The outcome of the Brexit vote and the US presidential election has turned forecasting on its head. Macro events have moved from uncertain to unpredictable, making it far more difficult to plot an investment course than just one year ago.
“Even if we have some sensible investment ideas, whether they play out or not depends on what [the new US administration] decides to do, that’s the challenge,” Bacon told FSA.
Nonetheless, he highlighted important areas in 2017.
The market is expecting the Trump administration to spend up to $1trn repairing and building the US infrastructure, which should boost the commodities, materials and construction-related sectors.
“If infrastructure investment happens as expected, that would unleash a huge amount of spending. That’s very good for jobs and growth but it will have inflation implications. Can we position for that now? No, it’s very tough.”
"If governments are moving from monetary to fiscal spending policies, Trump could be a catalyst. For me, that’s reason to be optimistic"
He added that if the US Federal Reserve is not carrying the burden of protecting markets on its own, then the rate cycle could normalise more quickly.
"Not 5% interest rates in five years, but we could see 2-3 more rate hikes in 2017 and in 2018 as well as the expected rate rise next month.
“It would have a major bearing on what we do with fixed income allocation. People will maintain a bias to short-term duration bonds and strategies until that picture becomes clearer.”
Sector-based investing will be a strong focus, Bacon said, and he highlighted three obvious ones. The financial sector will see a net interest margin expansion if rates rise more quickly than the Fed originally planned and the sector should also benefit from credit demand driven by investment in infrastructure, he said.
Energy is another attractive sector because Trump has been vocal about liberating some production capabilities, Bacon said. Healthcare also appears to be attractive because Trump revised his campaign promise to repeal Obamacare.
"It’s difficult to know how it will play out. Potentially it’s beneficial to healthcare. How to play within healthcare it is too early to say.
“We will think about specific sectors that will benefit from growth. Historically we have not focused so much on sector-based investing.”
EM 'stability premium'
No sustained market sell-offs occurred after Brexit and the US election, defying expectations. The upcoming Italy referendum, the Brexit decision in the UK parliament and the French elections next year are all key events that could have a huge impact on markets yet remain unpredictable, increasing risk in developed markets.
“We could start to see what you call a `stability premium’ in emerging markets,” Bacon said. “People are not necessarily looking at EMs in terms of trade or dollar strength, but they stand back and say from a political standpoint that EMs are bizarrely looking stable versus the developed market equivalent.
“We stand by [Citi’s] EM over DM call with the caveat of dollar strength, which might undermine that. We also expect a continued re-rating of EM equities based on valuations.”
In EM fixed income, some money comes off the table, but Citi stays with short duration-focused issuance, he added.
“There’s no reason why we won’t see continued short duration high yield EM performance. Fixed maturity products have become popular in Asia. People continue to focus on that, it’s a risk-mitigating effect in a rising rate cycle.
"Traditional total return bond funds will see most of the outflows.”
Bacon said Citi went into 2016 optimistic and the year turned out to be extremely challenging. Throughout the course of the year, it became far harder to make the same directional calls with the same degree of accuracy as in the past. In addition, cash equity and forex trading in Asia has been very weak.
“The problem is the market participants don’t have high conviction on anything," he said. "When cash equity and forex volumes are low in Asia, it creates a pessimistic environment. These are huge trading areas in Asia more so than in the rest of the world. We need those machines to be firing on all cylinders. That’s what’s holding us back.”
He is slightly more optimistic about 2017 than this year, and believes there is potential for pleasant surprises.
"People have been worried QE has played out. If governments are moving from monetary to fiscal spending policies, Trump could be a catalyst. I think it’s exciting. It suggests a slightly more normalised environment where central banks are not controlling everything. It’s people investing in their businesses, spending money.
"For me, that’s reason to be optimistic. It could lead to a few things going better than people expect."