncertainty related to the changing political landscape. In Bracing for change a historical context, US CCCs and LatAm corporates look cheap, but at a micro level we believe incremental risks are higher as well.  The seminal political events of Brexit and the Still, the spread pickup should be enough to US presidential election caused uncertainty in produce superior absolute returns even if 2016, but were not enough to destabilize risk-adjusted results are less impressive. markets for an extended period. We expect  In Municipals, valuations are that as the effect becomes more actual than attractive since ratios have theoretical, volatility will be higher in 2017. This should cap return levels well below those increased vs. Treasuries, and the of the past year, but still produce attractive asset class has underperformed returns in a global fixed income context. corporates. However, it is difficult  The rising tide lifted most boats in 2016. In to imagine Municipals rallying in developed markets, US high yield CCCs led the first year of a Republican the pack with 24% returns. Among the largest contributors to emerging market presidency. spread tightening were commodity dependent  High quality ABS is trading at tight levels that countries in recessions, including Russia, are consistent with limited risks. Among the Venezuela and Brazil. wider trading sub-asset classes we believe CLO liabilities look attractive relative to other Issuance forecast ABS and even underlying loans. We also see We expect gross fixed-rate issuance in 2017 to be lower value in private student loan ABS and whole than in 2016 (Figure 27). We forecast $1,350bn of business securitizations. issuance (-10% y/y), which translates to about $625bn of  We are more cautious on the subprime net issuance (20% below this year’s total). We project that financials issuance will decline to $380bn, driven by auto sector. We do not think impairments a small pickup in US bank issuance, but more than offset are on the horizon for even the most junior by a drop in Yankee financial issuance. Meanwhile, we tranches, but between more loans with lower expect non-financial issuance to decrease to $655bn (- or no FICO scores, longer loan maturity 12% y/y) and non-corporates to issue $315bn of terms, an uptick in issuance and negative investment grade fixed-rate debt (-14% y/y). Please see headline risk, spreads do not present a our 2017 Investment Grade Issuance Forecast for more compelling risk/reward. detail. US Credit Strategy Investment grade new issue volumes have been on a Investment Grade Strategy: Riding the yield record pace in 2016. Fixed-rate issuance (including non- tide amid uncertainty corporates1) stands at $1,375bn,2 $40bn ahead of last We forecast that the US Corporate Index will year’s fullyear total of $1,334bn, roughly on pace for a 15% increase y/y. Netting out redemptions, tenders, and post an excess return of 175-225bp and a total matured debt results in $775bn of annualized net return of 3.25-3.75% in 2017. Tax reform and issuance, 25% above last year. As Figure 28 shows, fiscal stimulus should push out recession risks most of the increase in issuance has come from Yankee beyond 2018 and, along with higher Treasury banks, utilities, and non-corporates. In fact, the yields, provide support for spreads. The long combined (annualized) issuance from USdomiciled industrials and financials in 2016 is exactly flat relative to end of the credit curve offers the best value, in 2015 (both at $760bn). In our view, there have been our view, and we prefer financials over three main drivers of issuance: 1) M&A-related issuance industrials. has kept pace with last year’s record total; 2) strong growth in Yankee bank issuance (+$54bn, +45% y/y) FIGURE 3 has more than offset lower domestic banks issuance (- Investment grade credit is valued for more than five years $23bn, -16% y/y) to drive financials higher overall; and of economic expansion 3) non-corporate issuance has increased about $80bn y/y High Yield Strategy: Respite from economic concerns, for now We forecast excess returns of 5.5-6.5% and total returns of 7-8% for the US High Yield Index in 2017. Valuations should be supported by GDP growth, modest supply and strong institutional demand. We believe higher-beta credits will outperform, benefiting from open primary market conditions, economic growth and inflation. FIGURE 20 Leveraged Loans and CLOs: Plan for another solid Although 10y bonds have tightened relative to the front year end,they remain well wide of historical averages We expect total returns of 5-6% in 2017. Rising rates should lead to retail demand, and we also foresee solid CLO formation; both should support loan valuations. With more than half of the market at or above par and the sub-$90 universe highly idiosyncratic, the bulk of the price appreciation should come from the $90-100 bucket. Municipal Credit: The year of turbulence 2017 will likely be a relatively difficult and volatile year for municipals, as Donald Trump considers implementing various policies, many of which will affect munis directly. To us, the biggest realistic threat to the market is corporate tax reform, which should …A BAB-like