After a rocky start to 2016, global equity markets are ending the year on a high note with solid gains for the fourth quarter so far in the U.S., Europe and Japan. We look for the advance to continue next year as global growth accelerates and corporate earnings improve. But on top of this cyclical improvement, we also expect a range of longer-term, structural drivers to influence relative performance across asset classes, countries and sectors. For each of our firm-wide investment mega themes of People, Government, Innovation, Earth and Markets, we highlight some of the key trends that we expect to shape the global economy and markets as we move into 2017.

1. People—the rising populist tide
The political order across many developed economies was rejected in 2016. A fringe left-wing party in Spain secured over 20% of the vote in its first national election; two major trade agreements involving the U.S., the European Union and Japan were resisted and now look moribund after years of negotiation; Italians voted against a major constitutional reform, toppling their prime minister in the process; the U.K. voted to leave the EU; and a political outsider won the White House. Populism is on the rise around the world, and in 2017 the market implications of this theme will become clearer. Established parties on both sides of the political spectrum have so far proven unable to prevent ever-widening income disparities within countries, even as aggregate economic gains from expanded markets, increased trade and technology-driven productivity growth have increased. After decades of closer global economic integration, the main risk for next year and beyond from this rising populist tide will be an erosion of international trade, foreign investment and labor migration links between countries as elected leaders set policy. Since the 2008 financial crisis, global trade has already slowed significantly (Exhibit 1) and investors will have to watch for any response to the growing populist backlash against globalization (whether through tax inducements, immigration policy, tariffs or other measures) that restricts the cross-border movement of goods, capital or labor.

In addition to the U.S. relationship with NAFTA countries under a Trump presidency, core Europe will bear particularly close monitoring in 2017 with nationalist parties expected to make big electoral gains in three of the five largest Eurozone economies. In the Netherlands, the far-right Freedom Party is currently leading the polls ahead of a March general election and has explicitly called for a referendum on EU membership. In France, the far-right National Front has pledged to hold a similar vote if elected—its leader is expected to reach the runoff stage of the presidential vote in May. And in Germany, the governing coalition parties of Chancellor Angela Merkel should retain their majority, but nonetheless continue to lose public support ahead of federal elections expected in September or October—a shift that has already prompted the current leader to toughen her stance on immigration. At the same time, Britain's negotiations on EU withdrawal are set to begin after formal notice to leave is tendered by the end of the first quarter. Depending on the degree to which existing U.K.-EU ties are loosened, this could deal yet another blow to global economic integration.

Market implications: Rising populism risks higher trade barriers, less offshoring of business operations and less migration. Such measures would reduce the expected pickup in global growth, putting countries and sectors with high exposure to exports, foreign direct investment, immigrant labor and remittances at particular risk. A geographical narrowing of production operations also risks pushing up wages and prices across supply chains for manufactured goods.

2. Government—increasing government activism
The last two U.S. presidents faced major events early in their first terms that remained key themes throughout their time in office. Under the Bush administration, security and defense policy became central following the 9/11 attacks. Under the Obama administration, monetary stimulus and regulation have been major themes in the wake of the financial crisis and great recession. And based on campaign rhetoric and cabinet appointments, the incoming Trump administration looks likely to focus on promoting growth at home through more government involvement in some areas and less in others. Subject to congressional passage, we expect three policy tools in particular—tax cuts, spending increases and deregulation—to serve as the main levers. On taxes, the incoming administration has proposed collapsing the current seven personal income tax brackets into three, while cutting the top rate for both households and corporations. This mirrors recent trends elsewhere. Across the 10 largest recipients of foreign direct investment (FDI) by stock, seven have seen their top corporate tax rates fall since the financial crisis, with the exceptions being Belgium, Ireland and the U.S. itself (Exhibit 2).

