US, Europe, Japan, emerging markets: the best regional prospects for 2017
We round up investment prospects across the major regional markets, in what looks set to be a year full of uncertainty and potential pitfalls.
The UK has had its referendum and the US its presidential election. Next year, it will be Europe's turn to hear 'the voice of the people', as elections take place in France, the Netherlands, Germany and possibly Italy in the first half of the year.
Andrew Bell, chief executive at Witan investment trust, thinks these could have a big impact on markets. 'There will be plenty to worry investors regarding the future of the euro and the coherence of economic policies in the eurozone.
'People have consistently underestimated the political commitment to making the euro work, but 2017 will present some tough tests,' he says.
'The weaker economies, with strong political opposition to the hair-shirt economic policies introduced to address budget deficits, seem likely to send rebellious political messages challenging the current policy status quo.'
Jeff Taylor, head of European equities at Invesco Perpetual, is more sanguine about the impact politics will have.
He says: 'Many cite political risks in Europe as a major source of concern in 2017, making equity risk premiums on European equities look quite elevated historically and compared with other asset classes.
'Yet we believe it is a big jump to assume that the rise in populism and radical politics will necessarily mean populist or radical governments.'
Indeed, Taylor is enthusiastic about the prospects for Europe. 'Europe proved itself to be remarkably resistant to global macro-economic turbulence in 2016, and a continuation of the modest but respectable economic recovery that the eurozone is seeing is our base case for 2017.'
He points out that continental Europe has been through years of under-consumption and under-investment, thanks to the region's successive crises, but believes that 'now it's catch-up time'.
He says: 'Accommodative monetary policy, a (finally) functioning banking system, falling unemployment and some wage inflation are all helpful.
'After years of subdued corporate earnings, expectations are depressed in Europe, but we believe these can improve on the back of structural reforms, favourable financing conditions and operational leverage.'
But Taylor warns that not all parts of the market are equally attractive and that selective positioning remains key.
'While some parts of the market don't look very appealing to us, for instance defensive growth areas, other sectors, where the valuation looks low historically but there is earnings recovery potential, look much more interesting.'
Tim Stevenson, manager of Henderson EuroTrust, also sees potential for Europe from a contrarian perspective. 'Europe has moved from being a favoured area to being an unloved one over the past 18 months. So in some respects it is now the contrarian's first choice.
'The flip side of that coin is the possibility of intense political uncertainty, which may lead to renewed threats to the existence of the euro.
'If you put these two extremes together, volatility is likely to ensue. In volatile times, consistent, reliable companies that increase the returns to shareholders tend to do better.'
Of course, the impact of any unwelcome vote depends on how policymakers respond to it - Europe's politicians have not been particularly effective at taking the public with them. 'If the European system reacts flexibly and pragmatically, a crisis could be averted,' says Bell.
'On the other hand, a continued focus on reducing budget deficits with economies already weak seems likely to intensify domestic pressure on some economies to leave the euro.
'The positives that might enable Europe to muddle through are a cyclical recovery that is underway, which may blunt some of the populist parties' appeal, and a stronger dollar/weaker euro, which would help the competitive position of the garlic-belt economies.
'That would favour European exporters. European financials are vulnerable to any less positive outcome, whether in the form of weaker growth or risk to the current composition of the eurozone.'
Andrew Milligan, head of global strategy at Standard Life, thinks the European Central Bank (ECB) will have to continue its programme of market support to get a recovery going - something that should be positive.
The ECB has announced it will extend quantitative easing (QE) beyond March 2017 - as core inflation is well away from target - but will buy bonds at a slower rate.
Milligan says: 'An extension of QE would help sustain economic momentum amid signs of the best retail spending and housing data seen in Europe for many years.
'Conversely, corporate earnings in many European countries could be adversely affected by uncertainty resulting from the UK's Brexit vote and concerns about the banking systems in several countries. Litigation threats will require careful attention from investors.'
No prizes for guessing what is occupying the minds of US fund managers as we head into 2017. Donald Trump's election as US president took the country, indeed the world, by surprise in November - and financial markets have been digesting the news ever since.
How will US markets and the economy react to his regime in 2017?
Simon Clinch, fund manager, US equity, at Invesco Perpetual, expects another unpredictable year. 'Trump has come to power following a heated campaign built on wide-ranging promises and little policy detail.
'We know he is passionate about reducing the tax rate and simplifying the tax system, boosting infrastructure investment, attacking global trade agreements, repealing Obamacare and reducing the regulatory burden.
'But we also know he lacks the unwavering support of the Republican Party, and thus of the US Congress; it will be difficult for him to break free from the shackles of the party's fiscal conservatives. As he reveals his plans through the year, I expect markets to be highly reactionary.'
