UBS: 2017 Markets Outlook: What needs to happen for '17 to be a game-changer year?

Will 2017 see reflation?

The path is visible, but narrow. Following the US election, markets have been trading a higher likelihood of reflation, with a focus on the US, and we have revised our rates and dollar forecasts. Fiscal easing can help the reflation trade, but it is not a panacea. Absent meaningful fiscal easing, we see a set of specific conditions that would need to be satisfied jointly for reflation to become a credible theme: Oil prices need to rise, but only gradually; global growth, ex-US, would need to hold up to contain dollar strength; financial markets need to avoid selling off in the face of global risk events; and the Fed needs to remain actively accommodative.

Dollar rallies have limits and would lean against them

Despite the visceral market reaction to the US elections, in our view the dollar has peaked vs major G10 currencies. Even with a modest Fed hike path until end-2017, policy divergence alone is insufficient to drive a rally, especially as a lot of this is already in the price. In addition, in a low growth environment, dollar rallies tend to be selfdefeating due to the feedback loop with tighter financial conditions, while the dollar's overvaluation vs the EUR, raises the bar for a sustained rally higher.

Rates to stay relatively low; however, upside risks have increased

The potential for large fiscal easing and the risk of higher inflation expectations have increased upside risk to yields. We are less bullish on duration, but still expect US rates to rise less than market priced forwards. We continue to prefer receiving long-end real rates and see steepening potential for the US yield curve. In the euro area, core rates hold the potential to beat market forwards to the upside. We favour long-end curvesteepeners as well as Gilt outperformance on cross market.

Equities should be able to withstand higher yields up to a certain level

We have argued that with a decline in the discount factor, high equity valuations do not represent a bubble. So, if yields rise, do equities suffer? It depends on why and by how much yields rise. A shock to yields unaccompanied by a better growth would be negative for equities. A reflationary lift would be associated with higher earnings expectations, and thus net positive for equities.

In credit markets, high yield under pressure, investment grade demand persists

With the US high-yield segment a likely exception, even relatively accommodative central banks in 2017 should continue to favour most developed market credits. It will take a taper-like move in rates or severe widening in spreads to reverse this dynamic.

EM rally to run out of steam as tailwinds subside and risks rise

Even with forecasts for broadly stable commodity prices, without further declines in DM real rates, further revaluation of EM assets will become harder and currencies will drift weaker. Equally though, there is no obvious trigger for EM assets to 'blow up.' On a risk adjusted basis, we see debt outperforming equities. Within EM debt, hard currency debt is most attractive, but we still find there are several investable dislocations within local currency debt.

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