For most of 2016, until mid-Fall, the US dollar retreated from the gains it had made in 2015. Following the late 2014 Fed's guidance that it would raise the Federal Funds rate eight times over the following two years, the USD quickly appreciated against all major currencies. However, after having raised its policy rate only once by the end of 2015, the market discounted the Fed’s guidance for more rate increases.
Eventually, early in 2016, the Fed announced much more modest targets for the Federal funds rate for the rest of the year. As a result, in 2016, the U.S. dollar gave back some of the gains it had made in 2015. The strong dollar in 2015 had contributed to lower the U.S. growth outlook for 2016 and justified the Fed’s less aggressive policy stance, going forward.
By the end of 2016, the U.S. dollar resumed its upward trajectory when it became clear that the Fed would finally tighten again. The removal of monetary accommodation and the greenback appreciation should continue in 2017. We expect the Fed to remain prudent in terms of the number of hikes it is anticipating for next year and beyond.
The Fed will want to avoid provoking another disproportionate USD appreciation which could force it, once again, to backtrack from its guidance. Depending on the fiscal measures Donald Trump and the U.S. Congress will agree on in early 2017, U.S. growth could surprise to the upside. Yet, we expect that, this time, the Fed will remain behind the curve to prevent another surge in the U.S. dollar.
Domestically, the Bank of Canada is likely to keep short term rates low and, potentially, even ease further if Canada’s growth outlook deteriorates. Yet, Canadian long term rates will continue to face upward pressures. The Bank of Canada may have effective control on the very short end of the yield curve but the country remains largely a “price-taker” for longer term maturity bond instruments, for which prices are determined on the global bond market. In 2017, expansionary U.S. fiscal policy and a tampering of Quantitative Easing in Europe, will contribute to increasing long term interest rates globally and Canada will have a difficult time escaping it.
At the end of 2015, we turned neutral on equities and advised investors to proceed with caution in the near-term as our dashboard of financial and economic indicators pointed to a worrying set of signals. This recommendation proved profitable as global equities largely underperformed bonds early in 2016 as rising speculation of a possible U.S. recession, a deterioration in global economic prospects and market volatility all weighted on investors’ outlook.
On the other hand, following the Brexit vote, we noted in late June that market sentiment had turned extremely bearish, with key indicators reaching levels similar to those achieved during past recessions and financial crises. With the economic backdrop then more positive than in 2008-09, for instance, and many leading economic indicators already on the upswing, we then recommended to overweight equities. This recommendation proved profitable, with equities largely outperforming bonds since late June.
We remain overweight equities as we expect earnings growth to continue to accelerate in the quarters ahead. The still-rising S&P 500 forward profit margins, steepening yield curve and the rebounds in both the ISM Manufacturing and the Global ZEW Current Conditions indices, are all supportive of a continued pick-up in earnings growth.
Moreover, despite the recent surge in bond yields, stocks still appear cheap relative to bonds as the S&P 500 earnings yield remains historically high relative to the effective yield of U.S. corporate high-yield issuers. Finally, market internals remain positive with corporate spreads still in tightening mode and capital market, transportation and weak balance sheet stocks, continuing to outperform.
In terms of regional allocation, U.S. and Canadian equities still figure as our favored regions since we decided to implement an overweight position in equities. This proved to be a profitable decision with both regions outperforming global equities during the period. Accelerating EPS growth and hopes for corporate tax reform and infrastructure spending should continue to stimulate U.S. outperformance. Also, late during the month of November, OPEC reached an agreement to cut oil production by 1.2 mb/d from October levels, which was the first cut in eight years. This deal should be supportive of higher oil prices and should contribute to the outperformance of Canadian equities.
For the most part, we believe that, in spite of the heightened uncertainty, global growth will pick up in 2017 and benefit equities.
- We expect the commodity rally to continue in 2017, especially in the oil sector. We forecast the WTI to reach $US68 per barrel by year-end. Our positive oil outlook for 2017 is, of course, conditional on OPEC members holding to the promised cuts as well as non-OPEC countries joining the agreement to reduce production, to swiftly reduce excess oil inventories.
- We expect gold prices to continue falling in 2017 with a mid-year target of USD1100. Yet, if the Fed remains behind the curve and inflation expectations start increasing, this trend could see a reversal in the second half.
- After another bad year, forestry and agriculture stocks (e.g. fertilizers) should recover in the U.S. and Canada amid the strong demand growth for such products, in emerging countries. A reversal should provide a good entry point.
- So far, with two weeks to go before year-end, the financial sector offered the second best performance in the S&P 500, beating the index by more than 10% and outperforming the return offered by the TSX (20.2% vs. 17.2%). The financial sector should continue its ascent in the new year.
- While we caution investors against the sector due to the rising rate environment, REITs are excellent hedges against inflation and their yield is expected to remain higher than that of long term government bonds. We recommend establishing positions in the REITS sector on weaknesses and as a diversifying strategy in a very volatile market.
- We expect consumer staples and discretionary to outperform in the U.S. and to underperform in Canada.
- The Canadian dollar, which regained some ground due to higher oil prices, but which remains weak compared to where it stood less than two years ago, should trade within a wide range during 2017. If the CAD were to cross the 1.25 threshold, we think that the Bank of Canada would be inclined to lower rates.
- The bottom line is that while the Canadian dollar will be volatile next year, it should remain sufficiently weak to increasingly benefit large Canadian exporters at the expense of domestically oriented businesses.
Finally, as in previous years, we caution readers there are risks to the above economic perspectives and market forecasts. First, global growth could falter as China and the U.S. enter a trade war. And second, USD borrowing in emerging markets to take advantage of low U.S. interest rates could cause havoc on the markets as the domestic value of these debts risks swelling to unstainable levels as the USD appreciates.