Asset Classes

Asset Classes


In 2016

We are positive on the outlook for equities as we enter 2016. Our preferred regional markets are the Eurozone and Japan, which should benefit from rising earnings, low refinancing costs, and currencies which are weak on a trade-weighted basis.

United States - Earnings growth acceleration to drive US equities

Aggregate S&P 500 earnings disappointed in 2015, with little to no growth. But stripping out the energy sector, S&P 500 earnings rose mid-to-high single digits. We expect 8-9% earnings growth in 2016 as the US economy gains some momentum and the headwinds for lower energy – and the strong dollar – fade. This acceleration should drive the market higher in 2016.

Economic growth remains relatively good, with consumer spending boosted by steady labor market gains and improving household balance sheets. We also expect capital spending to have a better year in 2016, with the drag from weak energy-related capex fading, and business spending on manufacturing and technology gaining pace.

We hold a neutral tactical asset allocation position on US equities. We believe that the bull market cycle remains intact, but that other markets, such as the Eurozone and Japan have a more favorable outlook given greater scope for near-term earnings gains.

Opportunity in US tech in 2016

Within US equities we prefer the technology sector. The technology sector has steadily outperformed the S&P 500 since mid-2013, and was also a leading sector in 2015. We expect the sectors’ market leadership to continue.

Valuations are attractive in our view. Over the past 25 years, the sector has traded on an average premium of 20% over the rest of the market, but today is trading in line with the market, given widespread skepticism that earnings growth can be sustained. We believe that earnings can go on rising in 2016, due to higher levels of business spending, and secular growth trends such as cloud computing, mobility, cyber security, online advertising, and big data.

The sector is also aggressively returning cash to shareholders, which should continue in 2016, given strong free cash flows and balance sheet strength. Aggregate technology sector cash is currently a massive USD 500 bn.

Emerging Markets - Much negativity about emerging markets is priced in

Valuations of EM equities are now relatively attractive, in our view. On a price-to- book ratio of 1.4x, EM valuations are comparable with the lows reached last in 2003 and 2008, and a price-to-earnings ratio of 12x puts EM at a 30% discount to developed markets.

Furthermore, we believe that investor expectations for the region are now sufficiently low that emerging markets could be prone to rally in 2016 on incremental positive surprises. We note that investor positioning in EM has now normalized – global investors hold an average portfolio weighting of 15.6% in EM, down from 17.3% at the peak.

After holding an underweight position on emerging market equities for much of 2015, we have recently moved to neutral. We believe that after years of underperformance against developed markets, enough negativity may now be baked in to allow for better performance in the future. That said, we acknowledge that there are still obstacles to overcome.

High quality EM dividend yielders

Although we expect emerging market growth to stabilize in 2016, it will remain muted. In this environment, we believe the market is likely to reward companies which return cash to shareholders, rather than rely on potentially questionable future growth.

Despite the very poor performance of emerging market equities in recent years, such stocks would have delivered returns of around 20% over the past two years, a trend of outperformance we expect to continue in the year ahead.

United Kingdom - Underweight UK equities on weak earnings growth

The UK market has delivered a negative total return in the past two years, but we do not believe it is the time to count on a rebound. The market lacks the earnings momentum usually associated with a sustainable rally: earnings are likely to end the year down by –13%, after –4% in 2014.

Furthermore, we believe that the full effects of weaker commodity prices are yet to be factored in by consensus, and expect further earnings downgrades over the coming months.

A further headwind to earnings comes from the relative strength of the British pound. While the pound is becoming less of a drag on earnings than it was last year, the UK does not benefit from a currency tailwind as do the Eurozone and Japan. The GBP has strengthened about 10% relative to the euro and traded sideways relative to the USD this year.

We look for UK value to outperform in 2016

Within UK equities, we believe that the market is most likely to reward “value” companies with low valuations and high dividend yields in comparison to the rest of the market.

Along with the US, the UK economy is relatively deep into its economic cycle. We believe 2016 will see the Bank of England hike interest rates (in May, in our base case scenario) and that 2016 will also see 10-year gilt yields rise.

In an environment of rising 10-year yields, and ahead of an interest rate hike, we believe that value stocks will outperform, given that investors may be more reluctant to pay for growth at a time when discount rates are rising. While in the US, our strong overweight of the “growth-centric” IT sector keeps us agnostic between US growth and value segments.

