Monday Briefing
The performance of financial markets provides signals about the state of the global economy. Market movements in part reflect shifting expectations about growth, inflation and risk. The messages from markets are fallible. But unlike economists’ forecasts, the positions investors take are backed by real money.

So who made money in financial markets in 2016 and what does it imply for the global economy?

It’s worth recalling that 2016 opened on a wave of pessimism about the global economy and about equities. A hard landing for the Chinese economy was seen as the number one risk, an outcome that could have dragged the global economy close to recession. One City of London analyst advised clients to “sell everything except bonds”, advice that was widely repeated in the media. Clients were told to brace for a “cataclysmic year” and a global deflationary crisis. It was an extreme statement of a prevalent view that 2016 would be a risky year.

Happily, predictions of cataclysm proved wide of the mark. The global economy continued to grow, and at a similar rate to 2016. The much-feared Chinese hard landing failed to materialise and growth in other emerging markets accelerated. At the start of 2016 a Brexit vote and the election of Donald Trump were seen as major risks to the outlook. Both, of course, materialised and yet equities have rallied in seven of the ten major developed economies we track.

UK equities have been the best performers, returning 16% in 2016. Large UK corporates, which tend to earn a significant chunk of their revenues abroad, in dollars, have benefited from the sharp drop in the pound, and have returned 19% over the year. But the rise in UK equities is not just about a weaker pound. The UK economy has proved unexpectedly resilient since the referendum and this has supported smaller, UK-focussed companies. They have done quite well, returning 14% over the same period.

Mining and oil and gas were the best performing sectors in the UK. They staged a spectacular recovery as commodity prices rose, returning 108% and 59% respectively. Miner Anglo-American was the biggest gainer in the FTSE 100, with its shares rising almost 277% over the year.

UK equity investors may be bullish but this sentiment has not spilled over to the corporate sector. Corporate risk appetite, as measured by the Deloitte CFO Survey, is running at low levels, with 80% of CFOs saying now is a bad time to take risk. Sentiment among economists has partially recovered from the Brexit vote. Economists swiftly slashed their forecasts for UK growth in 2017 on the Brexit vote, from 2.1% to 0.6%, a massive downgrade and greater than anything I have seen in 20 years. But from a low of 0.6% in August growth forecasts have risen every month and in January reached 1.4%.

After a rotten first half to 2016 US growth reaccelerated in the second half with the unemployment rate falling close to at eight year low and wages, at last, rising. Forecasts for US growth in 2017 are now drifting higher. Despite what, overall, was a lacklustre year for US growth, US equities returned 12% in 2016.

Markets have responded positively to Donald Trump’s election victory, with expectations of tax cuts and more government spending eclipsing worries about protectionism and geopolitics. US equities have returned 5% since the election. Telecoms and financials have been the best performing sectors, returning 11% and 9% respectively, since November. Mining and pharmaceuticals and biotech have been the worst performers.

Another sign of confidence in the US economy comes from the Federal Reserve which has suggested it is on track to raise interest rates by 75bp, or three-quarters of a percent, this year. Many US investors and analysts are speculating that interest rates and bond yields, could, at last, be heading back up to pre-crisis levels. With investors pricing in a less bond-friendly world of higher inflation, higher growth and higher interest rates the value of US Treasuries has fallen. I was in the US last week and was struck by the widespread view that the 30-year bull-run in US bonds could be drawing to a close.

Among major equity markets Italy’s had the poorest performance in 2016. Against a backdrop of weak growth, banking and housing crises and political uncertainty investors in Italian equities lost 5% last year. The worst performing sector was real estate with investors losing 28%.

Other major euro area equity markets made gains, with French, German and Spanish stocks returning 9%, 5% and 5% respectively.

2016 was a good year for commodities, with prices up 28%. Crude oil ended the year up 59%. This has boosted growth prospects for commodity-producing emerging markets such as Russia and Brazil and has helped fuel a 13% return in emerging market equities.

Chinese equities lost investors 25% in the first 5 weeks of 2016 on fears of a hard landing. Since then sentiment revived, and Chinese equities returned 14% by the end of 2016.

In the currency world the big news is the rise of the dollar, which has risen 10% on a trade-weighted basis from its trough in April, driven by a rebound in US growth and growing expectations of higher US interest rates. This is part of a long uptrend. Since reaching an all- time low in 2011 the dollar has risen in value by 39%.

The dollar’s rise has been so vertiginous that it is starting to look overvalued. The Economist’s Big Mac Index provides a light hearted gauge of currency valuations by comparing the price of a Big Mac around the world. The Big Mac index rates the dollar as being overvalued in 37 of the 42 countries it tracks (the exceptions are Switzerland, Norway, Sweden, Venezuela and Brazil).

Last year the euro rose by 2% on a trade-weighted basis, with 16% gains against the pound helping offset a 3% loss against the dollar. The pound was the worst performing major currency in 2016. It has fallen significantly since the Brexit vote and is down by 14% from its peak last May.

Gold is often seen as a safe haven in uncertain times. Greater optimism about the global economy, and in particular the US economy, has hit the gold price. It has fallen 5% since the US election.

So what do investors expect for 2017?

By and large most seem to be pretty optimistic that the equity rally has further to run. We tested opinion in our Year-Ahead webinar a couple of weeks ago. About half the audience, some 900 people, responded, of whom 81% said they expected equities to outperform bonds in 2017. Measures of US investor bullishness are running close to their highest levels in more than two years. Emerging market equities and US small cap stocks seem to be particular in vogue at the moment.

Investors seem to be expecting stronger global growth and inflation this year and rising interest rates. I would agree with the economic diagnosis.

As for the market conclusion – that equities will outperform bonds – well, I won’t even try to guess. The fact that the market pessimism of early 2016 was such a poor guide to subsequent events is a salutatory reminder of the fallibility of we prognosticators.