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BTMU Economic Brief | February 2017 2

bottomed, in part thanks to recent OPEC agreement to limit production (see Theme #3 below). Indeed, estimates from the likes of Wood Mackenzie suggest that capex in the oil and gas sector will reach US$450bn, which represents an increase of 3% on the previous year and reversal of two years of steep declines.

Theme #2: Markets likely to remain in thrall to Donald Trump

The convincing electoral victory of Donald Trump over Hillary Clinton late last year, while unexpected, was well received by the markets. While this rally – dubbed the “Trumpflation trade” has lost some momentum recently, our sense is that it has further to run, especially if Trump embarks on implementing his planned fiscal stimulus – made up of tax cuts and infrastructure spending – which will ultimately serve to reflate the economy and boost growth. Over and above this, Trump’s commitment to a deregulatory drive is likely, in our mind, to continue to be looked upon positively on the part of the markets, with for example the equity markets biding-up energy related stocks in the belief that some of the environmental regulation which currently exist in the US may be watered down somewhat under a Trump administration.

Elsewhere, but on rather negative note, markets have taken the view that with growth set to take off under the leadership of Trump, they have started to fret about inflationary consequences of such a move, especially given the fact that the US economy already appears to be at, or near, full employment, as a consequence of which wage growth appears to have gained meaningful traction2. Indeed, reflecting this, futures markets expectations of inflation have risen sharply since the election of Trump (see Chart 3).

2Average hourly earnings rose to a seven-year high of 2.9% in December

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Chart 1: PMI Surveys Point to a Synchronised Uptick in Growth...

(Reading>50 denotes expansion)

Source: Macrobond, BTMU Economic Research Office (Year)

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Chart 2: ... A Trend Which Appears to be Confirmed by a Favourable Evolution of the New Orders/Inventories

Ratio (Ratio)

Source: Macrobond, BTMU Economic Research Office(Year)


Against this backdrop, our sense is that risk assets, such as US equities will, on balance, continue to do well, while the US dollar may also benefit from any prospective rises in US interest rates in response to the build-up of inflationary pressures (see Chart 4). Conversely, defensive assets, such as US Treasuries, will likely continue to sell-off if inflationary pressures start to build on the back of higher growth. Elsewhere, with Trump likely to place a high priority on domestic infrastructure spending in the US, this could, along with further signs of firming growth at the global level, lead to a further leg-up in commodity prices as we progress through this year (see Theme #3 below). That said, there are a number of caveats in relation to the aforementioned points that are worth noting here:

� First, if the arrival of Trump causes an unsustainable move upwards in the US dollar (e.g. parity or beyond versus the euro), it could undermine the prospects of S&P500 companies which have a high reliance on foreign currency earnings.

� Second, and on a related note, a rising US dollar may undermine commodity prices, most of which tend to be denominated in the US currency.

� Third, the low level of market volatility and high correlations across different asset classes – which have characterised the markets in recent years – may be set to change going forward as the US Fed embarks on normalising its policy settings, while greater policy uncertainty under Trump, e.g. in terms of what emphasis he puts on his pro-growth versus protectionist agenda, may instil greater uncertainty in the mind of investors and, as such, focus their attention on the issue of who the winner and losers will be under his stewardship. This, in our mind, is likely to revive an interest in an “active” (versus “passive”) approach to investing going forward.

� Finally, while the likelihood of an activist fiscal policy under a Trump administration has been much touted, it’s important to note that fiscal policy works with inherent time lags. Infrastructure spending would have to pass Congress, and would take time to be implemented and longer still to feed through to the economy. With this in mind, we think that the beneficial effects of such a policy may become more apparent in 2018 rather than this year.

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Chart 3: The Market's Inflation Expectations have Spiked Upwards in the Belief that a Trump Presidency

will Serve to Boost Growth...

