2016 was a year of political change and uncertainty.
The UK’s decision to leave the European Union and the US election of Donald Trump were certainly unexpected events, but it was perhaps more surprising that equity markets eventually reacted positively in both cases. Twice in 2016 we saw a dramatic event cause media mayhem and uncertainty, only to be followed by optimism and strong markets. The weakness in sterling was perhaps the only significant expression of negativity resulting from the vote for Brexit.
We are reminded of an Edward Murrow quote “Anyone who isn’t confused doesn’t really understand the situation.”
This time last year, we emphasised the benefits to the global economy of the fall in the oil price. We also expected that US Federal Reserve would maintain low interest rates for longer than previously expected. These effects combined with supportive monetary policy by central banks across the globe to underpin the global economy and markets.
2017 is likely to be mired by further political uncertainty, but for investors, an equally dominant theme will be the return of inflation.
Inflation in 2017
Inflation has been low in western economies since the financial crisis due to a combination of relatively weak demand and the deflationary effects of globalisation. Commentators have been expecting a resurgence of inflation over the last few years but deflationary pressures have persisted. However, 2017 will be the year when inflation finally returns to the US and UK, and if it doesn’t spiral out of control, may well be beneficial for both economies. The story is not the same for Europe where deflationary pressures are likely to persist.
Given that the whole world is now watching America to see what Trump’s new administration will bring, our main focus for this review will be on the US.
The home of the brave
To contradict Mr Trump’s perceived need to “Make America Great Again”, the US economy is operating at close to full capacity, with unemployment at 4.7%, and average wages rising at 2.9% in December, the fastest rates since 2009.
Any serious effort to stimulate the economy in this position will encourage inflation, and Trump’s economic policies are expected to provide a significant boost to the economy. We are promised deregulation, which will be well received by businesses and the markets, and we should also expect significant spending on infrastructure and tax cuts for corporations and individuals. This combination of spending and tax cuts will quickly push the US government debt mountain to over $20 trillion, but will also add significant inflationary pressure.
Trump’s plan to boost employment will, however, be very challenging, firstly because of the capacity issues mentioned above, but also because technology and automation pose a far greater threat to the labour force than the threat of outsourcing workers to other countries. In addition, any effort to erect trade barriers will add pressure to inflation, given that the average US worker is paid several multiples of his or her equivalent in Mexico or China. It is worth considering the recent example of Carrier, a subsidiary of United Technologies. The company was strongly encouraged by Trump to cancel a plan to move operations to Mexico, which will significantly impact production costs given that Carrier employees earn ten times as much as their Mexican equivalents.
Across the world, economic data is improving, and businesses in the developed world and Asia are increasing their demand for raw materials, labour, and other inputs into production. Meanwhile, in China, the excess supply of these inputs that has persisted for years is now starting to fall. So the demand for business inputs is increasing, while at the same time, the glut of supply of inputs is falling. Commodities prices are rising and specifically the price of oil has risen from $30 per barrel this time last year to over $50. Rising commodities prices will certainly stoke inflation, although it should be remembered that at $55 per barrel of oil it becomes economic for the US to recommence the extraction of shale oil, and the fracking infrastructure is already in place. This impending increase in supply suggests that the rise in the oil price will slow beyond $55.
In general, a bit of inflation should be helpful for businesses, helping to improve profit margins. This should lead to an improvement in capital spending which has been lacking in recent years, and increased capital spending would in turn boost the economy, creating a virtuous circle.
The inflation rate is already close to the US Federal Reserve’s target of 2%. Therefore, further rises in inflation will of course encourage the Fed to raise interest rates, although they are likely to tolerate higher inflation for longer, given that it will help to reduce the real value of the debt mountain. In addition, care must be taken, because even a small rise in interest rates could cause problems, with the ratio of US nonfinancial debt to GDP near an all-time high. Increasing interest rates will eventually cause a rise in defaults.
The US vs the rest of the world
The capacity issues present in the US are less prevalent in the rest of the world.
In Europe, the unemployment rate is 9.8%, indicating significant spare capacity, although the playing field is far from level. Italy and Spain have ample spare capacity, but Germany has not, with an unemployment rate of 4.1% and a contracting workforce due to an aging population. Wages in Germany have been rising at 2.5% since 2010, faster than any other G7 country. Until recently, German firms had been absorbing higher wage costs without raising prices, but inflation is now starting to feed through with headlines appearing in German tabloid newspapers.
Growth has also picked up in emerging markets, and in China, renewed growth has given the government more room to focus on their agenda of rebalancing the economy from investment led growth to consumption. The emerging economies are likely to be watching developments in the US carefully. Of course, any trend against free trade will be a backward step for the global economy, but an isolationist path will hurt the US less than the emerging economies, because the US is less dependent on exports. Specifically, the contribution of exports to US GDP is 12%, whereas for China the equivalent figure is 22% (and for Mexico, it is 35%).
Of course, it isn’t wholly wise for the US to pick an unnecessary fight with China, when China is one of the largest holders of US government debt at $1 trillion (second only to Japan with $1.1 trillion).
In summary, headline inflation is likely to rise quickly in early 2017, due to a stronger underlying global economy and the rising oil price. Looking further ahead, as capacity is squeezed and inflationary expectations edge up, we expect the inflationary pressure to grow in 2018.
A little inflation in 2017 should help global businesses grow their profits, and this could encourage a long awaited resurgence in capital spending. If this happens and inflation doesn’t accelerate too quickly, there is a reasonable chance of a goldilocks scenario, a virtuous circle of growth.
Information Technology will continue to provide new ways for the global economy to grow, helping to boost productivity and growth, freeing up capacity, and reducing costs. However, this trend will continue to exclude certain sectors of society, feeding inequality and populism, and causing further political unrest.
Beyond identifying and highlighting these broad trends, we remain careful not to fall into the trap of basing our investment strategy on predictions about future events, and we continue to be bewildered by investors and fund managers who do so. There are many uncertainties for 2017, given the European elections in Holland, France & Germany, the negotiation (guesswork) required for Brexit, and above all, the unquantifiable risk that Donald Trump represents to global stability. As Larry Summers, former US Treasury Secretary, said recently, “This is probably the largest transition ideologically and in terms of substantive policy that we’ve seen in the US in the last three quarters of a century. Those kinds of transitions have to be, given the central role of the US in the global system, matters of enormous uncertainty.”
As ever, it is our aim to position our clients’ portfolios to be as insulated as possible from political and economic uncertainties, and we continue in steadfast adherence to the value approach that we know delivers the optimal result for long term investors.
We are reassured by the performance of our Equity fund over the last year:
30 June 2016 – 30 December 2016
31 December 2015 – 30 December 2016
Oakham Global Equity
(NB the equity market was closed on 31 December 2016)
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