The Year Ahead: Where to Invest in 2017

The Year Ahead: Where to Invest in 2017


Key takeaway – Across the globe, populism and protectionism are on the rise and macro fundamentals remain weak. In this challenging context, growth will remain subdued in 2017, hampered by sluggish investment and productivity, ever-accumulating savings and modest inflation. With the exception of the Unites States (US), developed markets (DMs) will stagnate, burdened by debt and structural rigidities. In the US, if Trump’s policies veer toward pragmatism, the economy will grow above trend, lifting financial markets, especially in the first part of the year. Emerging markets (EMs) will face low growth and risks of political volatility. At the global level, geopolitical tensions, financial instability and competitive devaluations remain key risks. Fiscal and monetary policies are unlikely to strengthen demand and investment; fiscal policy might turn expansionary only in the US. Monetary policies, unable to spur growth, will steadily diverge – with a mild tightening cycle in the US and easing in the Eurozone (EZ) and Japan. While traditional banks remain under pressure, asymmetric economic performance and diverging monetary policies will increase the risk of market dislocations. Unusual times call for unusual portfolios: investors should lower their return expectations, and increase exposure to alternatives.

Across the globe, protectionism and authoritarianism are on the rise … In a leaderless world, where political élites lack vision and power to coordinate key policies[1], economic co-dependence increases instability. As a result, the gap between the promises of globalization and the daily reality of average-citizens is growing larger. Joblessness[2], stagnating real incomes[3] and rising inequality put pressure on welfare systems. Nationalism[4] and protectionism threaten globalism. Populism[5] is leading to authoritarianism via democratic principles[6], i.e.: the “one person, one vote” tenet. Immigration-without-integration erodes social cohesion[7].

… and growth is stagnant. Going forward, sustained growth accelerations are unlikely, as cyclical and structural factors hamper economic activity. The global economy is: 1) in the middle of “a lost decade[8] – i.e.: still suffering the 2008-crisis and its long-lasting effects on credit markets, output, and employment; and 2) undergoing a long-term transformation, as: a) aging populations[9] reduce consumption; b) higher aggregate savings[10] depress interest rates[11]; c) services – less capital-intensive[12] than agriculture and manufacturing – keep rising as shares of global output, employment and value added; and, as a result: d) investment[13], productivity[14], demand and trade[15] remain weak, adding to structural unemployment.

In 2017, macro fundamentals will remain weak across the world. At the global level, gross domestic product (GDP) growth is projected to rise[16] to 3.5 percent in 2017, from 3.1 in 2016. Yet, debt – both public and private – and unemployment will constrain investment and productivity growth, hindering industrial activity and trade. Stagnant wages and flat real incomes will weaken aggregate demand and keep inflation in check – at 1.9 percent in DMs and 3.7 percent in EMs. Oil prices[17] will remain in the range of USD 50-60 per barrel (bbl), providing relief to oil producers[18]. The US dollar (USD) will strengthen against other currencies.

  • Burdened by debt and structural rigidities, DMs will stagnate[19] – with the exception of the US[20]. In 2017, the US economy will grow at 2.6 percent, lifted above its current trend by Trump’s tax cuts, fiscal stimulus and looser regulation; as a result, inflation will rise to 2.8 percent. The Eurozone (EZ) – hampered by unfavorable demographics, separatist politics, a heavy sovereign debt, inflexible labor markets, banking sector legacy-issues, a migrant crisis and religious divides – is expected to grow at 1.4 percent, with inflation at 1.2 percent. In Japan, a lack of structural reforms and a shrinking labor-force will keep growth below-potential, at 0.6 percent, and inflation at 0.4 percent. Across DM, the rise of income inequality and unemployment will strengthen political pressure to control immigration flows of un­skilled workers.
  • EMs will face low growth[21] and risks of political volatility. In 2017, EMs growth will be hampered by political fragility, structural bottlenecks, sluggish investment, high domestic debt[22], a sizeable external debt[23], capital outflows and vulnerability to sharp currency depreciation[24]. Interest rates will remain largely driven by monetary policy in the US and – to a lesser extent – in the EZ and Japan. In Latin America, Brazil is expected to grow at 0.5 percent, with inflation at 5.4 percent. In Russia, the economy will grow at 1.1 percent and inflation will stabilize at 5.1 percent. India will show robust growth at 8 percent, with inflation at 5.2 percent. China’s growth will decelerate to 6.3 percent – depressing the price of commodities and specialized manufacturing equipment – and inflation will decline to 2.2 percent, as the economy shifts[25] from investment and manufacturing to consumption and services. Lower commodity revenues will hamper commodity exporters. In the Middle East and North Africa region (MENA), rising political risks and lower oil prices will keep growth subdued[26] while fiscal consolidation, needed to face structurally lower oil revenues[27], will likely be put on hold.

