10 improbable but possible outcomes for 2017

It is time to forget central scenarios and think about improbable but possible outcomes. Some of our surprises would be bad (US recession, for example) but some would be good (a Mexican peso rally, say).

It is time to step back a little. We recently reviewed the success of our 10 “improbable but possible” outcomes for 2016 and now is the time to think about what might surprise us in 2017. These are not central scenario views; rather they are ideas seemingly ignored by the markets but where we think the probability is at least 30%.
We believe the biggest returns are earned (or the biggest losses avoided) by successfully taking out-ofconsensus positions (or avoiding the errors made by most others). A year ago, the broad consensus was pessimistic, hence a lot of our “improbable but possible” ideas were then based on a more positive outcome (“China surprises to the upside”; “Brazilian debt is a star performer” etc). Now, the markets are in a far more positive mood, so many of our ideas focus on the negative. However, we have tried to come up with a diversified and uncorrelated list. Do not look for consistency across the ideas; there is none.

1. The Mexican peso stages a recovery
The Mexican peso has fallen about 25% versus the dollar in the last 18 months, partly on the back of Donald Trump and his anti-Mexican rhetoric (see Figure 1). Trump talks of draining the Washington swamp but he has instead chosen to fill it with financial and corporate sharks. Unfortunately, we suspect the swamp will better suit the alligators that were already there and expect Trump and his sharks to be eaten alive and/or bogged down in quick-sand.
Throw in the reality of dealing with the international community (especially the Chinese and Putin, who we suspect is even smarter than Trump thinks) and a lot of Trump’s promises will grind to a halt (anti-trade rhetoric and building a wall financed by Mexico, for example). Add this to the fact that the real value of the peso is approaching levels seen during the Latam and Tequila crises of the 1980s and 1990s (Mexican inflation went above 100% in the 1980s) and this could turn out be a good year for the Mexican currency.

2. The US economy tips into recession
A year ago fears of a US recession were rife. Now it seems hard to imagine, which is exactly why it is worth considering. Q3 was the 29th quarter of this economic expansion, which is the average length of those since the war. That in itself suggests the risks are rising, especially as the Fed tightens and the dollar appreciates.

Corporate profits play a key role in the cycle and, though Trump may boost after tax-profits by cutting corporate tax rates, his policies could shift income from capital to labour (the attempt to create more jobs in a fully employed economy could raise wages rather than profits). Add to that the debilitating effect of a president second-guessing every corporate decision and investment could easily fall, rather than rise. Gold would enjoy a US recession, in our opinion.

3. US yields end the year lower
The 10 year treasury yield ended 2016 at 2.44% (up more than 100bps from the mid-2016 low). Analysts have been rushing to upgrade their forecasts, largely on the back of Trumponomics.
However, the US economy tends to be at its weakest during Q1 and this could push yields lower in the short term. The Fed has recently backed away from rate hikes when such softening has occurred and the above mentioned recession would be enough to drag yields much lower (in our opinion). Though headline inflation is on the rise (due to oil), core inflation has been surprisingly stable in recent months and we suspect inflation and interest rates will stay lower for much longer than anticipated.

4. Brexit chaos; Theresa May resigns; £ hits new low
The sending of the Article 50 letter will start a process about which the UK government appears clueless. The loss of jobs to Europe, lack of engagement from European leaders focused on their own domestic politics and agitation from Scotland and other “Bremainers” will provide a potent cocktail. Difficult choices will have to be made but Theresa May appears indecisive and could buckle under the pressure. In the midst of all this, sterling could test new lows, especially given such a wide current account gap (see Figure 2).
Though a 5% decline in real effective terms would bring sterling to those 1976 lows, we doubt that cable (GBP/USD) will break the 1985 low of 1.05 (that was 15% below the current level and was more due to dollar strength than sterling weakness).