program could also emerge under the substantially dampen demand from banks and Trump administration’s “America’s Infrastructure First” policy. If BABs are resurrected, larger insurance companies. negative effects of additional supply and of the long- forgotten ERP calls might occur. With respect to • 2017 will likely be a relatively difficult and volatile year for ERP calls, while there were few par calls, most were municipals, as Donald Trump considers implementing struck in a T+100bp range; many high grade credits various policies, many of which will affect munis directly. To us, the biggest realistic threat to the market is are trading tighter than that, and the reintroduction corporate tax reform, which should substantially dampen of BABs might allow some highquality issuers to call demand from banks and insurance companies. their outstanding bonds below their current levels • Assuming Treasuries stabilize at somewhat higher levels, (while refunding them with new BABs), resulting in we project total returns for the Bloomberg Barclays mark-to-market losses to investors. If BABs are Municipal Bond index to be about 2% in 2017, though we resurrected, some of the tighter IG credits could see a number of scenarios where munis perform much underperform as a result. worse. Meanwhile, taxable muni credit spreads are likely to widen about 5bp. 2017 Forecast • We forecast 2017 long-term gross issuance of $360- Unlike previous post-BAB era annual supply, this year’s 380bn, down about 16% y/y. As rates and muni- Treasury ratios move higher, we expect less advanced issuance will come in well above average. As stated refunding activity, but more new money and taxable earlier, long-term gross municipal issuance this year supply than in 2016. stands at $408bn, potentially surpassing the record • Overall, we recommend investing in better $433bn issued in 2010. Given the likely upward drift in quality credits across the board until there is interest rates next year, we expect 2017 supply to be more clarity with respect to tax reforms. We $360-380bn, down about 16% y/y, on the following would also prefer to trade up in rating and considerations (Figure 10)… coupon; to be overweight defensive sectors; and to shorten duration, as the yield curve is likely to …Taxable supply: continue steepening. For taxable issuance sold with muni CUSIPs, we expect • The tactical approach might come in handy this about $40bn of supply in 2017 (Figure 10). This forecast year. For example, levels could start 2017 relatively reflects the advantage of issuing in the less regulatory- cheap, supply could be underwhelming, while large intensive taxable market compared with the tax-exempt December coupon payments and redemptions should market. There could be a substantial possibility of an provide a positive backdrop. Hence, investors might upside surprise in taxable issuance next year. Factors consider overweighting the asset class going into 2017. supporting taxable supply in 2017 include… • Similar to 2013, crossover investors and direct retail will play an important role in stabilizing the Structured Credit: In a tight spot market and will likely be able to find abundant We favor short-dated floating rate assets, which should opportunities in the taxexempt space. Crossover benefit from a potential curve flattening; however, we buyers should focus on tobacco, healthcare, think there are compelling opportunities in subordinates corporatebacked munis and some other sectors. and more off-the-run sectors, which have not benefited They might also consider lightening up on their as much from this year’s rally, with some asset classes taxable muni exposure while reallocating into trading wider than they did a year ago. cheap tax-exempts. 2 December 2016 FIGURE 6 Municipal Strategy and Research Corporate vs. Muni Tax-Equivalent Yields 2017 Municipal Outlook: The Year of Turbulence • 2017 will likely be a relatively difficult and volatile year for municipals, as Donald Trump considers implementing various policies, many of which will affect munis directly. To us, the biggest realistic threat to the market is corporate tax reform, which should substantially dampen demand from banks and insurance companies. • Assuming Treasuries stabilize at somewhat higher levels, we project total returns for the Bloomberg Barclays Municipal Bond index to be about 2% in 2017, though we see a number of scenarios where munis perform much worse. We project total returns for the HY Muni Index to be 3%. 13 December 2016 Meanwhile, taxable muni credit spreads are likely US Equity Strategy to widen about 5bp. • Overall, we recommend investing in better quality credits across the board until there is more clarity FIVE PREDICTIONS FOR 2017 with respect to tax reforms. We would also prefer to trade up in rating and coupon; to be overweight As 2017 approaches we offer five defensive sectors; and to shorten duration, as the yield curve is likely to continue steepening. predictions for the new year. They • The tactical approach might come in handy this reflect our expectations for earnings, year. For example, levels could start 2017 dividends, buybacks, price relatively cheap, supply could be underwhelming, while large December coupon payments and appreciation, and sector redemptions should provide a positive backdrop. performance for the S&P 500. Our Hence, investors might consider overweighting the newly established 2017 year-end asset class going into 2017. price target is 2400, reflecting 17 November 2016 approximately 7% price appreciation Municipal Strategy and Research and a 9% total return. 