Geopolitical tensions, trade wars, and market volatility remain key risks. At the global level, a few economic risks could take a toll on the outlook: a) geopolitical[28] and social[29] tensions; b) trade wars and competitive devaluations; c) a tightening of financial conditions; d) financial instability[30], market turbulence and volatility; e) lower oil prices[31] and deflation; and f) weaker consumer and business confidence. Conversely, flat real incomes and rising inequality are major political risks and can lead to further instability, populism and authoritarianism.

  • In DMs, long-standing structural issues and migration will complicate politics and hinder growth. In the US, key risks are Trump’s ability to deliver on his electoral promises, the timing of his policy agenda, a build-up of social tensions, public debt – already at 2 percent of GDP – and the looming fiscal cliff, a faster-than-expected tightening cycle by the Federal Reserve (Fed), and a more than 20 percent USD appreciation. In the EU, elections in the Netherlands, France, and Germany[32] (and, possibly, Italy, the United Kingdom and Spain) will test EZ’s cohesion while immigration flows and social strains will compound the consequences of Brexit[33]. In southern Europe, political stalemate will put reforms on hold, while persistently low inflation could develop into deflation and unresolved legacy issues in the banking system – in particular in Italy and Portugal – could bring about bank failures and political tensions[34]. In Japan, the chronic lack of structural reforms will hamper the outlook.
  • EMs are fragile[35]. In Brazil, a political crisis could lead to early elections and depress growth, while a rise in inflation could spur social tensions. In Russia, lower oil prices – along with the ensuing rise in budget deficits, fall in reserves and decline in real incomes – and frictions with the West are major economic challenges. India’s slow reforms, lack of infrastructure spending and rural-urban divide pose significant risks. China’s reliance on credit[36], investment and exports as growth drivers will lead to over-leveraging, financial bubbles and over-heating of the real estate sector[37], increasing the risk of a disruptive adjustment, capital outflows and a falling yuan (i.e.: a hard-landing); meanwhile, fast urbanization will keep increasing income disparities. In Turkey, political instability – likely to be enhanced by a referendum on the presidential system – and the middle-income trap risk hampering economic resilience. In MENA, the main risks are negative spillovers of the Syrian, Iraqi and Yemeni conflicts – increasing tensions between Saudi Arabia and Iran -, lack of job creation and low oil prices[38].

Fiscal and monetary policies are unlikely to strengthen demand and investment. The global economy needs growth-enhancing taxes and expenditures, but it might get them only in the US. Over-reliance on central banks (CBs) will continue buoying financial markets, and monetary policy normalization will take longer than expected.

  • Fiscal policy is unlikely to turn expansionary, with the exception of the US. Now contractionary[39] in many major economies, fiscal policies are unlikely to support consumption and investment[40]. In 2017, led by Trump’s infrastructure spending, the US fiscal stance can turn expansionary. Yet – if other countries do not follow suit with significant fiscal stimulus – the US alone will be unable to support global consumption and investment.
  • Monetary policy will diverge. In 2017, monetary policy divergence will grow, driven by a mild tightening cycle in the US and easing in the EZ, Japan and UK. Overall, the upcoming tightening cycle will be well below historical norms and negative policy rates will lead to further financial repression[41]. As monetary policy normalization takes longer than expected, over-reliance on CBs will make their interventions ineffective. Additionally, CBs will risk making policy mistakes and lose their credibility.

