A thorough method for quantitative-based forecasting requires the assessment of dozens of different platforms that exist in the space. One of the more interesting areas of forecasting centers on geopolitics given the sheer number of data points required to make an intelligent estimate that sets out probabilities in the global markets.
For that reason, Modern Trader tasked PRS Group with the creation of a geopolitical outlook over the next year given the impact of major events happening in Europe, the United States and China in the months ahead. PRS Group maintains two proprietary methods to assess risk, which are quant-driven and back-tested regularly by independent organizations. They are the product of more than 20 years of research with the State Department and the Central Intelligence Agency (CIA). The data series, affecting 140 countries, dates to the early 1980s. PRS generates close to 100,000 original data points annually.
In 2016, the company accurately forecasted the likelihood of Spain’s special elections. In April, PRS Group accurately projected that Hong Kong’s September elections would shift in favor of pro-democracy and independence groups and exacerbated tensions between pro-Beijing and pro-independence camps.
In today’s media world there is a fascination with arbitrary lists of 10 different forecasts or events. Instead, we recommend that forecasting teams utilize a conviction strategy to emphasize the events in which they maintain the most confidence and provide a roadmap for our readership that lays out probabilities of major events so they can make more informed decisions on the future.
Despite the uncertainty surrounding President-elect Donald Trump’s broader policy agenda, investors are confident in his economic proposals. The S&P 500 has experienced a sharp rise since the election and the Dow Jones Industrial Average has surged within a whisker of the psychologically significant 20,000 level.
Still, expectations that tax cuts, deregulation and infrastructure stimulus will power robust economic growth have also fueled a rise in bond yields. This reflects the anticipation of aggressive monetary tightening in the year ahead. Bond yields have gained about 1% from their mid-year low. They moved above 2.5% in mid-December, pushing bond prices lower.
Stocks dipped slightly in the closing days of 2016, but a strong probability exists (55% to 60%) that the upward trajectory will revive as Trump settles into office. This forecast assumes Trump pursues tax cuts and deregulation. Both can help strengthen corporate earnings.
The political prospects are less bright for Trump’s proposal for $1 trillion in infrastructure spending, which is meeting Congressional resistance. If this plan encounters steep roadblocks, the Trump Administration will likely postpone action here and pivot to tax cuts and deregulatory efforts. A less ambitious policy agenda may dampen growth expectations enough to give the Fed pause and contain the rise in bond yields. Gains in equities would be sustained through the end of the year, although the pace of advance would slow to 4% to 5%.
With the Federal Reserve’s Open Market Committee (FOMC) “dot plot” current guidance forecasting three interest rate hikes in 2017, the dollar will remain buoyant in the coming year. Assuming monetary tightening by the Fed has been priced in by investors, we project the EUR/USD exchange rate will end the year somewhere in the 1.00–1.05 range (“Euro bottom,” below).
However, European developments (in particular, the outcome of elections in the Netherlands, France and Germany) could undermine the integrity of the EU and increase risks to the forecast.
The election of one or more Eurosceptic party (an outcome with a 35% to 40% probability according to PRS) would enhance the likelihood of the dollar pushing past parity with the euro.
An explicit rejection of anti-EU populism — a less likely scenario — together with monetary tapering by the ECB later in the year, could boost the EUR/USD above 1.10 by the end of 2017.
A significant sell-off of bonds in mid-December awakened memories of China’s stock market crash in mid-2015. Once again, this event highlights the risks from the Beijing regime’s economic intervention. In this case, a policy encouraging corporations to issue bonds and promote easy access to short-term financing powered a bull run in the bond market over the last two years. However, officials took steps to tighten liquidity in August in response to concerns about excessive leverage in the financial system. With inflation exceeding expectations and capital flowing out of the country at a record pace, the People’s Bank of China has come under pressure to boost interest rates. Signals that the Federal Reserve will pick up the pace of monetary tightening in 2017 has fueled expectations that China will be forced to follow suit. This has helped fuel the sell-off.
Pressures to sustain growth while simultaneously deflating financial bubbles will continue to pose a challenge for policymakers, who must now improvise as risks emerge.
Bond sell-offs are likely to persist at least through the first quarter, as officials take additional steps to tighten liquidity. The yuan, which lost 6.6% of its value against the dollar in 2016, will weaken at a similar pace next year, although there is a risk of a steeper slide in the event of heightened bilateral tensions with the U.S. that disrupt trade flows (see “Yuan on the run,” below). There is at least a 60% probability of another bout of significant market volatility in 2017. In that regard, the retreat from bonds and the government’s efforts to cool the real estate market may fuel an overheating in the nation’s stock market as investors seek a more attractive outlet.
PRS anticipates a legitimate possibility of a surprise victory for one of the outsiders contesting the French presidential elections in the spring. Odds are increasing of a non-partisan legislature forming after parliamentary elections in June.
Two primary scenarios are developing as an alternative to assuming Francois Fillon, the center-right Les Republicans candidate, secures victory in line with his strong poll readings against one of two second-round challengers. To date, it is assumed Fillon will face a run-off against the National Front’s Marine Le Pen.
Le Pen’s chances of succeeding in a runoff stage are not very strong. However, it is possible based on the “shy voter” hypothesis or if another terrorist attack occurs causing a swing in public opinion. In a runoff between Fillon and Marine Le Pen, we project the odds of the former winning at 65%.