5. Italy launches an EU referendum process
Investors often ask about European politics but markets do not seem to reflect that concern. We think this year’s elections have the potential to provide some upsets and we believe there is a non-negligible chance that another European country will this year announce a referendum on its membership of the EU. The most likely candidate, in our opinion, is Italy.
The German election (probably in September) appears relatively uncontroversial: though Merkel will lose ground, we suspect she will still be Chancellor, leading a CDU/CSU/FDP/SDP coalition.
The populist Alternative for Germany party will gain more than 10% of parliamentary seats (we suspect) but will be frozen out of power.
Many investors worry about a Le Pen victory in France and she clearly wants such an EU referendum. Though opinion polls suggest she will make it to the second round of voting, they also suggest she will then be heavily defeated (most likely by Fillon). Her father might agree.
In the Netherlands, opinion polls suggest the populist PVV party of Geert Wilders will win the most seats in March (perhaps 30-35 out of 150) but we doubt it will be able to form a ruling coalition. We suspect it will be frozen out by a “coalition of the unwilling” among other parties and that there will be no referendum.
The situation in Italy is less certain. First, we don’t know when the election will be (we suspect there will be one during 2017). Second, the populist and anti-EU 5-Star movement is closing in on the ruling Democratic Party in the opinion polls (an average of 29.2% vs 30.4% in December) and under the current electoral system, the two largest parties would compete in a second round of votes, with the winner guaranteed a parliamentary majority. Third, we don’t know if that system will still operate at the next election. If an EU referendum is called we suspect the usual so-called “safe-havens” will do well: gold, CHF, bunds and US treasuries.

6. Emerging market debt outperforms, again
Despite the best efforts of Donald Trump, Emerging Market Debt was one of the best performing asset classes during 2016 whether measured in local currency or in USD (even in December). As shown in Figure 3, this still leaves it well behind on a 3 and 5 year basis. Yields are well above those of the developed world, while debt metrics remain superior, in our opinion. We highlight the following opportunities: Brazilian 10 yr yields above 11% (or 5% on USD debt); Turkish 10 yr yields above 11% (or close to 6% on USD debt) and Venezuela, which is a basket case but offers 10 yr USD yields above 22% (well below the 2016 peak of 36% but still above the pre-2015 norm of 10%-15%).

7. Chinese A-shares outperform major markets
After the drama of 2015 and the opening days of 2016, Chinese A-shares have been rather calm (the 2016 FTSE A50 index range was 8,643 to 10,654 and it is now 10,083). Industrial profits were falling during 2015 but were on the up throughout 2016, with a gain of 14.5% y-o-y in November (the latest data available). Despite Trump’s threats and the fact the central bank now appears to be tightening, we think that a P/E ratio of 9.7 and a dividend yield of 2.9% makes the FTSE A50 an enticing prospect. We believe that MSCI still wants to add China A-shares to its Emerging Market index and this could be the year. Our 5yr target for the FTSE A50 is 16,000, suggesting an annualised return of 10% (13% if we include dividends). That will be hard to beat. An even cheaper version is available in Hong Kong – the Hang Seng China Enterprises index is on a P/E of 7.9 and a yield of 3.8%.

8. Kenyan stocks shine
This is one for the adventurous. We have highlighted the potential represented by Africa on a number of occasions in recent months and the Kenyan stock market is a case in point. Admittedly, the currency declined by around 15% versus the dollar during 2014 and 2015 but has since been pretty stable (by the way the euro fell by more than 20% over that same period). GDP was up 5.7% y-oy in Q3, inflation is around 6.5% and government debt to GDP is a manageable 48%. The only macro blemish is a UK-style current account deficit (the IMF projects it will have been 6.4% in 2016).
Despite this relatively comforting backdrop, the Nairobi SE 20 index is down 43% from its recent peak in March 2015 and is on a P/E of 9.5 and a dividend yield of 8.5% (it is rare to see the yield approaching the P/E ratio for country indices).

9. Oil falls to $20 and wheat rises to $6.00
Regular readers will not be surprised by the appearance once again of the $20 oil prediction. Our analysis suggests that since 1870 all price cycles have finished at $20 in today’s prices. OPEC has convinced many that it can limit supply but let’s see how that works out as the year progresses. Unlike oil, wheat loses value in real terms over the long haul. However, the decline in recent years has been pretty sharp (the 2016 loss of 13% brings the slump since July 2012 to 55%). A rebound may be due, especially with a little help from the weather. If the recent downward channel holds, the peak would be $5.00 but, if not, $6.00 could be easily reached (current price $4.23).

10. Team GB brings home the America’s Cup
We surrendered it at the first time of asking in 1851 and it has never been home since.

Paul Jackson – Head of Research – Source
András Vig – Research Director – Source