Traditional banks remain under pressure. Increasingly stringent[42] regulatory tightening – aiming at developing banking systems’ resilience to both uncertainty and turbulence – will force traditional banks to choose between lower profitability and sanction risks. Shadow banking will keep growing[43]. International banks will keep selling loss-making franchises and moving away from retail; local banks will prosper. Technology-driven innovation will boost non-traditional competitors: block-chains, biometric authentication for payment transactions, and new “digital” banks[44] – as consumers will increasingly refrain from going to branches[45]. In the long run, only banks able to remain customer-centric ‘trusted advisors’[46] will prosper. In the EU, financial sector vulnerabilities will not be tackled head-on and – as much as in Japan – the negative-interest-rate policy will de facto tax banks that hold reserves, without encouraging bank lending.

Diverging growth and asymmetric monetary policies increase the risk of market dislocations. Repeated CB interventions[47] will keep macro-liquidity abundant, prices elevated and unstable, and asset classes unusually correlated. In the first part of the year, liquidity will intensify asset inflation and keep the markets buoyant but jittery. Most markets are likely to suffer elevated volatility; over-bought and over-sold assets will create tactical exit-and-entry opportunities. Eventually, a rising disconnect between fragile fundamentals[48] and elevated valuations will bring about a bear market (a drop of more than 20 percent from the 52-week high) – if not a full-fledged market crash (a more-than-40-percent plunge)[49]. With high volatility traders will perform better than fundamental investors.

Portfolio approach: lower expected returns, greater exposure to alternatives. For most asset classes, expected returns are likely to be lower than in past years – because: a) valuations are elevated by historical standards; and b) aging societies, insufficient investment, and weak productivity constrain potential growth and corporate earnings (in other words: fundamentals will determine asset values). On a multi-year horizon, unusual, less liquid portfolios are likely to perform better than conventional ones[50]. Priorities are: 1) capital preservation via a defensive asset allocation[51]; and 2) broadening exposure beyond conventional stocks and bonds, identifying opportunities in the illiquid space. As a result, only 60 percent of the assets should be liquid, and as much as 40 percent should be kept illiquid. In the liquid space, the allocation should privilege stocks (20 percent) and bonds (20) over commodities (15) and cash (5). In the illiquid space, alternative investments should be split between real estate (20) and private equity (20).

Stocks (20 percent) – Investors, so far satisfied with the “buy on dips” strategy (as long as liquidity-driven markets keep achieving new highs), lack viable alternatives and, given limits on cash holdings, will keep buying equities. In DMs, corporate cash will keep supporting share buybacks. The whole allocation should go to DM large caps with cash flow[52]. In particular, dividend-paying blue chips are preferred – better if multinational brands with exposure to EM domestic demand. Volatility will remain elevated and small caps are better avoided, as much as EMs, where earnings growth will soften and currency risks will rise. If Trump’s policies veer toward pragmatism, US equities are likely to over-perform[53]. Japanese and EM equities can be hampered by trade restrictions.

Bonds (20 percent) – Bond prices are likely to decline, and yields to be pushed up by: a) rising fiscal deficits and debt; and b) a higher growth differential (i.e.: the US economy will expand faster than other DMs). High-quality credit and inflation-linked securities are likely to do better than nominal bonds. Held for capital preservation purposes, bonds should follow a “buy to hold” strategy, with profit-taking in case of yield-reducing risk-off episodes, liquidity-injections by CBs, and further reductions in long-term interest rates. The allocation should privilege corporate (15 percent, DM only) over sovereign (5 percent, EM only). In DMs, where the regulatory and institutional setting is stronger, the whole 15 percent should go to corporate, but only to high quality, high-yield blue chips, better if multinational brands. Overbought sovereign should be avoided[54]; US yields will rise, but remain subdued – supported by the ongoing shortage of safe assets[55], global demand, and the quest for financial safety. In EMs, corporate should receive no allocation, given currency risks and a weaker regulatory framework in case of insolvency; once country risk has been assessed, 5 percent should be allocated to sovereign bonds, only if USD denominated, investment grade and with above-inflation yields.