Source: Macrobond, BTMU Economic Research Office

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Dollar index S&P 500

Chart 4: ... And This, In Turn, Has Served as a Leg-Up for US Equity Markets and the Dollar

(YoY, %)

Source: Macrobond, BTMU Economic Research Office


Theme #3: Commodity markets set to see further light at the end of the tunnel

With continued progress being made to reduce the overhang of excess supply across a number of commodity markets, we expect the prospects for the commodity markets as a whole to undergo further improvements this year. A case in point, is the oil market which – on the back of the recent agreement encompassing both OPEC and non-OPEC member states to pare back production to the tune of 1.8m b/d – has seen prices rebound rather smartly (from around US$45-50/barrel to a figure in the region of US$55/barrel), such that at current levels prices remain above key technical level (see Chart 5). While there is a risk that oil prices may relapse if actual production cuts are not forthcoming, we think that – given the deteriorating fiscal dynamics across OPEC member states recently – there will be enough buy-in for the deal for oil prices to be underpinned at least around their present levels. That said, as the deal stands, we do not envision prices rising to such an extent that would allow most OPEC member states to breakeven in terms of their underlying fiscal and current account positions (see Chart 6).

Additionally, it’s also worth mentioning here that on the back of the OPEC-induced oil price rises that we have seen since start of December, the reaction function of US shale oil producers – which over the past decade or so have upended the traditional workings of the oil industry – will clearly be of some importance going forward. Our sense is that in light of the efficiency/operational improvements that the shale oil producers have undergone recently to survive the current oil price rout, they will be tempted to ramp up production if, on the back of the aforementioned OPEC cuts, prices continue to trend upwards from their current levels of around US$55/b. Indeed, with the US rig count – and the associated rise in US oil production – already seeing a noticeable pickup since hitting a low-point last year (see Chart 7), we expect this trend to continue to play out this year, especially if oil prices continue to exhibit an upward bias going forward.

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Brent crude 200 MA 50 MA

Chart 5: Oil Prices Continue to Hover above Key Technical Levels...(US$/barrel)


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Chart 6: ... But Despite This Prevailing Prices Remain Shy of the Levels Required to Balance OPEC

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(Source) Macrobond, BTMU Economic Research Office


Beyond oil, base metals will also continue on the road to recovery. This will be helped by recent production cutbacks by global mining companies, such as Glencore, as well as efforts that are being made in China to remove excess capacity among certain state owned enterprises that are active in the commodity arena. On the demand side, with the Chinese authorities looking to continue to prop-up growth at around the 6.5% level in 2017, metals demand from the country is likely remain supportive. This, coupled with the prospect of stepped-up demand from the US this year and next, particularly for construction and related commodities, will in our mind provide additional support for copper and other cyclical metal prices going forwards. That said, with metals prices, such as iron ore, already experiencing a substantial run-up in prices in 2016 – in excess of 90% in the case of iron ore – some pull-back in prices cannot be ruled in 2017.

Theme #4: A pivot from monetary to fiscal policy

Central banks have done most of the heavy lifting in terms of propping up growth and financial markets around the globe since the outbreak of the global financial crisis, such that they have essentially become the “only game in town”. But that may be set to change as the persistence of such policies has caused unintended side-effects, including asset price bubbles and distortions in wealth distribution, all of which have undermined potential growth and caused a backlash to develop against the existing policy regime (see Figure 1). With this in mind, the pendulum – aided by rising populism – has increasingly shifted in favour of activist fiscal and populist policy measures. That said, for the most part, this pivot will continue to occur gradually and highly accommodative monetary policy will remain in place within most countries. Nevertheless, the US, may prove something of an exception given the fact that the country was already on the path to tightening monetary policy in response to improving economic fundamentals. Additionally, there is a risk that the anticipated fiscal boost from the new Trump administration may accelerate this pace.