Asia Pacific - Low valuations to prove a support for Asia ex-Japan

The region’s equities trade on a price-to-book ratio of 1.4x, close to levels last reached at the 2008 lows. Of course, revenues are likely to stay under pressure. Growth in the region is likely to slow again in 2016, with China slowing even more rapidly in 2016 than in 2015 on our base case forecasts. As this year demonstrated, sentiment is also likely to remain fickle.

However, companies are beginning to successfully adapt to a time of lower revenue growth, reducing their fixed-cost bases and adjusting capital expenditure plans. This could mean that free cash flow generation is poised to surprise on the upside, even if revenue growth remains disappointing.

However, companies are beginning to successfully adapt to a time of lower revenue growth, reducing their fixed cost bases and making adjustment to capital expenditure plans. This could mean that free cash flow generation is poised to surprise on the upside, even if revenue growth remains disappointing.

Global opportunities in APAC

With growth in Asia expected to slow again in 2016, we advocate a focus on companies in the region that are tapping overseas growth opportunities.

For instance, in Hong Kong, the weakening real estate market is a headwind for both the economy and the equity market index. Retail sales in Hong Kong itself have declined for two consecutive years. We think companies with global exposure should generally see higher levels of earnings growth than those with domestic exposure.

In Singapore, economic restructuring is posing domestic idiosyncratic risks, but the relatively weak Singapore dollar creates opportunities for exporters and globally exposed companies.

And in China, we believe investors could benefit by seeking exposure to the many companies expanding overseas amid uncertainty about the outlook for the domestic economy.

Europe - Eurozone earnings boost 

We hold an overweight position in Eurozone equities in our tactical asset allocation as we enter 2016. Companies are benefiting from low refinancing costs, the euro is historically weak against major trading partners, profit margins have room to expand, and loose monetary policy is prevailing.

We believe that EUR weakness could help Eurozone exporters on a trade-weighted basis; corporate debt refinancing costs are low, helping corporate net profit margins, and domestic demand is improving, boosting revenue growth. Overall, we expect earnings growth of 8–12% in the coming 12 months, which is superior to other regions.

The improved profit margins in recent months are encouraging. Net profit margins have edged up to 4.2%, well short of the cycle peak of 7.3% reached in 2008. If margins continue improving, this would suggest scope for durable upside in Eurozone equities.

The ECB may loosen monetary policy even further, as recent statements suggest, cutting interest rates or extending the duration of quantitative easing, or at least maintaining loose policy for the foreseeable future. The likely effects: a weaker euro, lower borrowing costs, and looser lending standards from banks to business should all help boost Eurozone equities.

Opportunities in Eurozone energy and financials, and in Italy

Our preferred country within Eurozone equities for 2016 is Italy.

The Italian economy surprised to the upside in 2015, and recent bank surveys suggest that lending standards are loosening – something which should be positive for both growth and banking sector profitability. Financials make up 42% of the Italian equities market index, and we expect above-average earnings growth for the next two years.

Japan - Policy boosts for Japan

As we enter 2016, we hold an overweight position in Japanese equities, which we believe should benefit from improving profitability, and a range of policy initiatives to boost growth and the market in 2016.

Prime Minster Shinzo Abe's so-called "Three Arrows," of monetary easing, fiscal spending, and structural reform, have been critical to the relative success of Japanese equities over the past three years. Since October 2012, when "Abenomics" was first mooted, Japanese equities have outperformed global equities by a massive 90% in local currency terms.

We expect such policy-driven positives to continue in 2016.

First, we believe the Bank of Japan could expand its monetary easing program in an attempt to stave off deflation. This could include a significant expansion in its direct equity purchases. It currently buys JPY 3 trillion each year.

Second, we believe the Government Pension Investment Fund (GPIF) is likely to increase its investment in the Japanese equity market. We expect the GPIF to buy JPY 90–120 trillion in equities over the next one to three years.

Finally, the country's revised corporate governance code should lead to higher return on equity at Japanese companies, and greater levels of cash getting returned to shareholders. 

Top Japanese equity picks for 2016

We like stocks that are conducting share buyback programs. The change in the Japanese corporate governance code is encouraging companies to unwind cross-shareholdings, unlocking cash for shareholders. While this occurred more slowly than expected in 2015, we think it will accelerate in 2016, with Abe stating that "corporate governance reform is atop my agenda."

In any case, buybacks are already up 56% year-over-year in 2015, and those companies announcing buybacks have outperformed the wider market.

We also believe that Japanese auto manufacturers could be one of the best positioned sectors within the Japanese equity market in 2016. With the emissions scandal affecting automakers in Europe, and movement toward a Trans-Pacific Partnership agreement, Japanese auto makers are well positioned to take advantage of tighter emission controls and energy-saving regulations.  