Commodities (15 percent) – Weak global demand and abundant inventories will keep commodity prices subdued. Low global inflation and USD strength will remain headwinds for performance. Price increases will only depend on supply shocks. The allocation should privilege energy (10 percent), to capture the expected rise in oil prices. While rising interest rates will diminish safe-haven buying, precious metals should be allocated 5 percent, as an insurance against: a) currency debasement; b) sharp downturns; and c) periphery-to-core runs.

Cash (5 percent) – Cash is required as: a) seeding-capital to quickly seize opportunities; b) insurance against sharp downturns; and c) protection against negative rates. The 5 percent allocation should be held in money market funds, cash ETFs and hard cash. Given depreciation pressures on EM currencies, the USD and the Swiss Franc (CHF) should be favored in DMs, and the Singapore Dollar (SGD) in EMs.

Alternative investments (40 percent) – The allocation should be equally divided between real estate (RE, 20 percent) and private equity (PE, 20 percent). The whole 20 percent invested in RE should be allocated in DMs – as a fixed-income play, based on rental income and should go to: a) undervalued “trophy” assets; and b) distressed properties in rapidly growing cities. In EMs, a capital appreciation play based on fundamentals[56] is unlikely to materialize soon, certainly not in 2017. The whole 20 percent allocated to PE should also go to DMs only, invested in undervalued firms with positive cash-flow, able to produce non-replicable or luxury products in high demand in EMs. No allocation should go to EMs: regulatory and currency risks are too elevated, despite fair fundamentals.

The indicative portfolio is shown here below. screen-shot-2017-01-03-at-6-50-22-pm

I thank Eduardo Eguren, Pablo Gallego Cuervo, Mert Yildiz, and Francisco Quintana for their comments and suggestions. All errors are mine.

[1] Global problems – e.g.: protectionism, low trade and growth, financial instability, inequality and migration – need coordinated global solutions. Yet, the G-20 (the group of leading industrialized nations) is unable to provide the needed global public goods, i.e.: comprehensive policies to address transnational communication and transportation, financial system stability, technological change, cross-border welfare systems, peace-keeping and international security, unemployment and communicable-diseases.

[2] At risk of becoming a lost generation, the youth is increasingly disaffected by being: a) overqualified and inexperienced in the labor market; and b) unable to constructively voice its discontent.

[3] Between 2005 and 2014, in 25 high-income economies between 65 and 70 per cent of households suffered from stagnant or falling real incomes. In the period between 1993 and 2005, only 2 per cent of households suffered from it. Prolonged real income stagnation undermines political stability. Conversely, when everybody becomes better off, the positive-sum makes democracy easier to manage.

[4] Citizens feel threatened and resent sharing their wealth and privileges – including citizenship – with immigrants (see Brexit). Insecurity provides political support to: a) “defending” national identities and interests; and b) the “closing” of societies by reducing immigration and lowering cooperation on trade and security.

[5] Populism – by promising simple solutions to complicated problems and acting through the democratic process – relies on the “tyranny of the majority” to marginalize (ethnic or religious) minority groups and challenge the separation of powers and the independence of the judicial system, the Central Bank and the press.

[6] Citizens do not feel represented by traditional parties and protest vote is rising, along with anti-establishment feelings and xenophobia. Recent 2016 examples are Brexit, the rise of Donald Trump in the US, Marine Le Pen in France, and the plunge in Merkel’s popularity due of the attacks in Germany.

[7] The inability to assimilate minorities and the immigrants’ reluctance to conform to local norms result in discrimination, ethnic prejudice and xenophobia. As inflows are likely to last decades, poor integration policies will led to cultural isolation and religious divides will spur social tensions.

[8] Global growth has decelerated from 4.2 percent (1998-2008 average) to 3.1 in 2015.

[9] According to the demographic transition theory, as a country becomes wealthy and industrialized, fertility falls. Over the last 50 years, the global fertility rate decreased by almost-half, from 5.0 to 2.7 children per woman. Over the next 50 years, it is forecasted to drop to the replacement level of 2.1 children per women (Source: UN, 2016). The “replacement fertility rate” (2.1 children per woman) is the average number of children required to keep the population stable without help from immigration.