The extent to which he can get his policies through Congress will be the key to Trump's progress, but Angel Agudo, portfolio manager of Fidelity American Special Situations fund, questions whether a president can have much influence on markets.
'Irrespective of the initial market reaction, I do not think the outcome of the US presidential election dictates how the markets will act in the long term.
'Numerous studies have shown that presidential outcomes have limited impact on the performance of the US market. I do not think it will be any different this time.'
Trump will, however, inherit a US economy that is showing consistent signs of improvement. 'The US economy remains in good shape and should continue to improve at a moderate pace,' says Agudo.
'Given continued tightening in the labour market and the associated pickup in wage growth, consumption is expected to remain an important driver of growth. The strength of the services sector and improving activity in the housing and construction-related sectors should also support the economy.'
Clinch observes that the large number of variables in the US means it's hard to predict how the US equity market will perform overall.
But he thinks sectors that have become cheap - such as financials, energy and healthcare - should do well, while more defensive sectors such as consumer staples and utilities should underperform, given their high correlation with bonds.
'We expect 2017 to be a stockpicker's market, so investors need to be nimble and conscious of valuations,' he adds.
Among the key factors that will affect financial markets in the year ahead will be what happens to interest rates, whether and where taxes are cut, and how much of the much-vaunted infrastructure spending actually happens.
Bell thinks it is quite possible that a significant corporate and personal income tax cut will be enacted in coming months, and also plans for 'a more debateable but still possible infrastructure programme' in subsequent years.
'This will inject demand and inflationary pressure into an economy where the labour market is already tightening. This could mean the US Federal Reserve tightens rates more rapidly than expected. A buoyant domestic economy and rising interest rates could bring further near-term strength in the dollar.'
Milligan expects interest rates to rise more quickly than anticipated. He says: 'We assume that the Fed will raise interest rates slowly during 2017 and more aggressively into 2018.
'The election has forced investors to re-evaluate the inflation outlook in the US, challenging "gradualist" views, as a large fiscal boost in 2017/18 could combine with an already tight labour market.
'Wages are already showing signs of moving higher. We remain positive on the dollar, given the underpinnings of relative growth and therefore tighter monetary policy versus the rest of the world.'
However, Paul Niven, manager of Foreign & Colonial Investment Trust, is relatively gloomy about the outlook for markets everywhere, including the US, on valuation grounds.
He says: 'The fact that global equities have made muted progress overall is of little surprise when one considers the fact that corporate earnings have been flatlining for most of the past two and a half years and, on most metrics, valuations are at historically rich levels.
'It remains my view that valuations in equities are unlikely to move sustainably (and materially) higher from current levels. To see meaningful sustained upside to equity prices, corporate earnings will need to show improvement.'
He adds that while the most recent US earnings season showed a better quarter than has been seen for some years (at around 3 per cent growth year-on-year, it showed the first annual growth since the first quarter of 2015), there remains little to get excited about.
'In my view, with bond yields likely to push modestly higher (pressuring valuations), equity markets look unlikely, in aggregate, to meaningfully break out of their recent range,' he concludes.
SMAP, the boy band that has become Japan's equivalent of a national treasure, will officially break up at the end of 2016. Its creation 28 years ago more or less coincided with the peak of the Nikkei index.
But while SMAP's fortunes have soared, the Nikkei has been on a downward trend interspersed with occasional comebacks ever since.
Abe's 'three arrows' of reform programme, which was exciting investors in 2015, is the latest initiative to fall flat. Will the demise of the boy band finally mark a decisive recovery for Japan?
Our experts are not holding their breath. Milligan says: 'Japan was one of the biggest disappointments in the first three quarters of 2016, due to weak domestic profits, banking issues and currency swings versus the dollar.
'Looking at late 2016 and into 2017, though, we expect support from weaker exchange rates, plus the higher leverage of these markets to global growth as and when the US fiscal stimulus starts to have an effect.'
Paul Chesson, head of Japanese equities at Invesco Perpetual, agrees that a weaker yen will help Japan, although he points to the relatively low valuation of its stock market.
He says: 'The near-term outlook for Japan's equity market has benefited from a recent weakening trend in the yen and the potential for corporate earnings to improve in the second half of the fiscal year.
'In addition, valuations are currently undemanding relative to other developed markets, while a loose monetary policy and expansionary fiscal policy remain supportive of the domestic economy.'
The potential for further disappointment remains, however. Chesson cautions that any shift towards greater optimism over the near-term outlook should be tempered by continued caution over the longer term, not least because political uncertainty around the world is likely to remain a significant feature of 2017.
That, he says, 'suggests further volatility in global financial markets', including Japan.
Bell expects the weakness of the yen to bolster measures Japan is taking to try to end its long period of stagnation. He explains that Japan has adopted a looser fiscal policy, both by implementing some limited measures to boost spending and by deferring an expected rise in sales taxes.