Switzerland - Strength of the Swiss franc dragging on Swiss equities

The sudden appreciation of the Swiss franc in January sent Swiss equities down 15% from their peak.

It exemplified the importance of currency movements for the highly international Swiss equity market, which derives around one third of profits from Western Europe, one third from the emerging markets, and one quarter from North America.

With the Swiss franc having appreciated against key trading partners (in particular in Europe and the emerging markets) sales growth is suffering, and has shrunk in Swiss franc terms.

The currency drag should fade in 2016, but we believe investors should be prepared for near-term earnings disappointments, and limit overexposure to Swiss equities.

Opportunity in Swiss high quality dividend payers and mid caps

Within the Swiss equity market, we like Swiss high quality dividend payers, and mid caps.

In 2015, the end of the Swiss franc currency cap against the euro brought with it a new era of negative interest rates in Switzerland, with the Swiss National Bank charging –0.75% p.a. on deposits held there. In our view, this increases the attraction of high quality dividend payers – companies with sustainable earnings, high returns, and a history of raising dividend payments to investors.

By segment, we also prefer the Swiss mid caps, which have a) historically offered superior earnings and dividend growth to large and small caps (more than double the earnings growth over the past decade), b) stronger balance sheets (47% have net cash positions), and c) attractive valuations, at a premium of just 5% to the wider market, below the long-term average of 12%. 

And Beyond

Equities a key driver of portfolio growth

Investors who buy a stake in a range of companies can earn a share of corporate profits, and participate in ongoing economic growth and innovation.

To estimate future returns, we look at prospects for corporate revenue growth, profit margin expansion, and valuations. Based on our long-term global economic growth estimates, we expect nominal revenue growth of 3–7%, with higher rates of growth in emerging markets, and slower growth in the likes of Japan. There is room for margin improvement in Japan and the Eurozone, but margins are at high levels in the US and Switzerland. In general, valuations are currently fair to slightly high, in our view. The trailing price-to-earnings ratio on the US market (including write-downs), for instance, is around 20x, in line with its 25-year average.

Taking these factors into account, we estimate annual total returns of approximately 8% for global equities.

Diversification is important

We recommend investors diversify broadly across companies, market capitalizations and regions. This helps to position portfolios for long-term growth.

Diversification across a wide range of companies is critical. The average company in the S&P 500 tends to have the same return as the overall index. But no stock on the S&P 500 has lower volatility than the index itself.

Diversity of market capitalization exposure helps to provide more stable performance. The gap between large and small-cap performance has been as large as 34% over a 12-month period.


In 2016

As the world transitions to a moderately higher pace of growth, higher levels of inflation, and higher interest rates in the US, we expect bond yields to rise.

In a difficult environment for bonds, we underweight the asset class as a whole, but see opportunities within investment grade corporates.

US government bonds to underperform equities

With yields set to rise, we believe that the highest quality bonds are likely to underperform both equities and lower quality bonds in 2016.

We expect total returns of –1.2% for US Government bonds.

Positive on corporate bonds

We hold an overweight position in corporate investment grade credit as we head into 2016. In 2015, credit spreads were driven to their widest level since 2012, but we attribute this to technical, rather than fundamental factors.

Against a backdrop of decent developed market economic growth, current credit spreads of 155bps are attractive.

US high yield bonds still remain attractive

As part of a long-term strategic portfolio, US high yield bonds still remain attractive – offering an 8.2% yield to maturity with a volatility that is about half that of the S&P 500. The market also has a history of recovering swiftly from setbacks. It took US HY just eight months to return to its previous peak following the 2008 crisis, compared to about four years for the S&P 500.

The recent bout of risk aversion has left US HY trading at a relatively generous 635bps spread over equivalent government bonds, against an 18-year average of roughly 500bps. We believe this will fall back to 525bps as investors recover their appetite for risk assets over the coming six months.

We are underweight US municipal bonds

In 2015, municipal securities showed stability, posting a modest positive return. For the year ahead, we believe demand for munis will remain reasonably consistent as investors continue to seek refuge from high marginal tax rates. Municipal bonds should outperform US Treasuries
in a rising rate environment.

We expect most state and local governments to exhibit stability in their credit profiles over the next 12 months, but there will be some notable exceptions. Defaults on Puerto Rico bonds and wider credit spreads in New Jersey and Pennsylvania are probable. Careful credit selection is essential. We are underweight municipal bonds.