[10] Despite the 2008-crisis, global savings remained stable at 24.3 percent of global GDP in 2014 (1998-2008 average: 24.7). Savings will keep accumulating: first, as inequality rises, a higher share of income goes to richer individuals, with higher-propensity-to-save. Second, since 2008 EMs have accumulated massive foreign-exchange reserves and the world’s main Central Banks (CBs) nearly doubled – from USD 10.1tn to USD 18.2tn – their combined balance sheets. Third, corporations relentlessly accumulate retained earnings. Fourth, this rising supply of savings is rather unresponsive to interest rates cuts; hence, lower – even negative – CB policy-rates do not boost spending. As a result, and despite historically-low interest rates, economic growth stagnates, along with inflation.

[11] Real interest rates are on a downward trend and the ongoing low-interest-rate cycle – including negative real rates – is here to stay. The trend is not new: interest rates (short and long maturities) and inflation declined in most DMs since the 1980s. Lower rates were driven by the global (but mostly China’s) “saving glut” and “secular stagnation”. The post 2008 accommodative monetary policy put further downward pressure on interest rates, pushing more than 30 percent of the global economy into negative nominal policy interest rates. In many economies, with short-term interest rates close-to-zero and declining prices, achieving full employment is a real challenge, and negative real interest rates are needed to equate saving and investment with full employment. In 2016, countries with negative real interest rates were Argentina, Brunei Darussalam, Botswana, UK, Japan, Macao (SAR China), Mexico, and Papua New Guinea.

[12] Over the last 30 years, agriculture fell, manufacturing declined and services kept rising – as shares of: a) global output; b) employment; and c) value added. In general, services (i.e.: tech and digital companies) are less capital-intensive and contribute little to job creation, technological innovation and an already-sluggish productivity growth. As a result, the productivity boost of the “new economy” – the post-manufacturing, service-based economic system – is lower than in past industrial revolutions. After the 2008 financial crisis, labor productivity growth fell across sectors in most OECD countries, where 45 million workers are jobless.

[13] Consumption and investment are reduced by the interaction of three factors: a) falling birth rates and a rising life expectancy lead to aging populations, prone to saving (the looming pension crisis is an enhancing factor); b) as the pool of working-age (15 to 64 years old) individuals shrinks in both DMs and EMs, firms deploy less capital – because there are fewer workers to hire; and c) as a result, labor-force participation rates (the proportion of working-age individuals either employed or actively seeking work) decline and consumers refrain from spending. In 2016, for the first time since 1950, the working-age population will decline in DMs – where by 2050 it will shrink by 5 percent – and in key EMs, such as China and Russia. At the same time, the share population over 65 will rise steeply. Global net investment (gross investment minus depreciation, as a share of the total capital stock) is close to its lowest level since the Second World War. At the global level, FDI outflows rose from USD1.0tn (1998-2008 average) to USD1.5tn in 2015.

[14] Innovation is needed to significantly boost productivity. Lack of innovation and declining productivity trigger deindustrialization, and vice versa. Productivity growth declined from 2.6 (1998-2008 average) to 2.1 in 2014.

[15] Global trade growth declined from 6.5 percent (1998-2008 average) to 2.8 in 2015.

[16] Most analysts are optimistic: after years of reliance on monetary policy, fiscal policy is regaining prominence, and inflation is becoming a bigger concern than low growth. In the Unites States (US), expectations for de-regulation overcome worries about new regulation.

[17] In 2016, Brent averaged USD43.5/bbl, down from its 1998-2008 average (USD45.4/bbl).

[18] This forecast relies on three key assumptions: a) a stable Middle East; b) oil producers aiming at maintaining their market share (i.e. OPEC – which accounts for about 30 percent of world’s crude production – not responding to low oil prices by reducing output); and c) a recovery in the performance of US oil producers. Over the long term, low oil prices will put pressure on the fiscal balances of OPEC countries, forcing OPEC to reduce output to increase the price. Source: International Energy Agency’s World Energy Outlook, 2016.

[19] Across DMs, despite a reduction in potential growth, output gaps will close very gradually and actual growth will fare below-potential. The share of employment in manufacturing will not rise. Businesses will remain unwilling to hire, unemployment will stay elevated and consumers cautious. Labor slack – by putting downward pressure on wages and prices – and low commodity prices will keep inflation below target.

