Outlook 2017 - Politics to Eclipse Economics

Outlook 2017, Politics, Eclipse, Economics, Macroeconomics, Europe, UK, United States, China, Dollar, fx trader, forex

Investors are familiar with a broad set of macroeconomic variables that often drive asset prices.  Many are familiar with corporate balance sheets, price-earning ratios, free cash flow, Q-ratio, and the like.  

However, political factors are more difficult for investors to integrate into their analysis. Therein lies the main challenge in the year ahead.  There will be many opportunities for political factors to overwhelm economic considerations.  This past year gave an inkling of what is possible with the UK decision to leave the EU and the election of Donald Trump as the next US president, both of which surprised many.

Perhaps what is even more surprising is what happened next.  The sharp depreciation of sterling was anticipated, though the speed of the adjustment may have caught many off-guard.  The UK economy fared better than some economists had anticipated, though the aggressive central bank response may have helped.  In addition to the stimulus provided by an 11% decline in the 100-day moving average of sterling’s broad trade-weighted index, the Bank of England cut the base rate, provided cheap funding for banks, and resumed its sovereign bond-buying program, including corporate bonds for the first time. The economy maintained its forward momentum.

The markets responded enthusiastically to the unexpected outcome of the US election.  Interest rates, especially the long-end of curves, including the US Treasury market, sold off dramatically.  The steepening of curves is what many high-income countries wanted but could not engineer.  Despite the sharp rise in interest rates, equity markets rallied strongly though the composition and leading sectors changed. The dollar rose sharply against nearly all currencies, including G10 and emerging markets.

Other forces were pushing in the same direction.  There was mounting evidence that China’s economy was stabilizing with the help of even more debt.  Saudi Arabia abandoned its new strategy and returned, it would appear, as the swing producer, forging a deal with its rivals, Iran and Russia. Also, the inventory and manufacturing headwinds on the US economy abated.  After three quarters of sub-trend growth (Fed estimates at 1.8%), the US economy accelerated to 3.2% in Q3 ‘16, the fastest pace in two years.  It is also the fourth strongest quarterly growth since the beginning of 2010, and Q4 is tracking above trend as well.

At the same time as investors are having to navigate individual events, there is a sense of a larger wave that is washing across the world.  It is populism-nationalism, the link between Brexit and the US election.  Ironically, these are two economies that have emerged from the Great Financial Crisis in the best shape.  Policymakers aggressively responded to the crisis and both countries were near full employment.  Growth was steady even if not spectacular.  The populist-nationalist forces are on the rise in Europe, and they are particularly potent because the EU and EMU are essentially projects that require integration and some surrender of sovereignty in exchange for strategic goals, like greater chances of peace and prosperity.