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Total number of US rigs (left axis)US oil production (right axis)

Chart 7: US Rig Count VS. Oil Production(Barrels per day, millions)(Rigs)


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that populist tendencies are also sweeping across a range of other European countries as well (see Chart 11). Adding these concerns is the fact that forthcoming elections are also due in the likes of the Netherland’s, France and Germany this year, all of which have seen growing support for populist and non-mainstream political parties. Of these elections, perhaps of most significance for us is the French election, where the far-right National Front candidate, Marine Le Pen, has built up significant momentum, with opinion polls suggesting that she is likely to progress to the second round of voting. While, on balance, we do not expect her to win, such an eventuality cannot be dismissed out of hand. For one thing, she has cultivated a widespread following, particularly among disenchanted sections of the French population which, as we saw last year, proved to be decisive in the case of the Brexit vote and the electoral victory of Trump. For another, if she were to unexpectedly win the second round of the election, it could cause a major market dislocation, such as that seen during the 2011-12 Eurozone debt crisis and, not to mention, undermine the already fragile integrity of the Eurozone as a whole, not least given the fact she has already declared that she wants to take France out of the Eurozone.

Notwithstanding the pessimism noted above, it is worth highlighting that, thus far, we have seen few non-mainstream parties gain full political power within the EU. Rather, what we have seen is the fact that the growing popularity of such parties has enabled them to exert greater influence on the policy debate and, in line with this, many mainstream parties have adopted slightly sanitised versions of their proposals and policies as their own. Perhaps a good example of this is the UK Conservative party which, after the Brexit vote, has adapted its policy position, particularly in relation to issues such as the EU and immigration, to be more closely in line with that of the UK populist party, UKIP.

Theme #7: Banks back in vogue

Since the financial crisis, global banks have been faced with a litany of headwinds, not least rather sluggish economic growth, poor profitability, onerous regulations and rising NPL problems. However, we think that 2017 could be the year that banks start to turn the corner. Indeed, market sentiment towards the sector already appears to be improving, particularly in the US, and we think that this trend will run further helped by the following factors:

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Chart 11: Number of Europeans Espousing Authoritatian/Populist Views

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� First, economic growth which, as we’ve alluded to above, is set to improve somewhat, particularly among the developed market economies.

� Second, under the Trump administration, the regulatory burden on banks may be pared back somewhat, with talk that his government may repeal the Dodd-Frank Act.

� Third, the problem of NPLs appears to have peaked, including in Europe, with the exception of some peripheral economies, such as Italy.

� Finally, with global interest rates set to rise going forward, led by the US, this will help to improve the net interest margin (NIM) and, hence, profitability position of banks.

Conclusion

After a turbulent 2016, markets are rightly anxious about the year ahead. That said, with the global economy showing signs of modest improvement and the election of Donald Trump adding to this positive sentiment – though not universally shared – we’re of the view that markets will be more willing to embrace greater risk this year, with cyclical plays, such as the banks and those active in the commodity arena, likely to be in vogue within the equities universe. However, with the political trajectory going forward this year likely to be uncertain, thanks to the rise of populist forces – especially in Europe where a number of key elections are due this year – our sense is that caution is still warranted. Additionally, with the policy-mix between monetary and fiscal policy in the developed markets, particularly the US, also in a state of flux, how this shift is manged and ultimately plays out will, in our mind, also have an important bearing for the global markets/economy during the course of this year.

The Bank of Tokyo-Mitsubishi UFJ, Ltd. (“BTMU”) is a limited liability stock company incorporated in Japan and registered in the Tokyo Legal Affairs Bureau (company no. 0100-01-008846). BTMU’s head office is at 7-1 Marunouchi 2-Chome, Chiyoda-Ku, Tokyo 100-8388, Japan. BTMU’s London branch is registered as a UK establishment in the UK register of companies (registered no. BR002013). BTMU is authorised and regulated by the Japanese Financial Services Agency. BTMU’s London branch is authorised by the Prudential Regulation Authority (FCA/PRA no. 139189) and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of BTMU London branch’s regulation by the Prudential Regulation Authority are available from us on request.

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btmu economic brief - macro themes 2017

Economy & Finance