[20] On average and in rounded figures, over the next five years the US economy will grow at about 2.5 percent per annum, Europe (and the UK) at 1.5, Japan at 0.5. Brexit will reduce growth: a) in the UK (shaving in average about -0.8 percent per annum); b) in the EU (-0.3 percent per annum); and c) at the global level (-0.1 per annum) and increase political uncertainty. Yet, the EU and UK will manage to avoid a large increase in economic barriers and a major financial market disruption. Trade arrangements will converge to the Swiss model (leaving everybody unhappy). A portion of UK financial services will gradually migrate to the Euro area.

[21] On average and in rounded figures, over the next five years India’s economy will grow at about 6.5 percent per annum, China at 5.5, MENA at 3.0, Brazil, Russia and Saudi at 2.0.

[22] As a percentage of GDP, EM total debt rose to 179.3 percent in 2015 from 119.1 percent (2002-2008 average).

[23] Between 2009 and 2015, taking advantage of low interest rates in DMs, EM governments, banks and firms borrowed in USD at unprecedented levels. If a market-event – a US Federal Reserve (Fed) interest rates hike, a surging USD, a drop in commodity prices, a conflict – were to cause EM currencies to slide against the USD, the debt burden in local currency would rise even more: some borrowers would become unable to service their foreign currency debts and start missing interest payments; others could become unable to roll over principal and corporate defaults would ensue.

[24] US-denominated debt would, in sequence: a) become a bigger burden when measured in local currency; b) push international lenders to demand new collateral or loan repayment; c) impair local borrowers (governments, banks and firms)’s access to credit; and d) force these to allocate to debt servicing a larger share of their local-currency revenues. The higher demand for USD will foster further exchange-rate depreciation and further reductions in the USD value of the collateral.

[25] Amidst international economic headwinds and domestic financial bubbles, the rebalancing of the economy will be slow: local consumption will rise slower than expected and infrastructure spending will keep growing.

[26] Over 2016-21, MENA’s growth is projected at 3.4 percent, slower than its 1998-2008 average (5.3 percent.

[27] Many countries in the region are still plagued by conflict. Rising political risks and lower oil prices will result in low growth.

[28] Examples abound: Syria and Lybia’s civil war, ISIS and terrorism, migration from Africa and the Middle East, fragmentation (Brexit), Russia’s ambitions, South-China sea, currency wars, etc.

[29] After decades of socialization of losses and privatization of gains, the shortcut to recovery is likely to be ‘unfair’. A mix of orderly debt restructuring and mild inflation, equivalent to a transfer from creditors to debtors (debt restructuring) and from savers to borrowers (inflation) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system.

[30] Financial stress could intensify if macro-liquidity were to create asset inflation without translating into consistent market-liquidity. Note: “Macro-liquidity”: broad money supply. “Market-liquidity” (i.e. trading liquidity): ability to buy and sell financial assets with minimal transaction costs.

[31] Oil prices could drop to an average of 25USD/bbl, spurring dis-inflation and deflation.

[32] While Angela Merkel is likely to win re-election in Germany, Marine Le Pen is unlikely to win the French presidency.

[33] The UK will likely trigger Article 50 by the end of March, starting Brexit from the EU. Inevitably, Britain’s global influence will decline. Reduced trade ties – e.g.: post-Brexit trade arrangements could even revert to World Trade Organization (WTO) norms – will transform the UK into an isolated medium-sized economy. The UK could also become a regulatory and tax heaven.

[34] Governments consider public debt write-offs unacceptable (e.g.: Germany’s position on Greece) and private debt write-offs a political suicide (e.g.: Italy’s unwillingness to impose losses on holders of banks’ subordinated debt).

[35] EM debt rose to USD43.3tn in 2015 from its 2002-2008 average of USD12.1tn.

[36] China’s debt rose to USD26.6tn in 2015 from its 2002-2008 average of USD4.0tn.

[37] Over 2013-15, new house prices in China’s tier-1 cities grew by 14.4 percent CAGR.