2017 Supply Outlook Prediction 1: S&P 500 adjusted EPS will break out to at least $127/share. Following  Municipal issuance has maintained a strong pace in two years of stagnation we believe EPS growth is 2H 2016. It is currently on track to set an all-time poised to return in 2017 and our forecast is for it to annual supply record at $435-445bn, although reach at least $127 per share, which would represent market volatility could dampen issuance somewhat 7% growth. This forecast is supported by our view that in the coming weeks. revenue expansion will return, more than offsetting  For 2017, we forecast lower supply of rising wage pressure. Our upside case for EPS is $133 $360-380bn (down 16% y/y). We per share, which is 12% growth and reflects the project about $350bn of redemptions, potential benefits of tax cuts partially offset by a resulting in net issuance of about +20bn. strong U.S. dollar. We expect new money and refunding Prediction 2: Dividends will reach supply to be evenly split, at about $48/share, marking a 54% increase in $185bn each.  2017’s supply is likely to be lower just five years. Rapid and consistent growth in because of less refunding and a dividends has been one of the most positive themes for the S&P 500 and we expect it to continue in 2017. substantial number of deals that were Our forecast is for dividends to grow by 5% to $48 per accelerated to get in front of elections share. A high payout ratio should constrain growth but and the likely Fed hike in December, not eliminate it. although stronger new money issuance could partially offset this decline. Pace of Prediction 3: Gross buybacks will be issuance is likely to underwhelm in 1Q, unchanged at approximately $600bn. We in our view. expect buyback activity to remain close to a record  For taxable issuance, we expect about $30bn in high although the rapid growth phase may have come 2017. If BABs are resurrected, we project an to an end. The recent increase in buybacks has been upside surprise to our taxable forecast of $25- fueled by debt but elevated leverage ratios suggest 50bn. further growth may not be achievable. The wildcard is a potential change to tax policy regarding permanently FIGURE 6 New Money after Elections (2010-16) reinvested earnings, which would enhance financial flexibility. Prediction 4: The S&P 500 will end the year at 2400. We are predicting a 7% gain for the S&P 500 in 2017, in line with our baseline EPS growth estimate. Inherent in this forecast is an assumption that valuation multiples will remain unchanged, as they are already elevated and we are late in the business cycle. Our upside case, which is not an unlikely scenario, is a gain of approximately 12% to 2500 in line with our tax-led upside EPS growth forecast. We frame the downside case for the price of the S&P 500 Prediction 5: Health care will be the in 2017 as an approximately 10% decline to 2000, best performing sector in the S&P 500. reflecting tighter financial conditions but no recession. We believe health care is poised to be the best performing sector in 2017, bouncing back after being FiGUre 11 the worst performing sector so far in 2016. While …AND THE INCREASE IN RATES HAS MADE VALUATION political risk remains, positive considerations include LESS COMPELLING IN RELATION TO OTHER RISKY cheap valuation, adequate price inflation, favorable ASSETS cash flow, and stabilizing fund flows. With a PE ratio that is at its 52-week low in relation to the S&P 500, no sector has better potential upside entering 2017, in our opinion. 17 November 2016 Global Outlook Turning point FOREWORD “I don’t need my generals to be brave”, Napoleon Bonaparte is supposed to have said. “I need them to FiGUre 12 be lucky”. Investors who have lived through the past tHE PROBABILITY OF A RECESSION IN 2017 IS LOW… few weeks will nod their heads sagely and tell you that they know exactly how the French leader felt. For the second time in six months, the world has seen a momentous political outcome that completely upended existing consensus. And for the second time in six months, most risky financial assets (such as equities and credit) have not only survived the aftermath, they have thrived – the exact opposite of what the consensus would have dictated. In addition to the political earthquakes from the US presidential elections and Brexit, there are two slower- moving but important changes occurring. First, political consensus about fiscal expansion had started to shift globally, even before the Trump win turbo-charged expectations in the US. Japan, China, the UK and parts of Europe have either moved away from fiscal FiGUre 13 consolidation or are outright pushing fiscal expansion. …BUT FINANCIAL CONDITIONS ARE TIGHTENING Second, medium-term inflation expectations seem to have finally bottomed in