The Cayman Islands Journal, Feb. 1, 2017: By the time you read this, one of the most unlikely events that could have been imagined one year ago will have happened – Donald Trump will have been inaugurated as the 45th president of the United States of America. We are not here to sit in judgment of this fact, but simply to point out that in January of 2016, very few people anticipated this outcome, least of whom were the experts and pundits that make a living out of their predictive abilities.
It is with this in mind that we would like to look forward and try to think through two possible outcomes for financial markets in 2017; outcomes that financial markets currently price as improbable. Call it the list of “the most likely of the unexpected” events to occur. Everyone has a prediction for what WILL happen in 2017 and most of those will be wrong (refer to the Federal Reserve’s economic forecasts in December of every year since 2011), so here are two things the market has definitely not counted on, but which could actually occur.
- The triggering of Article 50 of the Lisbon Treaty, or the official Brexit, does not turn out to be the most important political event of the year.
The entire world will most assuredly be watching when Theresa May gives her speech and signs whatever needs to be signed, in triplicate no doubt, to trigger the U.K.’s exit from the Eurozone. This event is due to occur sometime in March. There will be an active betting market on which day it will be, and surely an estimate from the punditry of how many times Mrs. May utters “the British people.” This may not, however, turn out to be a market-moving event. Why should the symbolic signing of a piece of paper cue market volatility? There should be countless opportunities over the next two years (or more) of negotiations for volatility associated with this divorce, and we frankly see little reason for it to happen immediately at, or directly after, the event.
The real political market-moving event may be the presidential elections in France. We already know there is likely to be no Socialist candidate, so the government is changing. The election will almost certainly be contested between two conservative parties, one of a “center-right” disposition and the other very far to the right indeed. A panoply of polls has Marine Le Pen’s Front National scoring no better than between 32 percent and 37 percent in the last run-off of the election whether she faces Alain Juppe or Francois Fillon. Do you trust the polls after what happened in the U.K. and the U.S. in 2016? Or rather, do you trust them enough to believe that the unlikely simply cannot happen?
- U.S. Treasury bonds will not be the worst performing asset class in 2017, as the markets expect.
First, to be clear, we are among those who believe inflation will rise in the U.S. this year. If any, or most, of President Trump‘s policies are enacted into law, or decreed, as is his right in some cases, most of the policies are inflationary. If U.S. inflation is set to rise then, how is it possible for the Treasury market to perform well? Easily. Financial markets are giving a “huuuge” benefit of the doubt to Trump and the potential for his policies to be supportive of growth. More sensible forecasters, that we happen to agree with, have added only marginally to forecasts for measured GDP in 2017. Recall that in the end of 2015, GDP growth was forecast to be nearly 3 percent; 2016 was going to be the year that growth broke out of its “new moribund,” but it didn’t happen. GDP growth forecasts for 2017, even with the Trump bounce in sentiment are 2 percent to 2.5 percent, which, while better than 2016, is not much higher than estimated potential growth for the U.S. economy. U.S. 10-year rates finished at 2.45 percent, not materially higher than at the end of 2015. Therefore, if expansionary fiscal policy or tax cuts take longer than expected or growth negative policy takes priority, there is potential for GDP to disappoint and for rates to remain much more range-bound than recent price action would predict.
In conclusion, one does not have to truly believe that a far right candidate will win the French presidency, or that Trump’s policies will fail, to engage in an exercise questioning what is possible in 2017, even if it is not the most probable outcome. Thinking about how markets are valued based on the probable outcome does little to protect you from the potential downside of being wrong. One must assume some level of humility and test assumptions (both one’s own and the market’s) in order to ensure that if the unlikely occurs, your portfolio is protected from irreparable damage.
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.