The S&P 500 traded 10.5% lower during the first 28 days of 2016, the worst-ever start to a year. However, after turning on a dime in February U.S. stocks never looked back, with the S&P posting a nearly 10% annual gain. If stocks continue on their upward trajectory in 2017, a nine-year bull market would set an all-time record.
It was anything but a smooth road. This year brought political upheaval unprecedented in the post-World War II globalist movement. Most notably (as you might have heard), the U.K. voted to leave the European Union and Donald Trump pulled off a shocking victory in the U.S. presidential election. Both surprises shook up global markets, but not in the way analysts predicted. The pound plummeted versus the dollar but the dislocation hasn't yet significantly harmed the real U.K. economy and British equity indexes are trading at fresh highs. U.S. stocks did not recoil from Trump's electoral victory, instead setting a record for election-to-year-end gains.
The biggest move came in U.S. bond markets, where the 30-year treasury bull market appears on life support as investors anticipate inflationary policies from the incoming administration. The "Trump Trade" cooled off in the last two weeks of the year, however, with stocks digesting rapid gains and bonds moderating after a steep decline.
Great uncertainty remains in Europe, where elections in France and Germany next year will reveal the full extent of Euroskepticism on the continent. Yields on 10-year German and U.K. government bonds fell Thursday to their lowest levels since the U.S. election at 0.18% and 1.24%, respectively. Growing central bank divergence, with the ECB announcing new stimulus and Federal Reserve tightening monetary policy, is contributing to decreasing global market correlation. An imminent banking crisis in Italy appears to have been averted, but without more substantial growth the entire European banking system remains a ticking time bomb.
The most compelling economic and geopolitical story in 2017 will almost certainly revolve around China. The world's most populous country bankrolled an economic boom with high levels of debt and leverage, with which the government is now forced to reckon. Beijing is trying to split the baby between simultaneously liberalizing the economy and maintaining economic stability, but those two factors are increasingly mutually exclusive. Adjustments will likely be gradual in the first half of the year with President Xi Jinping prioritizing growth ahead of the 19th National Congress of the Communist Party of China, where he is expected to replace a slew of retiring Politburo Standing Committee members with trusted lieutenants. After that, the biggest questions are whether his government will consider ripping the band-aid off with a large one-time yuan devaluation and opening the door to greater foreign direct investment.
If 2016 is any indication, the next 12 months will almost certainly not disappoint when it comes to gripping storylines and investable surprises. Now, for a recap of the final week of the year...
China Takes Baby Steps Toward Accepting Economic Realities
China continues to prioritize economic stability while taking baby steps toward liberalization.
According to Societe Generale, China will abandon its rigid 6.5% GDP growth target sometime in the next two years in favor of a guidance range with lower bounds dipping as low as 5.5%. Such a move would offer evidence of the government's willingness to accept lower growth if it means dealing with the sour debt overhang plaguing the country's banking system.
The People's Bank of China (PBoC) also announced it is adjusting the mix of foreign currencies used in setting the yuan's daily value. Because of the dollar's extraordinary strength, the central bank has been forced to burn through a trillion dollars in foreign exchange reserves to maintain its peg. By adding 11 new currencies to the basket (for a total of 24) and reducing the weighting of the dollar from 26.4% to 22.4%, the PBoC will slow the headline depreciation figures for the renminbi. However, in reality the move allows the central bank to more quietly ease the value of the currency against the dollar. The Chinese government is hoping to stop the cycle of currency depreciation and capital outflows.
Investors will be closely watching capital accounts in January as the clock resets on foreign exchange quotas. Chinese citizens are permitted to convert up to $50,000 worth of yuan per year. Given the rising popularity of alternative strategies (like buying bitcoin) for moving money out of the country, analysts expect a fresh wave of cash outflows.
The pace at which China is burning through foreign exchange reserves to support the yuan is unsustainable, and tighter capital controls can't solve the problem. The currency fell 7% against the dollar this year to levels not seen since before the global financial crisis. The ratio of M2 broad money to forex reserves rose this year from 6.3 to 7.4, with sharp increases typically foreshadowing economic crises in emerging market economies. In recent years the Chinese economy has relied on capital inflows to boost the money supply, but that trend has reversed markedly. Meanwhile, Chinese debt-to-GDP has spiked from 150% in 2008 to nearly 290% today, according to McKinsey estimates, further eroding confidence.
The Chinese government needs to come up with a plan to move non-performing loans off bank balance sheets, recapitalize its financial system, close the debt spigot, shutter zombie companies and more closely crack down on opaque securitization in its shadow banking industry, which in itself Moody's estimates at around 80% of GDP. However, President Xi is unlikely to take such extreme measures before his expected consolidation of power in the fall.
The Chinese government is inching toward one solution for reversing capital flows: opening up its economy to more foreign direct investment. Beijing unveiled plans Friday to allow greater foreign investment in banking, insurance, securities and credit-rating firms. The announcement was short on details like extent and time-frame, but most expect the 49% cap on foreign ownership in non-critical financial companies to be eased.
Economically, conditions in China are improving slowly as industrial profits climbed 14.5%, led by coal and metals, mainly due to higher prices. Militarily, China continues to flex its muscles ahead of President-elect Trump's January inauguration. China's lone aircraft carrier has been prowling the Pacific.
A trade war is more likely than a naval battle, but both the United States and China have a lot to lose if economic cooperation diminishes in the coming years.
Italy Provides Details On Bank Bailout
We now know what the Monte dei Paschi di Siena (MPS) bailout will look like, and it's going to require more money than originally thought.
The Italian government will have to inject around 6.5 billion euros into the country's oldest and third-largest lender after the European Central Bank (ECB) revised the bank's estimated capital shortfall up from 5 billion to 8.8 billion euros. The ECB's Supervisory Board came up with the higher figure in a special meeting to determine how much liquidity MPS would need to meet minimum capital requirement thresholds.
The Italian government will have around a 70% stake in MPS after the bailout. To fill the remaining gap while staying within bounds of European banking rules, Monte dei Paschi will raise an additional 2.3 billion euros by converting subordinated bonds held by institutional investors into equity.
As part of the plan, the Italian government will reimburse the roughly 40,000 retail investors holding an estimated 2 billion euros worth of Monte dei Paschi junior debt. Those investors will be able to swap their new shares for senior bonds, then the government will buy back shares from MPS. EU officials have reportedly signed off on the deal.
With the bailout agreement ratified, Monte dei Paschi plans to further boost confidence and liquidity by issuing 15 billion euros worth of debt in 2017. The bonds, two-thirds of which mature in three years, will be supported by government guarantees. The liquidity scheme requires special approval from EU finance officials on a case-by-case basis, but the European Commission has reportedly agreed to extend the window for six months. The final third of the debt raise will come in the form of short-term commercial paper.