And beyond

A range of types

Make no mistake, interest rates are low, and potential returns for bonds are low too. We forecast minimal returns over the next five-plus years for the government segment. But bonds still have an important role to play in portfolios.

The performance of each segment of the market will be determined by several factors. For instance, some government bonds tend to be more heavily influenced by central bank policy, whereas riskier credits are more affected by changes in the economic outlook, or by idiosyncratic factors.

Because of these different drivers, investing across a wide range of geographies, industries, maturities, and bond types can help improve the riskreturn profile of a portfolio, and reduce exposure to specific risks. As an illustration, the return-torisk ratio of a bond portfolio weighted across different segments* over the past 15 years would have been 1.13x, higher than for most other individual bond segments.

* US AA+ 5-7y, US corporate, US high yield, emerging market corporate, emerging market sovereign

Returns for safest bonds likely very low

With yields close to record lows, returns on highly rated bonds are likely to be similarly low in the years ahead. Historically, the annualized return of highly rated bonds over five-year periods usually isn’t much different from the level where yields were at the start of the period.

Yields on most government bonds today are below 2%, and investment grade spreads are thin in a historical context. In our capital market assumptions we expect returns in line with these low yield levels less than 2.2% annual total return. for US government bonds and less than 3.5% annual total return for US investment grade bonds. If our assumptions are correct, this would represent the weakest five-year period for the asset classes since the 1970s, and goes to show that bonds alone are no longer enough to fulfil many investors’ goals.

High yield bonds: standout performers

Riskier than other bond segments, but less volatile than equities, high yield (HY) bonds provide income, diversification and balance to a portfolio. Issued by companies deemed by credit rating agencies to be at greater risk of default than investment grade issuers, HY, or “junk,” bonds have been among the standout asset classes since the US market trough in 2009, returning more than 13% annually (calculated using the IBOX USD liquid high yield index).

Despite these strong returns, we think the prospects for the years ahead are still positive. Over the long-run, default rates among HY issuers average around 4%. With average yields today more than 7% ( calculated using the Bank of America US high yield master II) we believe there is scope for attractive returns over the next five plus years, and expect a 5.6% annual return over in our capital market assumptions.

Extra return for EM debt exposure

Growth in emerging markets has slowed in recent years, but EM bonds, issued by countries and companies in the developing world, still offer attractive characteristics for long-term portfolios.

Notably, EM bonds can offer higher yields than developed market peers, even when they have the same credit rating. Since the financial crisis, US dollar-denominated investment grade bonds in emerging markets have consistently offered average yields 0.5–1.0% higher than equivalent rated bonds in the US.

EM currencies are highly volatile. Therefore, in long-term portfolios we recommend investors focus on debt issued in US dollars, rather in the local currency. Given that idiosyncratic difficulties can be common in emerging markets, we recommend a portfolio which holds a combination of EM sovereign and EM corporate bonds, to diversify risk.

We expect annual returns 4.9% from EM fixed income in our capital market assumptions.

Alternative Investments

In 2016

As our world transitions toward one of lower return, alternative investments will play an increasingly important role in portfolios, in our view. For 2016, we think investors could benefit from diversifying assets in a well-balanced hedge fund portfolio across different strategies.

A mixed year for hedge funds

2015 was relatively tough for hedge funds, amid weak returns from global equity markets and a number of idiosyncratic events affecting widely held individual stocks. At the time of writing, the HFRI Fund of Funds composite index is flat year-to-date. Returns were driven in part by the third-worst year in a decade for equity markets. This affected the equity-hedge style in particular (flat year-to-date).

Macro funds started the year strongly, but suffered from April onward with the reversal of the long running equity and government bond bull markets, and signs of bottoming in commodities (–1.5% year-to-date).

Event-driven funds also started the year well, but suffered the poor performance of some widely held companies in the healthcare sector in August and September.

Opportunities in hedge funds

We believe that hedge funds can deliver more favorable risk-adjusted returns in 2016 than in 2015.

2016 should offer better circumstances for hedge fund managers as structural macroeconomic shifts such as monetary policy normalization in the US, ongoing monetary easing in Europe and Japan, and falling demand from China are likely to spur regions and sectors to diverge across asset classes.

This should offer trading opportunities but requires a more thematic and tactical approach to investing, and favors actively managed investment vehicles that can adapt more readily to changes. Normalizing volatility toward long-term averages should also create arbitrage opportunities that some managers can capture.