A Le Pen victory would spark uncertainty over French participation in Europe and what it would mean for foreign business. The mere fact that there is so much uncertainty surrounding these elections is a factor that will also impact on asset prices in the weeks and months leading up to the twin voting events.
The other possibility involves Emmanuel Macron, the former Socialist gaining from Fillon’s austerity program as a centrist alternative. Macron could beat Fillon and then deflect the challenge from Le Pen. Against Le Pen, Macron has a 60% chance of winning.
It is also possible Macron and Fillon might both reach the second round in what would be a closer contest. A victory for Macron would be more unsettling not least because it is presumed Les Republicans will be in control of the legislature creating some conflict and preventing a smooth policymaking process. Emmanuel Macron has a 45% probability of winning against Fillon by alienating the right.
Investors should expect sovereign bond yields to rise (price falling). The French 10-year bond is at 0.65 with a gap over the comparative German bund around 47 basis points. Watch for that gap to rise to 55 bps or more. Five-year French CDS spreads of 38 bps could widen above the 47 bps for Slovakia. French equities will take a hit from any sniff of Le Pen winning. The French stock benchmark CAC 40 has risen to around 4,830 and would be expected to fall below its September-October stable range around 4,500 (twice this year it fell below 4,000). Depreciation of the euro toward parity is likely, but it’s hard to disentangle this one event from others affecting the currency.
The combination of a slowing economy and political maneuvers surrounding Brexit will undermine trade and investment, causing increased asset price volatility in 2017. The pound will react to every move, as well as the economy (including current account deficit). Talk of a rebound has proven wide of the mark, and it remains possible GBP/USD will slide (unevenly) toward $1.15 or $1.10 depending on how these political processes pan out. However, a cheap pound will put an end to the shorting, and capital inflows in search of cheap assets will eventually cause a rebound. Inflation and personal credit risks later in the year might see the Bank of England tighten monetary policy. This would provide some support to the pound. PRS sees a 50% probability of the pound falling to $1.15 by June and a 50% probability of recovery to $1.35 by December.
The Brexit debate is shaping around legal objections, with Great Britain’s Supreme Court due to adjudicate (in January) on an appeal to the High Court ruling stating the government should allow Parliament to trigger Article 50 of the EU Treaty, contrary to the government’s wishes it should go ahead alone. It seems this is heading for a unanimous 11-0 ruling backing the High Court which will provide the markets with a sense of moderation in the Brexit process – the possibility of parliamentarians only agreeing if a soft Brexit is pursued.
The government will then produce a Brexit Bill in March. However, there is a 75% chance there will not be sufficient information on the strategy or that it will be sufficiently unclear to leave it open to interpretation. Expect leaders to write something similar to: “This government will secure what is in the best interests of the UK, possibly mentioning it will discuss access to the Single Market, but with not enough fine details, not least because it will hinge on various scenarios regarding immigrant inflows and financial obligations, all of which will form the discussions with the EU for the post-Brexit arrangements.”
A hard Brexit (PRS probability of 55%) will shatter market confidence, but that seems the more likely option given the issues revolving around the U.K.’s financial contributions and the free movement of labor are inextricably difficult to resolve by remaining within the Single Market. Parliament will debate the motion and sit late in March, but will then likely back the decision to trigger Article 50 before the Easter recess in April. On the government’s side, only veteran Conservative Ken Clarke, who is close to retiring, has indicated he plans to vote against, meaning there won’t be enough members to stop it given the government’s working majority. Assuming there is a free vote not all of the opposition will vote against due to their own seats/constituency results on the referendum. In that case there will be some opposition, including all of the Scottish National Party voting against it, but it would still pass easily with an 85% probability.
The Lords stuffed with more Liberal Democrats will try to slow the process, so look for signs of a delay beyond next summer. Any indication of a larger Conservative rebellion in the House of Commons would also trigger chaos, resulting in further delays - that seems unlikely as most English MPs would not wish to go against their constituency referendum results, but it is this that could potentially lead to an early election. On that PRS gives only a 25% probability as there is a Fixed Term Parliaments Act avoiding such a scenario and Theresa May has a mandate to proceed (the referendum outcome).
PRS predicts substantial volatility in Italian asset prices and a weaker euro. The prospect of an early election weighs on the economy after the constitutional referendum defeat for Matteo Renzi. The new administration will press on and oversee the new electoral law and a partial bank rescue plan worth as much as €20 billion ($21.25 billion). These events will push structural problems down the road as the total funding required is believed to be approximately €55 billion ($58.45 billion). PRS expects the elections to take place either in March 2017, before the mid-April Easter break, or in May. That would entail a delay to the referendum on the government’s Jobs Act (its labor reforms), pending Constitutional Court approval of a request for one from the Trades Union, CGIL.
If Beppe Grillo’s anti-establishment, Eurosceptic Five Star Movement continues its rise in the opinion polls, the party may win the election and form a government, possibly with Lega Nord. Such an event would trigger a crisis of confidence in the Eurozone soon after the elections in the Netherlands, which are pointing to an uncertain outcome with gains for Geert Wilders’ anti-Islam and anti-EU, populist Freedom Party. This would increase Italian bond yields and widen CDS spreads. Italy’s 10-year yield is currently 1.79% (rising 0.2% in 2016, but easing on solid issuance at the final auction of the year). Look for a yield around 2% if the crisis worsens, with CDS widening from 158 basis points to the 160 to 170 range.