Another year has passed and the financial markets have been forgiving, despite China, Donald Trump, Brexit and Monte dei Paschi di Siena. Compared to the scenario of the risks we had feared, 2016 went smoothly and none of them manifested themselves in a serious form, even surprisingly positively. The key lesson of 2016 is that political events are too unpredictable to base an investment strategy on them.
A good start
If good morning starts in the morning, 2017 looks to be another year of good returns: the financial climate remains supportive and markets seem to price in a year of decent economic growth and inflation, typically favorable to risky assets (a slightly less than bonds). Compared to last year, the stabilization of raw materials has taken some pressure off energy companies and Emerging Countries.
Don't let your guard down
However, risks are always around the corner, so we asked ourselves: what can go wrong in 2017, so as to drastically change investment scenarios? Brace yourselves, there's a lot of irons in the fire.
1) Eurozone crisis
Italy's post-constitutional referendum calm shouldn't deceive too much: the eurozone remains the structurally most fragile area among the developed countries. The advent of Euro-sceptic parties reduces the cooperation needed to vigorously push forward the reform process. The Greece question remains essentially unresolved and Marine Le Pen's potential victory in France could spell the end of the European project. Let's not forget that Italy has a fragile banking system, super-connected with other European banks, and a government whose hours are numbered. In short, there is no shortage of systemic risk.
2) Hard Brexit
After the outcome of the British referendum, the only loser so far has been the pound (-17% since the beginning of the year). But the real battle has not yet begun: in March 2017 the process of Great Britain's exit from the eurozone should begin, which involves the renegotiation of a significant number of treaties. The battle could be tough (hence the name Hard Brexit) and without discounts, with possible repercussions on the financial markets and the economy.
3) Protectionism
Measures to protect internal markets are certainly nothing new, but they have increased significantly since the outbreak of the crisis. The worsening of relations between China and the United States, tensions between the Eurozone and the UK, as well as the growing weight of anti-globalisation parties risk further reducing trade, with clear repercussions on economic stability: consider that among the OSCE countries, more 25% of employment depends on foreign demand, so that if trade decreases it is difficult to think that anything good will come of it.
4) Runaway inflation
Inflation hasn't been heard of for a while, but historically it's the biggest reason investing is worth it. With commodity prices stabilizing, economic growth buoyed by expansionary fiscal policies and years of Quantitative Easing (QE), inflation could once again challenge central banks across much of the globe, which would find themselves in the difficult situation to fulfill its mandate or put the economy in crisis (with an increase in interest rates). According to managers interviewed by BoA & MerryLinch, the danger of stagflation (rising inflation and economic recession) ranks second among the major risks on the horizon: the fact that high inflation is now considered a rather remote hypothesis by most part of the people, rightfully inserts it among the potential "black swans".
5) Hard landing
Emerging Countries have come out of 2016 still on their feet, after having sailed in far from calm waters, especially after the collapse of raw materials. Now that Russia and Brazil seem to be on their way out of the recession, China is confirming itself (as it does every year) as the special observer. We don't believe much in the potential collapse of China (which would mean devaluation, a debt crisis with repercussions on the global economy), however the specific weight of the country and the riskiness of the task its authorities have to face make us vigilant. We recall that in January 2016, some bad Chinese data was enough to bring down the stock exchanges.
6) Abenomics
After four years of aggressive QE and zero rates, Japan is still not out of deflation. So far Abenomics has boosted corporate profits, thanks to sharp devaluation and the stock market run, but wages and consumption have remained flat. With debt at an all-time high and monetary policy stretched to the limit, the castle could fall at any moment.
7) US interest rates
The markets have shown that they are able to withstand a gradual increase in interest rates and, at the moment, there are no reasons to believe that the US monetary policy normalization process can occur faster than the FED Funds Futures market prices. (three rate hikes by 2018). The fact remains that if the FED's intentions and moves were misinterpreted, the financial markets could react negatively.
In summary, the latent problems of the Eurozone and the Hard Brexit are, in our opinion, the two risk factors which, seen at the beginning of the year, have the highest probability of realization and the highest potential impact on the markets. That is why we are mostly negative towards Europe.
Source: AdviseOnly