Generally, we expect returns of 4–6% in 2016 for the asset class as whole. A well-diversified portfolio investing in a range of managers with different styles and approaches to markets is the best way to benefit from hedge funds’ unique investment capabilities.

Hedge fund risks for 2016

An environment of sharp and unexpected equity market corrections followed by V-shape recoveries is challenging for managers to navigate, as we have seen in 2015. Highly directional equity-oriented strategies, the returns of which are more dependent on market beta than on alpha, could be vulnerable in such an environment.

In the credit area, market depth and liquidity remain a potential issue. Managers focused on capturing illiquidity premiums in fixed income could face temporary risk in the event of a significant dislocation, though this is not our base case.

Private markets in 2016

For investors who can tolerate illiquidity in a portion of their portfolio, private markets represent opportunities to deploy longer-term capital that can provide additional diversification as well as other potential benefits including inflation hedging. However, selectivity will be critical for investors looking to make new private market investments over the coming year. Dynamics such as low entry valuations and less competition that can represent return tailwinds earlier in the cycle, are unlikely to provide similar benefits in the current environment.

As a result, selecting the right strategies and managers will be of particular importance. We recommend investors consider long-term opportunities resulting from dislocations in areas currently out of favor in public markets; potential examples include energy and certain emerging markets.

And beyond

Hedge funds offer an attractive return-to-risk profile

We believe that hedge funds represent a crucial part of most well-balanced portfolios. In an environment where low yields will likely mean that future returns for bonds are low, we expect hedge funds to provide an attractive alternative as a substitute for bonds, with significantly higher returns, and only moderately higher risk.

Hedge fund managers have access to a broader range of investment strategies and instruments than most private investors or even long-only institutional investors do. The wide range of underlying assets, time horizons, approaches, and positioning of different managers should also allow individual investors to build a portfolio of alternatives suitable for their needs.

For the hedge fund index, we assume an annual total return of 6.2% and a risk of 6.7% our capital market assumptions. This represents an attractive return-to-risk ratio relative to other asset classes. In a portfolio context, it is particularly appealing that correlations to other asset classes are low.

Overexposure to hedge funds entails risks

Investors should avoid allocating too heavily to hedge funds. Any regular reader of financial media will know that alternative investments can go wrong. Whether through operational risks, badly timed investment decisions, or by managers preventing redemptions, the outside risk remains that individual funds may suffer losses or illiquidity at some point. In addition, investors should remember that some hedge fund managers employ leverage to magnify returns.

This can be favorable if strategies are performing well, but it magnifies downside risks. Individual manager risk can be partly mitigated by diversification. But from a portfolio perspective, investors with a high allocation to hedge funds should also note that correlations with other asset classes can arise in times of severe market stress. In 2008, the fund of funds composite hedge fund index fell by 21%. As such, while hedge funds are an attractive asset class, in our view, investors need to be cautious in setting their level of exposure.

A diversified selection of managers and styles is essential

We think it’s important that investors in alternatives seek a well-diversified portfolio of managers and styles. While it is possible for any individual fund to perform poorly over a set time horizon, with a well-diversified portfolio, investors can feel more confident in the long-run return prospects and relative stability of their holdings.

We recommend diversifying by investing in a range of managers with different styles and approaches to markets – ranging from market neutral, relative value, macro, and merger arbitrage. By taking this approach, investors should reduce their dependence on a single driver of return. If we consider a range of measures such as maximum drawdown, illiquidity, performance, volatility, and the Sharpe Ratio, a diversified portfolio of styles is superior overall to any individual strategy.

We expect high risk-adjusted returns from private markets

The “private markets” asset class includes private equity, private debt, and real assets. Investors who don’t need regular access to their money can benefit from investing in private markets, accessing opportunities with a wide range of return drivers, providing portfolio diversification, long-term capital appreciation, and, depending on the investment, potentially regular income and an inflation hedge too.

We think private markets can offer strong returns in the years ahead. First, private market investments offer access to opportunities that are not yet widely tapped, where mispricings may be more common.

Second, depending on the strategy, the active involvement of experienced private market fund managers can create significant value for investors.

Third, the illiquidity of the investment gives investors a return premium to compensate for the long-term capital commitment that enables fund managers to add value.

Finally, illiquidity is an advantage from a behavioral finance point of view. Biases can cause investors to trade out of investments at times of high volatility. The illiquidity of private markets means that quick exits aren’t possible, so investors are forced to take a long-run approach.

