The holiday season usually brings with it scores of grandiose predictions about what to expect from the year ahead. But if 2016 has taught markets anything it is surely the need for humility in the face of unprecedented policy uncertainty.
That does not mean we have no ability to divine a list of key considerations for 2017. Indeed, in doing so we reach a number of contrarian views.
But what it does mean is that we need the humility to recognise the limits of one’s knowledge. This is particularly crucial now, at a time when policy uncertainty reflects an unusually wide distribution of outcomes in global politics (US, European, British), monetary policy, the fiscal outlook, and prospects for economic reform.
Global Economic Policy Uncertainty Index
Source: policyuncertainty.com, Haver and GSAM. Data as of 2 December 2016
Regardless of how elevated policy uncertainty may be today, the confluence of major political and economic events over the course of the next year could drive both uncertainty and volatility yet higher still.
The US will embark on a markedly different political trajectory when president-elect Trump takes office and establishes the first unified Republican administration for a decade; there will be crucial elections in a number of euro area economies including Germany, France and the Netherlands; and, if the UK government is able to stick to its intended timeline, Article 50 will be triggered and the formal Brexit process will be initiated.
In our view, the resulting volatility arising from those events brings into sharp focus the need for a broadly-diversified portfolio and the judicious use of active volatility management (through, for example, incorporation of liquid alternative solutions into a portfolio). It also points to the need for a more tactical response to the inevitable surprises that will arise.
Such a degree of political uncertainty is unusual for developed markets – politics rarely feature quite so prominently and persistently as a driver of market direction in these countries. But the uncertain outlook is not just about politics; even if we leave such considerations to one side momentarily, the more “traditional” policy drivers of markets have the potential to generate an unusually high degree of volatility in the year ahead, with monetary policy a prime example.
The world’s major central banks have now taken markedly differing directions as the Fed pursues a policy of gradual normalisation while the ECB (and others) continue to throw the kitchen sink at the persistent disinflationary pressure plaguing other parts of the developed world.
Whereas, traditionally, the degree of monetary policy divergence is easily calculated as the difference between policy rate A and policy rate B, those headline interest rates now only capture a small part of the overall monetary policy stance, as QE and other such tools have been deployed by central banks to ease monetary conditions further once interest rates have run out of road.
So, instead of focusing on the headline policy rate, if we consider the ‘shadow policy rates’ published by researchers at the Reserve Bank of New Zealand – which seek to provide a gauge of the overall monetary policy stance, including all of those other non-standard measures – we already see that the divergence between US and euro area monetary policy has reached record highs.
Shadow short rates (%) and absolute difference (pp)
Source: Leo Krippner (Reserve Bank of New Zealand Analytical Notes series), GSAM. Data as of 12 November 2016
In our view that divergence will only continue to grow in the year ahead. We see little slack remaining in the US economy and core inflationary pressures are already ticking higher, even before any Trump-related additional fiscal stimulus is injected into the mix. Consequently, we foresee the Fed having to raise policy rates in 2017 by more than the market is expecting. The challenge for the Fed is to execute that exit strategy without causing severe market dislocations.
Recall that back in 2013 Andy Haldane, chief economist of the Bank of England, said “we've intentionally blown the biggest government bond bubble in history” – something that applies equally well to the US. The problem with bubbles is that they have a nasty habit of bursting rather than gradually deflating and, while we have confidence in the Fed’s ability to engineer a gradual deflation, the market will (rightly) fret about the ‘what if’ burst scenario – hence generating more volatility.
By contrast, on the other side of that divergence, the policy measures being rolled out by the ECB (and others) are necessarily becoming increasingly innovative. That reduces policy predictability and points towards higher volatility. Given our view that the euro area economy next year will slow materially – another contrarian view relative to market expectations for broadly stable growth – that need for policy innovation (and resulting volatility) could be amplified further in our view.
The good news is that uncertainty and volatility bring opportunity. To give one example, the divergence, volatility and level of interest rates could be helpful for the performance of relative value fixed income strategies.
At Goldman Sachs Asset Management our view of the market landscape for 2017 is markedly counter-consensus in a number of key areas – not only views on rising US rates and a euro area slowdown, but also around the signs of improvement in Japan and the attractive opportunities still on offer in emerging markets in the aftermath of the US election.
But we recognise that some of our views – and some of those expressed in current market pricing – might be wrong. So while a volatile market environment may be ripe for expressing tactical views, the need for having in place a soundly-constructed, well-diversified portfolio is becoming ever more important as we head into 2017.
James Ashley is head of international market strategy, strategic advisory solutions at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.