Global investors set to battle ‘dark side’ forces in 2017

PUBLISHED : Monday, 09 January, 2017, 10:16am
UPDATED : Monday, 09 January, 2017, 10:53pm

The new trading year is off to a bumper start, with stock markets notching up record highs and world economic confidence flying high thanks to new US President Donald Trump boosting hopes of stronger US-led global recovery. The appetite for risk has been uncorked and global investors are partying hard.

Investors should take as much advantage while they can as time is fast running out. The global economy is facing a myriad of risks in 2017. “Dark Side” forces are building and once reality hits home risk asset markets will be running on empty. Unlike the 2008 financial crash, this time there will be no policymaking superheroes coming to the rescue.

Central bank coffers are running dry and governments around the world remain too strapped for cash to fund any major fiscal reflation initiatives. The next time the world economy hits a rough patch global markets will be in trouble. The safety nets are disappearing fast.

The mismatch between investor euphoria and fundamental reality is acute enough, without factoring in “dark matter” forces. The global glut of financially-engineered money, economic recovery pumped up on QE-steroids, shadowy world politics and the dark-unknown of another destructive market event – whether credit or debt inspired – all pose major challenges for stock market valuations in 2017.

Without a doubt, the explosion of global liquidity generated by the central banks’ QE and zero interest rate operations has driven an 8-year super-cycle of economic and stock market recovery. But what about the longer-term legacy as the world faces up to the challenges of super-stimulus being wound down and reversed? In this respect, world markets are steering into the dark.

After two interest rate rises so far in the US, the latest whispers from the Federal Reserve suggest another three increases could be in the pipeline later this year. More worrying is the Fed could soon be under intense political pressure to roll down its US$4.5 billion stockpile of QE assets. Republican Party hawks have made no bones about criticising the US’s phenomenal monetary explosion in the last 9 years and will be gunning for the Fed to rein in the largesse.

US bond markets have already picked up on this, as well as signs that nascent US inflation risks are starting to resurface. The latest US jobs report shows wage costs starting to get traction, while higher energy price rises are building momentum as Opec gets its act together on oil production cutbacks. It is not being lost on an increasingly nervous bond market.

As the appetite for risk builds, stock market momentum will continue to ramp it up. But in an environment of much tougher credit conditions and higher global borrowing costs it will become harder to rationalise expectations for stronger global recovery and perpetual stock market out-performance. At some stage, investors will hit a brick wall as optimism is left high and dry.

And that’s the rub. A lot of the market’s bullishness is based on nebulous Trump election promises, upping the ante on US fiscal reflation, cutting taxes and boosting infrastructure spending. The key questions are; where will the money come from and how much? The scale of Trump’s budget-busting bravado is already being downsized and a threatened Democrat filibuster could be a major fly in the ointment as markets scour the fine-print.

The dark side of global politics pose a major obstacle for the bull market’s longevity this year

The dark side of global politics pose a major obstacle for the bull market’s longevity this year. Trump’s blustering brinkmanship with China, Mexico, the United Nations and Nato could all backfire, raising the spectre of increased political risk this year. In the long run, this will only serve to keep market sentiment indicators, like the VIX volatility index, on their toes.

Meanwhile, event risk in Europe poses a deepening danger for global investors. Fears about a financial hard landing in Italy and the threat of a voter backlash in key European elections this year could spell the end of the euro very soon. If the euro self-destructs, it could sling global markets back into the Dark Age.

The worry is there is nowhere left to run and hide. Investors have all but exhausted their stock of safe haven bolt-holes. There would be scope to pile back into US Treasuries, German and Swiss government bonds and the US dollar and Japanese yen currencies would be in high demand. But generally, flight-to-quality opportunities are limited so cash would be king.

If dark side forces prevail world markets are due for a deadly toxic shock in 2017.

David Brown is chief executive of New View Economics