The investment landscape in 2017

• The current environment is challenging for equities but potentially pretty grim for bonds and bond-like dividend-paying stocks.
• The winners in this climate should include cyclical shares as well as traditional hedges against volatility and inflation, such as gold, the VIX and inflation-linked bonds.
• We also think it is prudent to go into next year with ample holdings of cash – both as insurance against market falls and, arguably more importantly, to be ready to take advantage of any dislocations and mispricing that could follow from political upsets or policy actions.

Even a low-intensity trade war stoked by the new US administration can do long-term damage.

European stocks are trading at discount to the US based on the 12-month price-to-earnings (PE) ratios. But while European equities could present an attractive investment opportunity in the medium term, for now there are good reasons for the hefty risk premium.

For now there are good reasons for the hefty risk premium in European equities.

In particular, we would highlight the potential for large scale recapitalisations in the banking sector. An even bigger issue is regulation, with European domestic institutions, such as insurers, restricted in their ability to sell bonds and buy equities. That means the impetus for a market rebound will need to come from foreign investors. This is unlikely to happen while there are still uncertainties over both ECB policy and the outcome of various European elections.

By the second half of 2017, these risks may well have cleared, paving the way for a reversal in the extremely negative sentiment and thus for a market rally.

When it comes to equity sectors, cyclical stocks are in general well-positioned for the coming year, despite their recent rally. If nominal GDP growth and corporate earnings accelerate as we expect, cyclical stocks should rally to trade in line with their long-term 10 per cent premium to defensive stocks.

This compares to the current 4 per cent premium and 10 per cent discount in early July. Capex related stocks should perform particularly well as corporations step up investment. Financials shares, meanwhile, are set to benefit the most from global reflation due to their cheap valuations and their tendency to respond positively to a steeper yield curve.

US bonds look under pressure with inflation is on track to top 2 per cent for the first time since 2014. Trump’s policies are likely to add to inflationary pressures through tax cuts and public spending increases.

Trump's policies are likely to add inflationary pressures.

We also see bond yields moving higher in Europe where the risk of tighter central bank policy is underappreciated. European bonds also look very expensive compared to their US counterparts.

With global producer price inflation surging to five-year highs, inflation- linked bonds are starting to look attractive again but we continue to think that gold is a better hedge in the long-term.

The dollar could strengthen further in the next few months due to stronger US growth and the Fed signalling more hikes than are currently priced in. 

In the short term the UK economy and assets are likely to exceed expectations.

Sterling, meanwhile, looks cheap following the steep depreciation since the Brexit vote. The exchange rate is now consistent with fairly dire economic growth. While weak growth may materialise eventually as Britain progresses with the EU exit, we believe that in the short term the UK economy and assets are more likely to exceed expectations.