Meanwhile, on the spending side, the transition team has proposed credits for private investors with the aim of funding up to $1 trillion of infrastructure investment in roads, bridges, tunnels, airports, railroads, ports, waterways and pipelines. And increased outlays on domestic defense spending have also been proposed (in part by a repeal of the 2013 budget sequestration), at the potential cost of less support for military allies in Europe. Whether or not these proposals can meet their stated aims remains to be seen, but the clear policy bias is toward pro-growth fiscal policy at the likely cost of a larger budget deficit. Deregulation should also be a key government theme in 2017. Both the financial and energy sectors (each of which has outperformed since the election) have been singled for looser restrictions on their business activities. And health care has also been targeted, though the effect of deregulation is more likely to be a headwind in this case. The potential repeal of the Affordable Care Act medical device tax would be a support for equipment makers. But concerns over increasing competition and weaker pricing power may weigh further on the more heavily weighted insurance, pharmaceuticals and biotechnology segments. Allowing insurance companies (12% of health care market capitalization) to compete in different states could lead to pressure on revenues through lower premiums, while the proposed allowance of overseas-branded drug sales into the U.S. market, though likely harder to get through Congress, would be a further headwind for biotechnology (20% weight) and pharmaceuticals (37% weight).

Market implications: The incoming U.S. administration will be pro-growth, with lower tax rates boosting corporate net income, and higher government spending on infrastructure helping to extend the business cycle and support related industries such as construction, engineering and industrial equipment. A greater emphasis on domestic defense expenditures should also support military contractors, while encouraging more local defense spending abroad (only five of the 28 NATO member states, for example, are currently meeting their official 2%-of-GDP spending targets). However, a larger budget deficit and rising inflation are likely to result in higher bond yields and the underperformance of bond proxy equity sectors. Financials and energy stand to be beneficiaries of the deregulation agenda, while efforts to increase price competition should weigh on health care.

3. Innovation—the expanding digital economy
The secular trend toward digitization, automation and embedded computer processing across industries will advance in 2017. As we have stressed in the past, the digital era of today should be viewed in parallel with previous periods of major technological change. The machine tools and steam power of the first industrial revolution ultimately became integral parts of the 19th-and-early-20th-century economy through mass production and mass transit. Electrification would later enable the rise of 20th-century communication devices such as the radio and telephone. And we similarly expect the digital technologies of recent decades to become even more central to the 21st-century information economy over the coming years. The Boston Consulting Group and World Economic Forum project that the digital economy will account for 7.1% of GDP ($6.6 trillion) across the G20 countries by 2020, a near doubling from 4.1% in 2010. Since the broad equity market bottomed in early February, information technology has been among the leading sectors for 2016, and we expect further gains next year as earnings (currently projected to grow by 12% in 2017) are supported by structural innovation trends across a range of key areas. As one example, industrial robot deployment has accelerated since the financial crisis, with global unit sales growing at an annualized 15.7% since 2010 (Exhibit 3) compared to 8.9% during the last cycle. Falling system costs, improving functionality and rising wages are increasing the competitiveness of machines relative to humans.

Among the key advances in robotic functionality is the growing use of artificial intelligence software to build machines that can decipher images and language without being explicitly programmed to do so. Behind this capability is machine learning technology, through which computer programs are trained to recognize individual objects by identifying their distinguishing features within large data sets. Beyond robotics, we expect this technology to be used across a broadening range of applications over the coming years—from autonomous vehicles to drones, medical imaging, online retail and digital assistants in mobile devices—as programmers gain access to more data and high-performance processing chips are more widely adopted. In the case of autonomous cars, for example, a large Silicon Valley mobile ride�?hailing firm launched supervised driverless vehicle services in San Francisco and Pittsburgh this year with the aim of rolling out 100 cars in the latter by the end of 2016. An expansion of these services is expected in 2017. We also look for digital media penetration to increase. Streaming television should continue to take market share from traditional cable providers, while separate virtual reality (VR) product launches from U.S. and Taiwanese hardware designers this year represented the most advanced consumer offerings to date. Several entry-level devices on the market are already helping to spur more mainstream VR adoption, and over the coming years we expect the technology to be used in a wider range of applications from gaming and live events to advertising, journalism, education and site inspection. The rapidly expanding digital economy will also mean a greater degree of vulnerability for individuals, private businesses and public services to online attacks, with more resources being put into addressing them. According to the latest annual global security report from PricewaterhouseCoopers , the number of detected information security incidents in 2015 rose by 38% from the previous year across the more than 10,000 high-level executives surveyed. Over the same period, respondents increased their IT security budgets by 24%.

Market implications: The digitization of a broadening range of economic activities and the growing need for data processing and storage represent a key support for providers of application and systems software (including cybersecurity), as well as internet services for entertainment and content distribution. The growth of computing needs across industries should also remain a tailwind for semiconductors, while wireless telecommunication service providers are well placed to benefit over time from associated new revenue streams.

