Year Ahead 2017

147 Pages·2016·6.66 MB·English

by  Steve Feiss

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.