Market Outlook 2017

After a US presidential election that surprised many in November last year, lots of people in the market have become much more hopeful of assistance along the way from the expansionary fiscal policy promised by victor Donald Trump.

So far, not much concrete has been seen in the form of stimulus. Some details have become apparent, but it will be some time before the effects are visible in numbers. That said, there are certainly signs of expectation, with the outcome of macroeconomic surveys having skyrocketed.

"We deal in stocks, and growth in the US economy is a bit sluggish – the hope is that it will improve. But valuations are high and, at these levels, we do not usually see much value growth in equities. Many of the companies also have relatively high debt," says Sven Thorén who, like the other portfolio managers in the conversation, is involved in the management of Catella Hedgefond.

Something that Donald Trump has already been successful with, according to the managers, is frightening a number of companies, both domestic and foreign, with the need to have production locally in the United States in order to get their share of the pie.

On the credit side, the US market has been strong for a long time. The corporate bond market has taken note of the fact that bankruptcy risks have become apparent, mainly in the energy sector, last year, and as the price of oil has revived energy companies have taken off. Meanwhile, the number of defaults, or credit events such as bankruptcy under US Chapter 11 legislation, has been very low in other industries. This means that credit investments in the US, excluding the energy sector, have continued to pay off.

The Federal Reserve has managed to raise its benchmark interest rate, the Fed Funds, a couple of times, and a major issue for the rest of the year, of course, is the tempo at which further increases are likely to happen. And, of course, whether inflation will start to become more apparent. Expectations of inflation have certainly already started to grow.

Employment in the US is quite high, with unemployment at around 5 percent?

"Yes. But industry has had some fairly decent years in the United States, and is not acting as a motor for the job market at the moment – a lot is being achieved through automation and robotics. Capacity utilisation is very low in both the US and Europe. Some inflation is being driven by oil prices, but it can be seen in other areas as well, in rising labour costs," says Thomas Elofsson who, together with his colleague Stefan Wigstrand, manages the Catella Avkastningsfond, Catella Nordic Corporate Bond Flex and Catella Credit Opportunity bond funds.

According to the fund managers, the market is anticipating two Fed hikes, each of 25 basis points, during the remainder of the year. But there could be more if the US economy gains more momentum.

"We should remember that the Fed has bought a lot of assets and, if the time comes, it could also look at not reinvesting in its portfolio, in addition to interest rate hikes. The major threats in the market right now are threefold: China; political issues, including the impact of Trump and forthcoming European elections during the year; and also the world's central banks becoming less expansionary. Asset prices have moved a lot, and this could create a lot of concern," says Thomas Elofsson.

Sven Thorén agrees with him, and sees a limit to what the anticipated highly expansionary policy promised by Donald Trump can achieve.

"I think the same as Thomas. There are limits to the US economy and to the valuations of companies, and also to how high growth can be. How successful will it be to add a large package of stimulus now, eight years into a boom and when unemployment is so low? I'm not sure that (Fed Chair) Janet Yellen is happy with it. The stock market will probably develop positively, but I don't expect a giant party in 2017," says Sven Thorén.

Chinese growth is now lower than it has been for a long time. Some slowdown is visible in the country's housing market, while China has to deal with large capital outflows. There is an underlying risk of a currency war between the world's regions, but there are already some signs of more trade barriers between regions.

Another factor to watch is that some inflation is starting to become apparent in China, while real estate prices have risen – these are likely to be two things for the country's leadership to watch carefully in future growth forecasts, believe the portfolio managers.

In Europe it seems to be banks' poor balance sheets that have characterised the mood?

"There is more potential in Europe, at least. Lending looks okay and, in particular, the profitability of European companies is much lower than at previous peak levels. Looking at last year, US growth was disappointing while European growth was in line with expectations. But there are coming elections that could result in increasing political turmoil in Europe, which could get messy," says Martin Nilsson, who manages Catella Småbolagsfond and Catella Nordic Long/Short Equity.

One worry, according to the portfolio managers, could be the contented lack of concern shown by many market participants - this manifests itself in how investors choose to position themselves and how they price risk.

In the Nordic countries, Norway had a tough time last year while the recovery of oil prices and commodities has been an important driver recently.

