Investor euphoria and economic reality are set to collide in 2017

‘For investors, 2017 could quickly turn into the year of living dangerously’

PUBLISHED : Monday, 19 December, 2016, 10:29am
UPDATED : Monday, 19 December, 2016, 10:45pm

2016 is ending on a high note, with global stock market optimism breaking new highs, pumped up on a raft of central bank money and ultra low interest rates. But it is optimism that is growing increasingly detached from economic reality. 2017 could easily see investor sentiment come crashing back down to earth.

Likewise many economic confidence surveys remain upbeat about next year’s outlook, boosted by hopes that US President-elect Donald Trump unleashes a fresh wave of global economic stimulus into the world with a barn-storming US fiscal reflation. Yet there are many parts of the global economy still showing scars of slowing growth set against a backdrop of rising risks.

As investor euphoria and economic reality collide the markets will have every good reason to panic

Fears of a China hard landing, political upsets in Europe, risks of an emerging markets debt crisis and the US Fed on an even tougher tightening quest next year are just a few of the potential trip wires markets must contend with. Perhaps the greatest wild card threat of all is that so-called “Trumpflation” turns out to be nothing more than huff, puff and bluster.

Whether the market continues to be driven by “irrational exuberance”, or “rational despair” sinks in, will be the defining test for 2017. For the US, where the monetary stratagem of ultra low interest rates and QE pump-priming seems to have worked wonders in the last eight years, there is no guarantee of future success, especially when the monetary tide is on the turn.

Right now, the odds are clearly shifting in favour of a tougher Fed policy response than markets might have been expecting. The whispering campaign is already shifting up a gear, with hints the Fed might need to hike interest rates more than three times next year. With headline US inflation already up to 1.7 per cent and the core annual CPI rate at 2.1 per cent, the Fed’s new emphasis is cooling down future price pressures.

The worry is that it goes too far. Expectations about the Fed are already driving up the US dollar and pushing up US bond yields, potentially strangling exports, mortgage demand and corporate borrowing in the process. This suggests the US is unlikely to be the hive of extra demand that world financial markets are gambling on – unless Trump stumps up an even bigger reflation deal.

This seems very unlikely considering that Democrats in the US Congress have vowed to filibuster the new president’s budget-busting plans. Also, fiscally-conservative Republican hawks will be extremely reluctant to sign-off carefree tax-cutting and extravagant spending without some assurances that it’s not going to blow an even bigger hole in the US budget deficit.

The markets have put a lot of stock in the notion of a partisan Republican-dominated Congress rubber-stamping Trump’s growth-boosting plans. Trump made a lot of enemies on his way up to the Presidency and it is unlikely to be forgotten. With the Fed leaning harder the other way and removing more stimulus out of the system, the stronger growth story suddenly looks a lot less promising for equities.

In theory, stock markets should be in a better fundamental position to exploit the promise of stronger growth. Right now, equity holdings by mainstream fund managers remain close to multiyear lows, both for US and global investors, providing a potentially solid bedrock for markets as the appetite for risk picks up.

But the flipside of the story suggests the market’s recent strength is mainly down to short term speculative money – hedge fund, proprietary and leveraged capital flows. The danger is the market bias is now probably much more exposed to downside risks should the mood turn sour.

Once the truth dawns on the market that Trump’s action plan could be severely compromised in 2017, global stock markets will be in trouble. As investor euphoria and economic reality collide the markets will have every good reason to panic.

If US GDP expectations gravitate back towards the 2 to 2.5 per cent annual growth trend rather than the 4 per cent plus hinted at by Trump, there will be nowhere else to turn for comfort. Growth-wise, Europe is looking stumped, Japan is becalmed, China is losing momentum and emerging markets look vulnerable.

If markets are simply being driven by a central bank liquidity spree with growth fundamentals looking increasingly doubtful, there will be a day of reckoning, especially once the global supply of cheap money begins to run dry.

For investors, 2017 could quickly turn into the year of living dangerously.

David Brown is chief executive of New View Economics