WorldWatch proposes several potential investment surprises for the year ahead.
As is customary in December, many of our fund management competitors and most of the broking community write outlook pieces for the coming year. Whilst these certainly have merit and are interesting to the reader, we are, as ever, keen to avoid following the herd. Instead, TT's ‘Ideas Factory’ – a combination of all our investment teams – has compiled our potential investment surprises for 2018. These are a collection of standalone ideas that could have important ramifications for markets if they were to come to pass. Readers should be clear that these most certainly are NOT our base case expectations. In some instances they are light-hearted speculation, and in others they are more serious possibilities worthy of greater consideration during portfolio construction. In all cases, we believe that they are not priced in, and have the potential to influence markets substantially in the year ahead. We hope that you enjoy reading them.
1. Falling eagle, rising dragon
With Trump living up to his slogan of “America First” and a weakened Merkel increasingly preoccupied with domestic issues, both the US and Germany become more inward looking in 2018. Such self-absorption comes at a time when China’s most powerful leader since Mao Zedong is stepping up his efforts to spread Beijing's influence globally. Asian leaders considering the future balance of power on their continent see the advantage in edging closer to Beijing and away from Washington. Meanwhile in Europe, Mr Xi’s apparent attempts to defend international co-operation on climate change and trade gain him kudos at a time when these ideals have seemingly been shunned by Trump’s America. Consequently, Xi Jinping seizes on the opportunity to step into the power vacuum left by a weakening West, becoming the world’s de facto leader.
2. Jez we can
Disagreements on the direction of Brexit negotiations spark further infighting in the Conservative Party, triggering a vote of no confidence in Theresa May. This forces a Conservative leadership race between Boris Johnson, Michael Gove and Amber Rudd. Johnson and Gove’s distaste for one another is clearly evident in a particularly acrimonious battle fought in public. This ultimately damages both candidates and Amber Rudd emerges as the clear winner. However, the wafer thin Conservative majority soon proves untenable and a UK election is called by year-end. Leftwing populist Jeremy Corbyn successfully mobilises young voters, frustrated by growing generational inequality, and is swiftly elected as Prime Minister of the UK. Sterling weakens sharply, driving inflation higher as the new Prime Minister attempts to renationalise various industries, raise wages and hike taxes.
3. Shale shocked
After OPEC’s decision to extend production cuts, positioning in the oil futures market is overwhelmingly long going into 2018. With a lot of good news already in the price, traders appear to have overlooked the fact that the US has a record number of drilled but unfinished shale wells, which can be completed relatively quickly if the price is right. Sure enough, an elevated oil price leads to many of these wells being finished, resulting in a wall of supply coming online. Oil swiftly drops to $50/barrel, exacerbated by profit taking from speculative traders. This undermines inflation expectations and accelerates yield curve flattening.
4. US dash for tax reform
Early 2018 brings America’s largest tax overhaul in a generation after President Trump manages to scrape through a victory for his plans in both Houses with only modest amendments. Companies begin to repatriate cash and capital investment increases markedly, boosting employment and productive capacity. This accelerates growth in an economy that was already performing well and the Fed raises rates twice in the first half of the year in response. However, with little evidence of inflationary pressures building, the central bank makes no further hikes by year end. Equity and bond markets react positively, led by domestic cyclicals. This in turn drives further strong gains in international markets, with global cyclicals leading the charge.
5. Yuan thing after another
As China’s $10 trillion investment programme that has been taking place over the past two years comes to an end, it slowly becomes clear that about half this investment will not generate a positive return. This starts to exert pressure on Chinese banks as loans cannot be serviced by borrowers, leading to a spike in non-performing loans. Since 2016, the Chinese authorities had managed to stem capital outflows, helping to stabilise the yuan. However, as the stimulus is withdrawn and the Chinese economy slows, capital flight resumes via swaps with Hong Kong banks. This is when a Hong Kong bank makes a US dollar loan to an individual or corporation with a yuan deposit in a Chinese bank, which subsequently opens a swap line with the Hong Kong bank. Consequently, the Chinese currency weakens against its main trading partners, particularly the US dollar.
