Market Comment December 2016

Christophe Bernard, Chief Strategist Vontobel

Brexit and Donald Trump – a referendum and an election that shook the world (if not financial markets) in 2016. So far, disaster hasn’t struck, but there is no question that the conditions for investors have radically changed. Will next year be as eventful? Chances are we won’t get bored.

Who would have predicted a year ago that British voters would support the country’s exit from the European Union and that the American people would elect Donald Trump as their president? It is probably fair to say, nobody (we didn’t either). One can only try to fathom the exact reasons for such unexpected outcomes. To name a few: frustration about the establishment in a broad sense, the perceived threat from globalisation, fears of uncontrolled immigration and the loss of sovereignty. In fact, these events represent a seismic shift in the prevailing political and economic environment.

There goes the long-established order

Politically, Brexit is an existential threat to the future of the European Union and sets a precedent for parties whose populist agenda include leaving the EU or the euro area, such as Italy's Movimento Cinque Stelle or France’s National Front. Donald Trump’s agenda – if implemented literally – questions the pillars of America's global order since the Second World War and the related institutions such as the United Nations or the North Atlantic Treaty Organization (NATO). His “make America great again“ leitmotiv rings with isolationism.

Chart 1: Is the secular low in US-Treasury yields behind us?
In percent

Source: Thomson Reuters Datastream, Vontobel Asset Management

The consequences of the Brexit and Trump watershed events for economic policy are twofold. First, an era of fiscal restraint will be followed by fiscal expansion –the UK’s way out of the EU will lead to a higher budget deficit, as will Donald Trump’s plan to invigorate the US economy. Second, existing trade agreements will be renegotiated, in one way or the other. Everything else being equal, a gradual normalisation of monetary policies should follow over time.

Favourable aspects of “Trump agenda” may prevail

Given America’s economic weight, our outlook for 2017 is to a large extent dependent on developments there. Generally, it is important to note that some of the incoming president’s ideas have merits. We are therefore considering two corner scenarios: on the one hand, a “reflation” scenario would see the positive aspects of the Trump agenda such as tax cuts and infrastructure investments implemented while, at the same time, the negative aspects such as import tariffs and restrictive immigration policies would only be confined to symbolic action. This would result in a pick-up in growth and rising inflation. On the other hand, a “stagflation” scenario with strict anti-trade and anti-immigration measures would hinder growth while stoking inflation.

As the year progresses, things probably won’t turn out to be entirely black or white, but reflect a combination of both corner scenarios. This will provide a framework for us to gauge the impact of forthcoming measures on financial markets. At this juncture and ahead of Donald Trump’s inauguration on 20 January 2017, we give the “reflation” scenario a higher probability than the “stagflation” one. The reason for our confidence is simple: it is easier to garner support for tax cuts and infrastructure spending than to confront a powerful lobby of US multinational corporations that would clearly lose out in the event of a trade war between the US and China or Mexico.

In both scenarios, we expect rising inflation and tighter monetary policy to exert upward pressure on government-bond yields (see chart 1) and provide support to the US dollar (see chart 2). However, this could create a headwind for emerging-market assets. Generally, the “reflation” scenario supports equities, at least the sectors that benefit from rising interest rates and accelerating economic growth. Conversely, the “stagflation” scenario is negative for both fixed-income and equity markets.

Cash is king

Trade-weighted US-dollar

Source: Thomson Reuters Datastream, Vontobel Asset Management