mid-2016 after years of declines, at least in major economies not named Japan. Year-on-year growth might have been mediocre in the current economic expansion, but the business cycle has been long-lived, with output gaps closing steadily and major economies around full employment for a while. This is finally being reflected in inflation data and breakevens. So the macro backdrop is one where maturing economies with little slack and gradually building inflationary pressures are likely to be boosted by economic stimulus. The long bull market in bonds might have ended, at least for the foreseeable future. At the same time, we caution that there is an unusually high dispersion of potential outcomes around our economic baseline in this cycle. This is partly due to the uncertainty regarding President-elect Trump’s policies, and their impact. For example, if he hikes tariffs or declares China a currency manipulator, will that spark a trade war? We assume proportional against this, threatening global trade responses by affected countries, but that is opinion, relations. Gains for anti-globalization parties not fact. Will the new administration be able to pass in upcoming European elections could further fiscal stimulus without offsetting cuts, a stance that add to this political uncertainty. goes against decades of Republican orthodoxy on  Core central banks will have to account for public debt? Will his policies on immigration and the these risks and will likely move cautiously. Affordable Care Act be milder than election rhetoric? This should contain the rise in core yields and Many such assumptions are built into our relatively benign economic outlook, far more so than in previous related pressures on EM economies. changes of government in the US. While the US has Otherwise, a scenario of renewed dollar trend elevated policy uncertainty, Europe has elevated appreciation and commodity weakness could political risk. Three major governments have national bring back the volatility around China and elections, and in two of them, the Netherlands and EMs experienced earlier. France, leading political parties have a strong anti-EU stance. If market-implied probabilities of a country leaving the currency union rise sharply, the economic Commodity Markets Outlook 33 and financial consequences could be dramatic. A more uncertain path Investors who dismiss European politics because of the relatively calm reaction to Brexit do so at their peril. We see further improvements in commodity fundamentals ahead. However, uncertainty has In other words, life promises to be exciting for risen, as many of Trump’s possible policies have both investors in 2017. And analysis, at both the macro and positive and negative implications for micro level, will be key to outperformance in a world different commodity markets. where many assets are already at historically elevated valuations. We hope that this publication helps you,  Commodity prices have performed much our readers and clients, make successful investment more strongly in Q4 than for many years and decisions in the year ahead. we see further improvements in fundamentals ahead. Overview 4  Uncertainty has risen since the US election as Turning point many of President-elect Trump’s possible The macro backdrop is now one of mildly improved policies have both positive and negative growth, firmer inflation, and a shift to implications for different commodity markets. fiscal stimulus in major economies. However, the  Nevertheless, we expect oil and US natural prospect of higher policy volatility in the gas prices to recover from their recent dips, US and higher political uncertainty in Europe means the though the huge run-up in copper and iron range of potential outcomes for ore prices looks overdone. financial markets is unusually large entering 2017. Foreign Exchange Outlook Steeper rage Economic Outlook 13 Markets face a brave new world of steeper yield curves Political change brings policy change and manifest “Politics of Rage.” They have chosen to take a more optimistic interpretation of The global economy has been moving in the right these events, and we cautiously assume direction, but the outlook is unusually that they are correct, but the range of potential outcomes uncertain; the expected US fiscal expansion should is diffuse. add to better growth and inflation, but new protectionist measures could work against this, threatening global trade relations. Gains for Interest Rates Outlook 46 anti-globalization parties in upcoming European Brave new world elections could add to the uncertainty. The US elections have changed the  The global economy has been moving in the backdrop for global rates markets, and right direction. Growth accelerated in Q3, and rates have likely bottomed. Yield curves the momentum could extend into coming are likely to diverge at the front end, quarters. In parallel, inflation is picking up on although inter-market developed oil-related base effects, while core labor markets are also tightening further. economy spreads should stay contained  The outlook is unusually uncertain, however; at the long end. the expected US fiscal expansion should in principle add to better growth and