"If we look at oil prices, there is no problem on the demand side, which is strong and growing quite well, mainly driven by emerging markets. China has overtaken the US to become the world's largest importer of oil. The problem is rather the supply, and shale oil production. Because OPEC has restricted supply a little, the rigs are returning very quickly. Offshore production will probably continue to have a tough time, and it's unlikely that particularly many major oilfields will be sanctioned for a long time yet," says Martin Nilsson.

He notes that the major oil companies made large investments during the boom years and borrowed in order to pay higher dividends to shareholders, which in many cases are pension funds. Nowadays, they have cut back investment sharply and this trend is likely to continue.

"A number of companies previously needed an oil price of 120 dollars to reach break-even," says Martin Nilsson.

Stefan Wigstrand points out that the Norwegian economy is very exposed to the oil sector, and particularly to deep-sea production, a sector that has been, and partly remains, hard-pressed.

"Lending to companies so unilaterally dependent on one factor – the price of oil – is unwise. We will continue to have low exposure to the sector, even though it is very large in terms of the high-yield component of the Nordic credit market," says Stefan Wigstrand, who also emphasises the importance of creating more sectoral differentiation among corporate bonds. Since he and his colleague Thomas Elofsson started in September last year, they have sought out sectors other than just oil/gas and real estate, the latter of which accounts for nearly half the market for high-yield bonds in Sweden.

The conditions in Sweden are still high growth combined with negative interest rates. The portfolio managers point out that there are high expectations in many areas, especially in engineering, where valuations have risen substantially and are fairly close to peak levels. Hopes that the engineering sector will gain further momentum are based partly on sub-sectors like oil/gas and mining starting to do better than previously. But the high valuations in the sector mean that investors have to be very selective, believe the Catella managers.

Growth companies then. Have their share prices come down enough?

"In some cases they have. Between 2008 and 2015, Copenhagen was the world's best stock market, and in 2016 it was instead the fifth-worst. Partly driven by Novo Nordisk, but not just that. What happened was a major rotation," says Martin Nilsson.

He adds that the share price performance of growth companies coincides with the decline in interest rates that began in 2008. When interest rates subsequently began an uptick there were expectations of inflation, which caused rotation from growth stocks to value companies. Some growth stocks have again become attractive while others, according to Martin Nilsson, are still expensive.

"A bit of the shimmer of growth has disappeared – companies are not immune. Novozymes is one example. It promised us 8-10 percent growth for 2016, but when we summed up the year it was zero. That mean you can't trade at p/e 35," he says.

How does it look for real estate?

"Real estate is all about one thing: interest rates. Property shares had stunning performance until the second half of 2016. Castellum recently issued a better interim report than expected, and raised its dividend, but what happened? The share was down because interest rates rose that same day. As long as interest rates are rising this is a rather icy sector," says Martin Nilsson.

Thomas Elofsson points out that it has been beneficial for companies in the real estate sector to have high leverage as property prices have risen.

"We don't believe people want more exposure to real estate, both rather less. Then there's the risk of interest rates rising substantially, and the exit could get crowded. We do not believe we get sufficiently compensated to take on the better real estate companies. Many of them are large and have big debts that need servicing, and in an environment of highly expansionary monetary policy that's not a major problem. But it would not take much for it to become a problem," he says.

And how will this year be for the Nordic banks?

"The Nordic banks are Europe's most well-capitalised. Though real estate had a tough second half in 2016, the banks did well. There is a large discount compared to engineering in terms of multiples, and they have significantly higher dividend yields. But Nordic banks are quite expensive, although high quality. Handelsbanken has p/e 16 on 2017 earnings – quite generous for a bank."

As to the market for corporate bonds in general, some analysts have talked about a bond bubble, but Thomas Elofsson is not impressed by this.

"In the longer perspective, all assets now have bubble tendencies: real estate, fine wines, art, stocks, bonds... It's hard to find anything that's really cheap at the moment. But a bubble? As long as companies continue to increase their profits we do not believe so. I would be more worried about government bonds given that the Riksbank, like other central banks, has bought its own bonds. I would be surprised if it there were no effect on prices when they stop buying."

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