2017 began with significant uncertainty surrounding the implications of the major geopolitical changes that happened during 2016. In the next few weeks, we will learn more from the British Prime Minister on the process to withdraw from the European Union. On January 20th, Donald Trump will be sworn in as the next President of the United States. The impact of these two changes in the global environment will most likely drive the course of markets during the year ahead.
From an economic perspective, the U.S. economy continues to chug along, and the December employment report, despite the headline payroll number being slightly below expectations at 156,000 versus an expected 175,000, confirms that the U.S. economy remains on firm footing. The increase in average hourly earnings (0.4% in December and 2.9% in the past 12 months) will be closely watched to see if pressure on wages drives an uptick in inflation and/or pressure on corporate profit margins.
From a markets perspective, I prefer to be defensive on U.S. bonds, both Treasury and Corporates, due to rising inflationary pressures and the potential impact of protectionism. There are two ideas I like for fixed income securities. The first is being long non-U.S. dollar-denominated bonds versus bonds denominated in U.S. dollars, as I believe the U.S. dollar will weaken during 2017 and reverse the trend seen in 2016. The second idea is buying Treasury Inflation Protection Securities (TIPs) and paying fixed on 30-year interest rate swaps to hedge the interest rate risk. With rising inflation expectations, TIPs stand to benefit and the negative swap spread is a compelling way to manage the interest rate exposure. Of note, swap yield is less than Treasury bond yield
I look to move to a short position on U.S. equities around the time of the inauguration, as the stock market has had a significant move and valuations appear stretched. I don't expect earnings to keep up with expectations in the first half of 2017.
The year ahead has the potential for significant surprises, as the changes currently impacting the environment only occur every few decades. Being nimble and ready to revise strategies and opinions to adjust to market sentiments will be important.
This blog post is for informational use only. The views expressed are those of the author, Dave O’Malley, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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