inflation, but new protectionist measures could work Credit Market Outlook 53 sovereign commodity producers. Improving fundamentals argue for an overallocation to The end of the innocence LatAm, but recent US election results provide a counterbalance. Brexit and the US presidential election caused  In Municipals, valuations are attractive since ratios uncertainty in 2016, but not enough to have increased vs. Treasuries, and the asset class has underperformed corporates. However, it is destabilize markets for an extended period. As difficult to imagine Municipals rallying in the first the impact becomes more actual than year of a Republican presidency. theoretical, volatility will be higher in 2017 and  High quality ABS is trading at tight levels that are cap return levels well below those of the consistent with limited risks. Among the wider trading sub-asset classes we believe CLO liabilities past year. look attractive relative to other ABS and even underlying loans. We also see value in private  The seminal political events of Brexit and the US student loan ABS and whole business presidential election caused uncertainty in 2016, securitizations. but were not enough to destabilize markets for an  We are more cautious on the subprime auto extended period. We expect that as the impact sector. We do not think impairments are on the becomes more actual than theoretical, volatility horizon for even the most junior tranches, but will be higher in 2017 and cap return levels well between more loans with lower or no FICO scores, below those of the past year. longer loan maturity terms, an uptick in issuance  The rising tide lifted most boats in 2016. In and negative headline risk, spreads do not present developed markets, US high yield CCC’s led the a compelling risk/reward. pack with 24% returns. Among the largest contributors to emerging market spread tightening Equity Market Outlook 65 were commodity dependent countries in recessions, including Russia, Venezuela and Brazil. Reassessing the rotations  The rally in high beta was partly a product of a difficult 2015 and lower quality still trades wide in Going into 2017, equities should be supported by a historical context. As long as growth remains an upturn in EPS and still attractive valuations positive and the hunt for yield is a major flow versus bonds, though volatility is likely to remain factor, we believe investors will trail the market if elevated. The rise in rates should accelerate they move to fully conservative positioning the bond-equity rotation, and implied equity considering the premium that exists in higher beta allocations are still 3-4pp below 2015 levels. assets.  For US investment grade we believe spreads are at the tighter end of the range, particularly in the  Going into 2017, equities should be supported by higher quality parts of the market, and therefore an upturn in EPS and still attractive valuations would advocate an overweight to BBB’s. We also versus bonds, though volatility is likely to remain believe financials can outperform post-election. elevated. The rise in rates should accelerate the  The European credit market will once again take its bond-equity rotation and implied equity allocations cue from the actions of the ECB, where we believe are still 3-4pp below 2015 levels. 2017 is unlikely to pass without widespread  A US 10y range of 2.0-2.5% in Q1 17 anticipation – or actual – tapering of the pace of suggests the rates-related equity QE. With spreads tight and compressed compared rotation is 75%+ through near term, to macro indicators, this makes us cautious on while USD strength should continue European credit, and we look to sell into rallies.  Default rates are either decreasing or remaining to drive country equity returns. The low depending on the market, and spreads are less recent rise in many commodities stretched down the credit spectrum. This should seems at odds with USD strength. set up high yield assets for another year of solid  Populism has momentum, liberalism does not. returns despite the potential for short-term flow- Taxes and regulations are being reduced while related volatility due to interest rates. labor headwinds are rising. Politics are an  Our hesitations from recommending a down-in- overhang in Europe, but much appears to be priced quality trade stem from the commodity risk in. associated with the highest yielding assets and  Trump’s protectionist plans look positive for US increased uncertainty related to the changing equities (but not the rest of the world). A 15% political landscape. In a historical context, US corporate tax rate could boost S&P 500 EPS by up CCC’s look cheap to the high yield market, but at a to ~10%, but there could be sizeable offsets. micro level we believe incremental risks are higher  Across regions, we would prefer to own USD assets as well. Still, the spread pickup is enough to justify (US equity overweight); reduce EM exposure a neutral position, in our view. tactically to neutral, given FX hedging costs, but  The down-in-quality trade in emerging markets selectively buy the dips; and prefer euro area over means exposure to Latin America and its quasi- Japan in local currency terms.  