'This will help sentiment in the economy, but the absence of tightening is not a stimulus,' he observes. However, the renewed weakness of the yen is.
He adds: 'The yen's strength stunted profit margins in corporate Japan, making it the weakest major market in local currency terms through 2016. The stock market should enjoy a period of improving earnings estimates in 2017 if recent yen weakness is sustained.'
Bell even thinks inflation, which for years has been stubbornly low or non-existent, could start to tick up again. He says: 'Perhaps investors have given up too early on the chances of inflation taking hold in Japan.
'A weaker yen, coinciding with the turn in oil and commodity prices this year and a US economy set to be run with more inflation risk, could see inflation rise more than expected in 2017, even if not to the Bank of Japan's target of 2 per cent.'
One wild card, in his view, is the risk that, with such a large percentage of the government's debt owned by Japan's central bank, the temptation to take the axe to the country's high debt ratio by effectively defaulting on the publicly owned portion might be irresistible.
'It's more likely,' says Bell, 'that Japan sees a relatively good cyclical and a stock market revival in 2017 but makes little progress in changing its entrenched deflationary mind-set.'
Milligan pays tribute to Japan's policy-makers for considering other means of stimulus, rather than simply relying on quantitative easing. '[The approach] of Japan illustrates the shift in fiscal policy thinking taking place among the leading economies,' he says.
'Alongside the move away from QQE (quantitative and qualitative easing), the government has introduced a large fiscal stimulus to boost growth in 2017, while a debate has begun about whether an income policy might shock inflation expectations for households and companies.'
But Chesson warns that it remains hard to predict which way the Japanese market will go.
'The dichotomy between fundamental reasons for optimism in the short term, such as selectively attractive valuations and a brighter earnings picture, and a longer-term outlook that is more difficult than usual to predict is reflected in our portfolios.
'For now, we believe the valuation disparity in Japan between stable, cash-generative companies and more economically sensitive sectors is excessive.
'As a result, we have a bias to the latter but retain positions in some areas where we can find companies that offer greater earnings clarity at what we consider to be reasonable prices.'
Given the tumultuous developments outside Asia in 2016, Tim Orchard, Asia Pacific ex-Japan chief investment officer at Fidelity International, argues that emerging Asia 'should not necessarily carry a significant corporate and political governance discount to her western brethren'.
Orchard concedes that concerns have been raised over Asia's ability to cope with the spectre of higher US interest rates. But he points out that Asian markets have typically performed well when US interest rates have risen, which perhaps reflects the fact that higher rates tend to signify more robust global growth.
However, one area in which we are unlikely to find respite next year, according to Robert Horrocks, chief investment officer at Matthews Asia, is the continuing debt problem in China.
He says: 'On the one hand, we are not seeing the degree of panic we saw at the beginning of 2016; on the other, this issue will take years to resolve.'
Elsewhere, better news is coming out of India, as the country's reform plans seem to be gaining some momentum. Progress has been made with the implementation of the goods and services tax, which is similar to VAT here.
It would remove many layers of tax and replace them with a single rate. It's a welcome development, says Orchard.
Horrocks says India's recent chaotic demonetisation experiment (in which 86 per cent of the currency notes in circulation are being withdrawn and replaced with new notes) is deflationary over the short term. But he points out that India's market is one of the more expensive in the region.
'While this will inevitably damage near-term growth, it is nonetheless a positive reflection of prime minister Narendra Modi's desire for reform,' adds Orchard.
'There has also been progress in reducing India's twin deficits (in the national budget and in foreign trade), inflation levels have fallen and the scope to cut interest rates further remains.'
He adds that while the cyclical downturn may be prolonged and the issue of Modi's re-election start to concern the market, the longer-term view for India is set to remain good.
Beyond China and India, Asia's global heavyweights, the region harbours another dynamic and fast-growing market cluster that remains relatively unknown, says Sriyan Pietersz, investment strategist at Matthews Asia.
He refers to the 10-nation grouping known as the Association of South East Asian Nations (ASEAN).
Formed in 1967 to promote regional co-operation, the group is broadly separable into two blocs: CLMV (Cambodia, Laos, Myanmar and Vietnam) and the more developed Asean+6 (Singapore, Malaysia, Thailand, Indonesia, the Philippines and Brunei).
The CLMV bloc members all enjoy rapid growth, but they are at an earlier stage in their economic development than the ASEAN+6.
Asia Pacific has made strong, if uneven, progress since ASEAN was founded nearly half a century ago, with the region now growing at an average annual rate of approximately 6 per cent over the past decade.
The region covers more than 4.4 million square kilometres, which makes it more than half the size of the continental US.
In the year ahead, ASEAN is poised to make further strides by leveraging some key attributes: a population of more than 630 million people (the third-largest in the world), a potential market larger than the EU or North America, and a strategic location between Asia's two economic giants, India and China.
