Whether you consider 2016 a good or a bad year, it was by no doubt the year of surprises. Not just because Donald Trump was elected the 45th president of the United Stated or because the UK decided to leave the EU, but the markets’ reactions to these events were even more surprising and most forecasters got it wrong.
A new year has started and many questions remain to be answered; here are some of the most asked questions for 2017: Will the Trump rally carry on? How many rate hikes will the Fed deliver? What is the future of the UK and the EU? Will OPEC finally balance the oil markets?
Will the Trump rally carry on?
Following the election of Donald Trump on November 8, all U.S. major indices recorded new highs. The Dow Jones industrial average rose 8%, S&P 500 and Nasdaq composite gained 5%, and the small-cap stock market index Russell 2000 outperformed its peers rising by more than 13%.
From a market valuation perspective, very few may disagree that stocks are expensive, but the expected combination of fiscal stimulus and deregulation for some sectors under Trump’s presidency were the main catalysts for the rally. Of course, financial markets tend to price in events before they occur, but this time I believe investors have priced in most of the good news, and it requires very strong corporate profit growth to keep this bull market alive. Predicting the end of the bull market is a tough call, but the downside risk in 2017 is likely to be larger than the upside potential. If U.S. policy makers succeed in delivering the anticipated growth we can see another 5 – 10% gains in U.S. stocks, but failure to do so will cause a steep selloff that could exceed 20%.
Day traders may be luckier than investors in 2017 as a new indicator has been added to their watch list: Trump’s twitter account. On December 6, Trump tweeted “Boeing (NYSE:BA) is building a brand new 747 Air Force One for future presidents, but costs are out of control, more than $4 billion. Cancel order!”, few seconds later Boeing stock wiped almost $1 billion from its market cap. We expect to see more of these tweets in 2017 and algorithms will probably require long time to put them into play, leaving retail traders with opportunities to profit from such market disruptions.
How many rate hikes will the Fed deliver?
2016 kicked off with the expectation that four rate hikes would occur, but only one was delivered in December. Although it was anticipated that the Federal Reserve will be more cautious in their forward guidance for 2017, December’s meeting took many economists by surprise as they hinted for three rate hikes.
Since the financial crisis in 2008 the Fed has got many things wrong, whether it is forecasting rate hikes, economic growth and inflation levels, and now with a new administration to take office on January 20, this could make the Fed’s projections even more complicated.
Inflation has always been the main justification for low interest rates, but now, even before Trump takes office, a couple of inflation gauges are running above 2%. The Fed did not account for any fiscal stimulus measures in their most recent projections, suggesting that huge shifts in expectations may be seen.
The rising U.S. dollar which is currently at a 14-year high is another source of worry for the Fed, and tightening too fast will lead to even stronger dollar hitting U.S. exports and multinational companies’ profits.
If Trump’s measures were passed and economic growth picked up, the Fed will have few options, either tightening monetary policy more aggressively, or to fall behind the curve and let the fixed income market lead the way, but three rate hikes in 2017 is my base case. Either way the dollar is likely to remain strong as pergence in monetary policies will continue to widen.
Future of the UK and the EU?
Hard, Soft or Grey Brexit. This was the most argued topic in the past six months, and until now there’s no clear path on what direction the UK will move. The pound ended 2016 17.5% lower against the US dollar since June 23 and there’s lot of speculation on how it will end in 2017. Of course, much will depend on the path Britain will choose. Theresa May promised to trigger Article 50 by the end of March, but we still need to hear from the Supreme Court on whether the UK government needs parliamentary approval before starting the withdrawal from the EU.
The delay in triggering Article 50 will be positive in the short term for sterling, and negotiations may last well beyond 2017 on the terms of Brexit. Meanwhile investors will be focusing on the economic developments and the direction of the Bank of England’s monetary policy, which will probably be the second major central bank to raise rates after the Fed.
Politics within the EU will rule investment decisions in 2017. Germany and France, the two largest economies will hold elections amid the rise of Eurosceptic candidates. Italy is likely to see an early vote, after the resignation of Matteo Renzi last month, and the Five Star Movement has vowed that if it wins power it will hold a referendum on whether Italy should leave the Eurozone.
Although many polls indicate that far right candidates are still behind, nothing should be taken for granted after Trump won the U.S. presidency and Britain voted to leave the EU. Expect to see more pressure on the Euro and look out for parity against the dollar in the first six months.
Will OPEC finally balance the oil market? After hitting a low of $27 a barrel in February 2016, Brent prices more than doubled by the end of year and many investment banks still see further increase in prices for 2017.
OPEC’s decision to cut its output by 1.2 million barrels a day starting January, and non-OPEC producers to cut 558K barrels for the next six months to drain record global oil inventories led Brent prices to post its first yearly increase since 2012.
Whether more appreciation is to be seen in 2017 will depend on multiple factors, and the biggest one currently looming is compliance to production cuts. It’s in no one’s interest not to comply, but historic figures show that delivering on previous production cuts has been poor.
U.S. producers are another element to be focused on, how fast shale may come back is a key component to be considered in the price equation. Although Trump has made the energy sector part of his economic growth plan, I believe it won’t have a lot of impact if prices don’t hold up. The dollar strength will likely impact the demand side, as continued strength will make oil more expensive in other currencies.
With all these unknows we will likely see prices moving in tight ranges in the first quarter until we get a clearer picture.
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