6. Kim’s double-cross
With the North Korea situation clearly escalating after Kim tests a larger nuclear weapon in early 2018, Trump concludes that his current tactics aren’t working. Instead of threatening “fire and fury”, the seasoned dealmaker seeks to persuade China that it is in its own interest to curb North Korean aggression. China fears that if the Kim regime collapses and Korea reunites, the thousands of American troops currently stationed in the South would be right on its border. Trump makes it clear that freezing and then rolling back the North’s nuclear programme is his goal rather than regime change. He also guarantees that, were the North to collapse into the arms of the South, America would keep its troops south of the current north-south boundary. Xi Jinping is receptive to Trump’s arguments, grasping that an increasingly belligerent North Korea risks starting a regional arms race that could lead Japan and South Korea to build their own nuclear weapons. Importantly, he is also aware that his consolidation of power at the latest Party Congress has provided him with greater scope to take a more radical stance against North Korea. Xi succeeds in bringing Kim to the negotiating table by promising significant investment in the country. Tempted by this offer, and wary of the growing risk that China could shut off North Korea’s oil supply, Kim agrees to suspend his nuclear programme. This prompts an immediate rally in the Korean equity market, which has long traded at a significant discount to its regional peers, due in part to heightened political risk. However, by year end concerns begin to mount that Kim has taken the money and continued his programme in secret. Indeed, two previous deals have failed for the same reason.
7. Bitcoin goes mainstream
CME Group, the world’s largest exchange owner, introduces bitcoin futures before the end of 2017. Up until that point, investors had no easy way to bet against bitcoin – the only “short” was to sell coins. Crucially, CME’s decision allows investors to place negative bets. This triggers a sharp sell-off in the currency, which intensifies as speculators that bought bitcoin based on the greater fool theory are spooked and rush for the exit. However, this sell-off does not stop bitcoin becoming far more mainstream in 2018 as it is accepted by significantly more retailers and banks. Indeed, demand for cryptocurrencies such as bitcoin is based on more than mere speculation. Digital currencies undoubtedly address some of the genuine concerns associated with more traditional currencies: they cannot be counterfeited; enable immediate settlement; eliminate transaction fees; and allow anonymity. The adoption of bitcoin is particularly rapid in developing economies, home to most of the 2.2 billion people with access to the internet or mobile phones who don’t currently have access to traditional exchange. Meanwhile, Russia’s central bank establishes a state-sponsored cryptoruble, which becomes the first cryptocurrency to be adopted as a reserve currency by one of the world’s central banks. Though this moves bitcoin further into the mainstream, it also serves to delegitimise cryptocurrencies more generally by undermining one of their greatest attractions, namely that they cannot be controlled by the government or banks.
8. US sanctions: Putin the boot in
Robert Mueller’s investigation into Russian interference in the US election ultimately concludes that the actions of the president do not amount to criminal activity and no charges are brought against him. However, the investigation does uncover irrefutable evidence of Russian attempts to influence the election. Stricter “Iran style” sanctions are swiftly imposed, with Russian banks forbidden from accessing the US financial system and US investment into Russia severely restricted. These painful sanctions are expected to continue for an extended period of time as it would be politically toxic for Congress to consider lifting them. This puts serious pressure on both the Russian economy and equity market.
9. Land of the rising price
After years of tightening the labour market in Japan finally cracks as companies are forced to increase compensation to compete for scarce labour. This decision is catalysed by a new government tax regime that offers incentives for any company that greatly increases its workers’ pay. Not only do companies hand out base wage hikes but they also start long overdue investment in IT and automation to address the sustained labour shortage. Prices for domestic services such as hairdressing and internet deliveries are forced up for the first time in almost 30 years. The return of mild inflation supports the equity market as domestic activity is boosted. Banks return almost 50% as they rerate towards book value. Conversely, some of the structural growth winners of the past few years struggle as value stocks outperform markedly.