Five themes that look set to shape portfolio returns in 2017

After last week’s attempts to learn key lessons from 2016, this column will now turn its attention to the year ahead. In the (unfortunate) absence of a crystal ball, no promises or guarantees can be offered, but below are five themes which investors will need to think about when it comes to portfolio strategy in 2017 and beyond.

They are:

1. The dollar and whether President-Elect Trump’s fiscal policies and the US Federal Reserve’s monetary ones drive up the US currency to fresh heights
2. Bonds and whether rising growth and inflation expectations inflict further damage on the fixed-income asset class after a 30-year bull run
3. Emerging markets and whether they can continue their outperformance of 2016, with the dollar and commodity prices likely to play important roles here
4. Brexit and the shape the British Government’s negotiating position takes
5. Banks and whether they can maintain their good run in the second half of 2016, helped by a swing from expensive defensive and quality growth stocks toward cyclical and value plays

Each one is outlined in further detail below.

1. The dollar, the Fed and Trump

Markets are latching on to the reflationary potential of the fiscal-spending, tax-cutting and regulation-slashing programme outlined by US President-Elect Donald and rising US share prices and a stronger dollar are the clearest signs of the current enthusiasm for the plan.

December’s interest rate hike from the US Federal Reserve could also further boost the bouncy buck, which is once more trading north of 100, using the Bank of England’s trade-weighted basket as a benchmark.

Any acceleration in US GDP growth and inflation, or further Fed rate hikes in 2017, could take the greenback higher and also add to the value of US assets held by UK-based investors (it may also draw more US-based predators to launch bids for UK firms).

The dollar basket reached 120 in the early 2000s and soared to 160 in the mid-1980s (when the first Reagan administration was following plans similar to those proposed by Trump) so it could have a lot further to go, especially if the ECB, Bank of Japan and Bank of England keep running their QE schemes and show little inclination to tighten policy themselves.

The dollar is responding to hopes for fiscal stimulus under President Trump

Source: Thomson Reuters Datastream

2. Bonds

If stocks and the dollar are welcoming the Trump plan, then bonds are recoiling from it, given the potentially inflationary implications of both the US President-Elect’s pro-growth strategy and a surging oil price.

Summer’s dash into fixed-income assets, which left many Government and even some corporate bonds offering negative yields, looked like a dream for bondholders as the European, British and Japanese central banks bought paper at almost any price as part of their QE schemes. The subsequent sell-off means this now looks like a nightmare as the capital losses suffered will way outstrip the benefits of the coupons on offer for many years to come.

The question facing income-starved investors now is whether bonds offer a suitable risk-reward balance – inflation is still low, the world is more indebted than it was in 2007 and long-term demographic trends in the West look deflationary (as the population is ageing and shrinking). Moreover, low interest rates are keeping a lid on corporate default rates and credit spreads (the premium yield offered by corporate bonds relative to Government ones) are tightening, not widening so there may be some value to be had here. In addition, there is no guarantee the Trump plan actually works – Japan has seen multiple stock rallies and bond sell-offs fizzle out since 1989 while US and UK Government bonds have seen around 10 hefty reversals since 1986, only for yields to make new subsequent lows (and prices new subsequent highs).

If fiscal stimulus fails and the world turns Government bonds could still be worthy of a place in a balanced portfolio.

2017 will tell us whether the bond sell-off is the real deal or just the latest in a series of temporary pullbacks

Source: Thomson Reuters Datastream

3. Emerging markets

One of the greatest dangers of the Trump fiscal stimulus plan is that it actually short-circuits itself by driving bond yields (and borrowing costs) and the dollar higher, as both could serve to smother any fresh spark in US economic output and corporate earnings.

That may not become apparent until 2018, if it becomes apparent at all, but one asset class is already feeling the heat from a dynamic dollar, namely emerging markets.