4. Earth—entering the era of emissions reduction
According to preliminary data from the United Nations World Meteorological Organization, 2016 will be yet another record-setting year for global temperatures (the 17th since 1998). And with the ratification of the United Nations Paris climate accord this past October, the world now appears in response to have firmly entered the era of emissions reduction. We expect 2017 to bring more global efforts at decarbonization in what will remain a multidecade process of energy switching and greater energy efficiency. As part of its Paris commitments, the U.S., for example, has pledged to reduce its greenhouse gas emissions by 26% to 28% below 2005 levels by 2025; the European Union has set a greenhouse gas reduction target of at least 40% below 1990 levels by 2030; and China by 2030 has pledged to achieve peak CO2 emissions, increase its non-fossil-fuel share of primary energy consumption to around 20% and lower its emissions per unit of GDP by 60% to 65% from 2005 levels. Concerns that the incoming U.S. administration could halt the global trend toward lower emissions seem misplaced. Aside from international agreements, the cost of renewable energy is falling as the technology improves. The price of the average silicon solar module, for example (the largest cost in a typical residential system at over 20% of the total), has fallen by 60% over the past five years, while average residential utility rates have risen by more than 7% over the same period. According to a 2016 report from Wood Mackenzie, 20 U.S. states have now reached grid parity (price competitiveness with the conventional utility generation), and 42 states are expected to reach it by 2020. And with investments in clean energy systems lasting well beyond even two presidential terms, the direction of travel is unlikely to change based on one administration. The Environmental Protection Agency now counts 784 organizations including corporations, universities and government departments on its 100% Green Power Users list, up from 736 a year ago (Exhibit 4). And a $500 billion Silicon Valley internet firm recently announced plans to run its offices and 13 data centers entirely on wind and solar by the end of 2017.

For large emerging market emitters such as China and India (which together account for 33% of all CO2 emissions worldwide), renewable energy deployment also aligns with key domestic aims of the national government. For China, energy switching is part of the broader goal of promoting advanced manufacturing and controlling air pollution as articulated in the Communist Party's latest five-year plan. And for India (where 19% of the population still lacks access to the power grid), renewable generation serves as a means of providing electricity to a larger share of the population, particularly in rural areas. As implementation of the Paris agreement begins, we therefore see structural support for climate change mitigation and clean energy investment continuing into 2017.

Market implications: Global energy switching will support renewable energy project developers, as well as manufacturers of solar modules, wind turbines and current inverters. And the ongoing trend toward greater efficiency should support cost-saving producers of energy-efficient appliances, semiconductor-based lighting and hybrid and electric cars.

5. Markets—asset rotation, market reflation
The final months of 2016 have kick-started a shift in market sentiment based largely on pro-growth policy expectations. At close to 90 months, the current U.S. economic expansion has now lasted almost three years longer than the average post-war cycle. And by the end of the first quarter of 2017, it will be the third-longest in post-war history. As previously described, we expect policy under the incoming Trump administration to mark a major departure from the outgoing Obama government. And this combined with a business cycle that may be entering its latter stages should have a material impact across asset classes. The main market themes in this new environment are likely to be fiscal expansion, larger deficits, a greater risk of trade impediments, rising inflation and higher interest rates (Exhibit 5).

Cuts to income and corporate taxes combined with an increase in infrastructure spending should be tailwinds for economic growth, but could also see Treasury yields continue to break higher on budget and inflation risk, particularly as the Federal Reserve raises rates. As a result, we expect investors to increasingly shift away from longer-duration fixed income and defensive bond proxy equity sectors. U.S. large cap equities should continue to trend higher as earnings turn up again (with 12% calendar-year growth currently expected in 2017) after a flat 2015 and 2016. Meanwhile, smaller capitalization, more domestically oriented equities should outperform given the acceleration in U.S. growth relative to the rest of the world, the likely strength of the U.S. dollar and the risk of new barriers to cross-border trade and investment. With bond yields rising, banks should also continue to benefit from a steepening of the yield curve. Following a decades-long shift toward freer trade, lower inflation and lower interest rates since the 1980s, it remains to be seen how persistent these trends will be. But we expect cycle- and policy-led reflation to be a key theme across markets going into 2017.

Market implications: Fiscal stimulus and an extended cycle should boost domestic consumption and investment activity, with inflation and interest rates moving higher. In this environment, cyclical sectors outperform, while higher-yielding, rate-sensitive sectors and fixed income assets underperform.

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