We recommend staying overweight financials and spiked higher, contributing roughly two thirds of healthcare, underweight bond proxies. Financials the rise. However, it is unlikely that the USD have largely moved with rates but an improved would surge to the extent and broad basis that it regulatory and capital backdrop keeps us long. did if the rise in both was largely driven by policy Healthcare relative valuations have nearly 20% risk premia (Figure 7). Similarly, the sharp drop upside to 2015 levels. in the S&P 500 equity risk premium is also  Rotate into discretionary and out of industrials. inconsistent with the rise in yields being mainly Consumers stand to receive a $620bn+ windfall from lower taxes, yet S&P 500 discretionary due to a risk premium for USD assets (Figure 8). market cap is $80bn lower QTD.  The market appears overly excited about Trump’s …Because of the slower near-term growth and infrastructure plan, but the ~$500bn increase in the uncertainty that would prevail over a fiscal China public FAI spending in 2016 dwarfs package, we expect the Fed to pause between estimates for US upside. We prefer defense over the December hike that we forecast and machinery given defense spending is ~$100bn September when it resumes as uncertainty over below pre-sequester levels and machinery is the fiscal offset to tariffs is lifted. We expect this trading at the highest P/E premium (23%) since to lead to more of a saw-tooth pattern for the 2010.  Across styles, as inflation and rates rise, value USD, with gains concentrated later this year, should continue to outperform and the low vol going into the December FOMC meeting, and in unwind has further to run, particularly in Europe; H2 17 as fiscal uncertainty clears. In the interim, we prefer US small caps over large caps. the USD may struggle or tread water as markets reassess “Trumponomics”. Emerging Markets Outlook 77 Finding a footing in political crosswinds But these forecasts assume much that is Adverse implications of more protectionist US policies unknown in reality. The Trump platform is and steeper core yield curves are likely to weigh on unclear and already shifting post-election, hence economic prospects, sentiment and the outlook for EM prioritization, form and magnitude of intended assets. However, we expect the cyclical improvement in policies all are highly uncertain. We do not even bottom-up EM fundamentals to continue for now have much insight into the Cabinet and White and see the case for select longs in EM, particularly in House team that will determine and push those credit, rather than local markets. policies. Combined with Mr. Trump’s unconventional path and past policy 17 November 2016 contradictions, the distribution of plausible Global FX Quarterly potential outcomes is much larger than for any modern American president, implying far greater uncertainty over the impact on the US and global Steeper rage economy, asset prices and exchange rates. Yet, ironically, we expect this uncertainty will Markets face a brave new world of steeper yield manifest itself in a stronger USD regardless. curves and manifest Politics of Rage, with There is no real alternative to the USD as a arguably unprecedented uncertainty (for the reserve currency or as a large-enough safe haven modern era) surrounding a wide range of US for global portfolios in times of stress. The EUR is policies including fiscal, trade and foreign itself a victim of The Politics of Rage (23 October relations. Markets have chosen to take a more 2016) and Europe is the likely future epicentre optimistic interpretation of these events, and we (see below), particularly if the EUR were to cautiously assume that they are correct, but the appreciate sharply and rising global risk premia range of potential outcomes is extremely diffuse. crush global growth. Japan’s markets are neither Amid this uncertainty, volatility markets appear large enough nor welcoming. China does not to be underpricing both tails and the potential for even have a convertible currency and its debt further increases in volatility. markets do not inspire confidence. Further, the key risks that appear to worry market Making the USD great again participants about a Trump administration – …The election result also led to a sharp sell-off in reversing globalisation, geopolitical instability, or US Treasuries, consistent with one popular pre- reckless fiscal policies – likely harm the rest of election thesis that Mr. Trump represents a risk the world more than the US, which benefits from to USD assets, in particular the USD’s reserve the world’s largest and most dynamic economy, a currency status. Both the real component and the secure position in its own hemisphere and the inflation breakeven component of Treasury yields world’s most powerful military.

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globally, even before the Trump win turbo-charged expectations in the US. Japan, China, the UK and central bank policy and macroeconomic uncertainty. In this week's call we present our 2017 Our core pricing assumption for 2017 assumes a modest uptick in diesel prices throughout the year.
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