[38] In the GCC, if oil prices were to decline to 25USD/bbl, real estate prices could drop more than 30 percent. In Saudi Arabia and Kuwait, the budget deficit could grow larger than 20 percent; the Saudi Riyal (SAR) could de-peg from the USD and – along with the Kuwaiti Dinar (KWD) – could suffer a devaluation of more than 20 percent.

[39] In 2015, DM government expenditure declined to 39.3 percent of GDP from its 2010-14 average (41.1 percent).

[40] While measures to support short-term domestic demand are politically palatable but fiscally challenging, structural reforms to reinvigorate medium-term growth are fiscally palatable but politically challenging, and hence on hold.

[41] Without inflation, the easier way to reduce debt is a slow process of sustained negative returns and – where possible – some orderly restructuring. In other words, a transfer from savers to borrowers (negative returns) and from creditors to debtors (debt restructuring) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system. Financial repression occurs when interest rates (the returns earned by savers) are held below inflation. When accompanied by inflation, it becomes a form of debt reduction. In today’s low-inflation or deflationary environment, CBs need negative policy rates to produce negative real rates. By transferring benefits from savers (the lenders) to borrowers via negative real interest rates, financial repression works as a tax on savers and bondholders, which helps liquidate the (public and private) debt overhang and eases the burden of servicing that debt. In other words, policies implemented to help debtors benefit from capital that, in a deregulated environment, would be invested elsewhere bring about “financial repression” and include measures aimed at: a) creating a captive domestic market for government debt via: i) explicit or implicit ceilings on interest rates; ii) high reserve (or liquidity) requirements combined with the issuance of nonmarketable – i.e.: to be held until maturity – government debt; iii) prohibition of gold purchases and securities transaction taxes; and iv) cross-border capital controls; and b) aligning local banks to government goals via: i) barriers to entry into the financial sector; ii) public control of financial institutions; and iii) directed lending to government entities by captive domestic audiences (i.e., domestic banks, pension funds).

[42] For example, the capital adequacy ratio rose to 10.5 percent of risk-weighted assets (RWA) under Basel III from 8.00 percent under Basel II.

[43] Shadow banking assets rose to USD36.0tn in 2014 from USD31.2tn in 2011.

[44] As of August 2015, there were more than 12,000 FinTechs across the globe. During 2013-2014, investment in FinTechs grew by more than 300 percent.

[45] In 5 years, only 10 percent of consumer interaction will be through branches.

[46] I.e.: aggregators of services – driven by customer needs, such as personalized cash and wealth management, confidentiality and data protection.

[47] Supported by CB liquidity, financial markets have ignored structural economic and political developments at the global level. Despite chronically below-potential growth, Brexit, fragile Italian banks, populism and terrorism feeding each other and Turkey’s failed coup, US equity and bond markets set record high prices. In other words, by providing liquidity, CBs strengthened investors’ confidence in market resilience.

[48] In the US, growth could bring fundamentals up to match valuations. However, the US alone cannot drive global markets.

[49]Market correction”: a fall of more than 10 percent from the 52-week high, over a single week. “Bear market”: a fall of more than 20 percent from the 52-week high, over 300 days. “Market crash”: a fall of more than 10 percent in just one day, or 40 percent from the 52-week high over 150 days.

[50] Low interest rates pushed investors into illiquid allocations and higher risks. Some large pension funds – e.g. Canada – had to accept, in order to keep expected returns at 7.5 percent, a triplication of risk (as measured by the standard deviation of expected returns) via portfolio diversification and an increase of illiquid allocations. Source: Wall Street Journal, 2016.

[51] Conservative investment strategies need to be tactical and dynamic, and accept lower expected returns in exchange for lower volatility (i.e.: a lower standard deviation of the expected returns).

[52] As of January 1, 2017 stocks listed on the Euro Stoxx index trade at a price-to-book ratio (P/B) of 1.67, considerably cheaper than the 2.8 P/B ratio of their counterparts on the S&P 500.