There is a strong historic negative correlation between the buck and MSCI Emerging Market (EM) equity index because a rising dollar is inherently deflationary for nascent economies – it makes dollar-priced commodities more expensive and chokes off exports (or makes imports more costly) and means servicing dollar-priced, overseas debt more expensive.

EM assets underperformed during 2012-15 but stormed back in the early stages of 2016 (helped by a slight weakening of the dollar, improved commodity prices and a renewed valuation case) only to fall back post Trump.

The good news is that commodity prices are still holding firm (at least in the case of oil and the industrial metals), something which Bank of America Merrill Lynch research says has only happened 30% of the time during periods of dollar strength and during that 30% EM assets have generally done well. The dollar and commodities look set to once more dictate how EM assets do in 2017.

Sustained commodity price strength could help sentiment toward Emerging Market assets in 2017

Source: Thomson Reuters Datastream

4. Article 50 and Brexit

Unlike its US equivalent, the UK equity market struggled to hold on to the new highs reached in the autumn (as benchmarked by the FTSE 100) and the prevailing uncertainty over how the Brexit process would work out had a lot to do with that.

The terms of the ‘soft’ or ‘hard’ Brexit will therefore be instrumental in shaping sentiment toward the UK equity market in 2017. A ‘hard’ Brexit and the absence of any hawkish policy talk from the Bank of England could well snuff out the autumn rally in sterling, especially as Britain still runs a combined annual budget and trade deficit that would shame a banana republic.

That in turn could boost the overseas earners in the key indices, although this trade is now well known and ironically the real value may be appearing in the downtrodden domestic names, such as real estate plays and consumer discretionary stocks, where a lot of the potential damage offered by a ‘hard’ Brexit to the economy is priced in (even if no-one ultimately knows what the impact of Brexit will be).

This may offer further scope to funds known for their value-hunting expertise, especially if Brexit does not turn out to be as bad as feared, while the UK’s 4%-plus dividend yield for 2017 could also be a source of support, especially as rising oil prices underpin the 24% contribution to UK dividend payments forecast to come from Shell and BP alone.

The oil sector remains a key source of dividend payments for investors in UK stocks though earnings cover is lower than ideal

Source: Digital Look, consensus analysts’ forecasts

5. Banks

Bull markets don’t tend to last too long unless the banks are doing well, as the lenders are such a key provider of credit, a vital lubricant in the modern-day economy.

The Banks have been awful performers in the UK since 2010, ranking in the bottom 10 of the 39 sector groupings which make up the FTSE All-Share every year between with the exception of only 2015 and they started 2016 terribly as well, held back by the UK’s lofty debts, tight regulation and hot competition. They began to fare better in the second half, post Brexit, as they perhaps sniffed a release from the EU’s regulatory clutches and welcomed hopes for improved economic growth and higher interest rates, as all three could boost their earnings power.

Ironically this is the first time in over four years that analysts do not expect the coming 12 months (i.e. 2017) to see banks generate higher earnings than they did at the peak in 2006, perhaps suggesting they have finally given up and thrown in the towel.

Contrarians may see this is a positive sign, especially as all of the Big Five bar HSBC trade at below one times book value. Sceptics will point to negative earnings momentum, ongoing misconduct fines, the UK’s modest economic momentum and hefty debts as good reason to stay away.

But with the banks representing 14% of the FTSE 100’s market cap and 15% of both forecast profits and dividend payments in 2015 this is one sector that fund managers have to get right in 2017 if they are to outperform as the rally in late 2016 has caught many off guard.

If that momentum continues in 2017 it will be a huge pain trade that could force many into clambering aboard, giving the FTSE indices a lift, but if the UK economy fails to deliver and bond yields go lower again, banks could once again find themselves out in the cold.

Analysts have finally given up assuming the UK bank sector’s profits will return quickly to the 2007 peak

Source: Digital Look, consensus analysts’ forecasts

Russ Mould, AJ Bell Investment Director