Increasing intra-regional trade and global linkages are fuelling income growth in this foreign direct investment-driven manufacturing base, which is second in scale only to China.
This, together with the bloc's young and increasingly urban workforce, makes ASEAN one of the fastest growing consumer markets in the world.
However, Mona Shah, senior research analyst at Rathbones, points out that ASEAN stock markets are still relatively small, 'although they are continually widening and deepening'. As a result, she says, investment flows can have a great impact on these markets.
'For example, in 2007 the region suffered outflows of $45 billion (£35 billion), but in 2010 this had shifted to inflows of around $4 billion. This meant that in 2008 the market was down by more than 50 per cent, but by the end of 2010 it had more than doubled.'
She warns that investors should bear in mind not only that this is a relatively illiquid market, but also that the number of stocks that are actually investable is fairly low compared with South Korea and Hong Kong.
'This is why most managers in this space tend to be fairly concentrated and sometimes have a long tail of small stocks.'
Global emerging markets bounced back in 2016 after disappointing investors in recent years. Over the year to 8 December, the MSCI Emerging Markets index rose by 10.4 per cent.
But fear over Donald Trump's protectionist policy statements and campaign pledges to rely on 'local labour' instead of outsourcing manufacturing might bring difficult challenges.
Russia is coming out of a recession and has the potential to grow by 1-1.5 per cent in 2017, estimates Gary Greenberg, head of emerging markets at Hermes.
But the Russian economy remains severely constrained by sanctions, the relatively low oil price and the fact that it is focused on extractive industries rather than value-adding ones.
Given the apparently warm relationship between US president-elect Trump and Russia's president Vladimir Putin, the economic sanctions may be lifted. This would allow Russian companies to raise capital, and greater economic liberalisation could ensue, says Greenberg.
The market is currently rallying on such an outcome, but it's unclear how likely such a move is. It is worth noting that Russia's recent deployment of new anti-ship missiles in Kaliningrad, which angered Nato, does not send a co-operative signal.
Commodity prices generally seemed to have bottomed out, says Greenberg, but price rises are constrained by a surging dollar. The dollar can go only so far before it starts to affect the earnings of multinational companies.
He guesses that we're near the dollar peak, and that commodity prices could improve further as it starts to fall, which is 'what it's all about in Russia'. The Russian economy depends on oil, nickel, platinum and palladium production, which will benefit from a pickup in commodity prices.
Long term, Russia does not have much of a competitive edge in terms of value-added manufacturing, electronics, civil society or intellectual property. The country faces serious long-term problems, but Greenberg says it's possible to be optimistic for 2017.
A key attraction of frontier markets has been and continues to be their low correlation with each other and with emerging and developed markets, says Sam Vecht, manager of the BlackRock Frontiers Trust.
This made frontier markets such as Pakistan and Bangladesh valuable diversifiers in 2016, and it will remain the case in 2017.
Vecht adds that frontier markets have better cash-flow growth than others and continue to offer above-average yields. Of course, each frontier market region poses its own political and economic risks.
Frontier markets tend to be under-researched, he says, which gives active managers an opportunity to outperform in these countries. The trust he manages has so far had a large weighting in South Asia, particularly Pakistan, Bangladesh and Sri Lanka.
But shares in these countries are becoming expensive, so Vecht may shift his focus away from South Asia in 2017, possibly towards the Middle East, Africa, Vietnam or Latin America.
He says he would be interested in buying more Nigerian companies if the currency traded at a fair exchange rate, which it does not currently.
He points out that economic reform will continue in Argentina in 2017, while flotations could reinvigorate the local market, providing some interesting opportunities. In emerging Europe, Romania has been growing fast for the first time in decades, he says.
Like Russia, Brazil is coming out of a recession. It has been plagued by spiralling debt for some time now, and because its interest rate stands at 14 per cent, its debts are growing fast.
Over the next year its base rate might drop to 10 per cent, which would be a boost for the economy and markets, says Greenberg, because Brazil's main concern is to stop the debt spiral.
'It is like a heavily leveraged company because it has such a high interest rate, and that's what makes it so volatile.'
The country swings from euphoria to dire pessimism. While the electorate voted for former president Dilma Rousseff, Brazil's Congress impeached her. Various political actors who could implicate the current president Michel Temer in scandal are being arrested.
Two reforms have been tabled recently, which are being seen very positively by investors. The first, a cap on government salaries, has been passed. The second relates to the social security system, but has not yet been approved.
In terms of valuation, Brazil is not cheap, says Greenberg. If interest rates go down to 10 and then to 8 per cent in 2017, the market will take off.
But Greenberg is unsure which way rates will go. Given the threat of further political scandals and the reforms that have not yet become law, he remains underweight in Brazil.