[53] In the first year of the Trump administration, stocks are likely to benefit. In a rising-interest-rate environment, equities tend fare better than fixed income. If Trump keeps his electoral promises, lower corporate taxes will to support earnings, and then infrastructure spending and financial deregulation will increase revenues. The construction sector will benefit from infrastructure spending, while financials, pharmaceuticals and healthcare will benefit from a more favorable regulatory environment. Banks will also be supported by rising interest rates. Renewable energies, however, are bound to suffer. If trade-restrictions are adopted, technology and automotive (with large parts of their supply chains in China and Mexico) will see their costs increase. Trade restrictions are likely to be limited. The details and timing of policy implementation will define direction and size of the impact on stocks. In the (unlikely) case of a global trade war, most corporates will suffer earning declines. Towards the end of the year, however, higher inflation and interest rates are likely to bring about price-to-earnings ratio (P/E) compression. With a yield curve of about 2 to 3 percent, the historic average P/E is about 14 or 15; today, the PE is close to 17.

[54] In DMs, yields on safe assets are likely to decline, reflecting expectations of a more gradual pace of monetary policy normalization, a higher global risk aversion and compressed term premia, but yields are already low or negative, and core DM bonds (UST and German Bunds) will benefit only from shocks.

[55] In bond markets, regulators – by forcing institutional investors to invest in triple-A assets, while the supply of these assets has declined by 50 percent – are pushing real interest rate even lower. More than 30 per cent of global government debt is trading at negative nominal yields. Yields on sovereign and corporate bonds, which pay a spread over government debt, have fallen in tandem. Conversely, in equity markets, historically-low real-interest-rates have pushed asset prices high and created asset bubbles, boosting investors’ returns via capital gains. However, as profits grow in line with the economy, investment income (the dividend yield) steadily declined. In 2017, the markets will benefit from almost 1.8 trillion of additional quantitative easing (QE), or 2.19 percent of the worldwide bond market (total debt outstanding), estimated at $82.2 trillion. In particular, in 2017 the US Federal Reserve (Fed) will roll over (i.e.: no expansion of the balance sheet) maturing securities – purchased with its QE program – for $194bn. In the Eurozone, the European Central Bank (ECB) QE program will decline from 80bn per month (in January-March, for a total of €240bn) to €60bn per month (in the April-December period, for a total of €540bn) and amount to a yearly total of €780bn ($816bn). In Japan, where in September 2016 the Bank of Japan (BoJ) abandoned pre-set amounts of monthly purchases and moved to price targeting, i.e. it will buy securities until the 10-year bond yield reaches around 0 percent, annual purchases are likely to remain unchanged from previous levels (¥60 to 70 trillion – $512 to 615bn). In the UK the Bank of England (BoE) QE will likely amount to £130bn ($160bn), disaggregated as follows: a) £10bn of Gilts; and b) £120bn of corporate bonds (over the 18 months between September 2016 and February 2018, the BoE will buy £180bn of corporate bonds).

[56] In EMs, RE has a lower regulatory volatility than PE.

[57] S&P 500 – the index includes 500 leading companies in the US and covers approximately 80 percent of the available market capitalization; S&P 100 – a sub-set of the S&P 500, the index comprises 100 major blue chip companies across multiple industry groups; Morgan Stanley Capital International Emerging Markets Global – a capitalization-weighted benchmark index covering equities from 29 developing countries; MSCI EM Equity – the index covers 23 countries and represents 13 percent of world market capitalization; JP Morgan Sovereign Bond – the index tracks DM and EM sovereign bonds; JP Morgan Corp. Bond – the index is widely used as the benchmark for EM corporate bonds; LPX50 Listed PE Companies – a global equity index, it covers the 50 largest listed private-equity companies; FTSE EPRA/NAREIT Global Real Estate – the index is designed to represent general trends in real estate equities, worldwide; S&P GSCI Agriculture – a sub-index of the S&P GSCI, it provides investors with a benchmark for investment performance in agricultural commodity markets; S&P GSCI Energy – a sub-index of the S&P GSCI, it provides investors with a benchmark for investment performance in energy commodity markets; S&P GSCI Precious Metals – a sub-index of the S&P GSCI, it provides investors with a benchmark for investment performance in precious metals commodity markets; S&P GSCI Industrial Metals – a sub-index of the S&P GSCI, it provides investors with a benchmark for investment performance in the industrial metals commodity markets.

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