Illiquidity must be tolerated

While we believe that a private markets allocation is essential for long-term-oriented investors who can tolerate illiquidity, investors need to carefully consider their need to access capital, particularly in times of market stress. Should an investor need to sell large parts of the liquid part of a portfolio to meet expenses, it could leave the asset allocation unbalanced, and forced liquidation increases the risk of selling at unfavorable prices.

Investors also need to consider the current market environment when making these illiquid commitments. Dynamics like lower valuations and less competitive capital, which can represent natural tailwinds for private fund managers earlier in the business cycle, are no longer available at this point in the cycle. Manager and strategy selection are increasingly important in such an environment, and investors should seek out funds pursuing differentiated strategies and focusing on complexity and execution given these dynamics.


In 2016

The US dollar is likely to remain strong for much of 2016, with the Fed increasing interest rates, but may be nearing the end of its run. Meanwhile, we expect short-term weakness for the euro as the ECB extends its loose monetary policy. Oil-influenced currencies like the Norwegian krone and Canadian dollar should perform well in 2016.

US dollar – close to the end of the road

After a ca. 10% trade-weighted appreciation in 2015, the US dollar is at its strongest, on a trade-weighted basis, in more than a decade. We believe that the strength of the US dollar will continue in 1H 2016. US unemployment is now sufficiently low that the Federal Reserve is likely to hike interest rates through 2016, while the ECB and Bank of Japan seem closer to easing than hiking.

That said, we believe that any appreciation surrounding initial interest rate hikes may conclude the USD’s run. The USD’s value looks stretched on a purchasing power parity basis (we think 1.25 against the euro is fair), and some Fed officials have expressed concern about the impact a strong dollar might have on exporters and inflation.

We forecast EURUSD to fall to 1.05 over the next three months, but rise back to 1.10 over the next 12 months.

British pound – still going

After another year of appreciation (+7% on a trade-weighted basis) in 2015, the British pound is at its strongest since 2008, when the banking crisis provoked a rapid decline.

We believe that the GBP will likely appreciate from here, in particular relative to the EUR. As with the US, the UK is poised for a normalization of interest rates. Solid GDP growth, a strong housing market and falling unemployment mean that crisis-level interest rates are no longer needed.

However, with no imminent inflation threat, and signs of moderately slower growth in the UK in recent months, the Bank of England is likely to be cautious. As such, the pound is unlikely to appreciate as strongly in 2016 as in recent years.

The Japanese yen – modest further weakness 

In 2015, the JPY has traded in a very tight range against the USD, appreciating overall by 3% on a trade-weighted basis through the year after sizable depreciation in prior years.

In 2016 we expect modest further weakness. Japanese monetary policy will remain conducive to keeping the yen weak, inflation has remained well below the government’s target, and it is doubtful that it will reach this 2% goal in 2016, either.

But the scope for further depreciation is limited by the extent of the yen’s slide over recent years.

We estimate JPY purchasing power parity against the USD at 78, a significantly stronger level than today, and in the long run, as with the EUR, low rates of inflation should be favorable for JPY.

Emerging market currencies – under pressure again

After a particularly bad year for EM currencies in 2015, 2016 is likely to be better, but only moderately.

EM currencies tend to appreciate when GDP growth is strong and the gap with developed market is large; when commodity prices are strong and rising; and when declining developed world interest rates push capital toward emerging markets.

For 2016, we expect EM GDP growth to improve, but only modestly (to 4.3% from 4.1%), and the gap to developed markets will relatively low (2.1%). Commodity prices look set to recover, but the revival will be modest and prior highs will not be regained.

Finally, rising interest rates in the US will make it harder for emerging nations to attract capital.

As a result, we expect EM currencies to remain under pressure.

Peg breaks

A currency peg is a type of exchange rate regime in which a currency’s value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold. A peg breaks when such currency is no longer fixed to the chosen benchmark.

2015 was notable for a number of currency pegs, caps, and floors fail, including in Switzerland, China, Kazakhstan, and Vietnam.

Prior to a peg break, volatility is low by definition. This means it is often “cheap” to invest for the potential of a peg break. In the event of a peg break volatility and returns can be outsized. That said, investors should be cautioned that “timing is everything” and premium spent or carry paid betting upon a peg will be lost if the peg is maintained.

Options in both the Hong Kong dollar and the Saudi riyal have recently indicated an elevated probability of their pegs breaking although we still deem both events as unlikely in the Year Ahead.

Euro – easing to the bottom

After plunging more than 10% on a trade-weighted basis in the first quarter of 2015 after the European Central Bank announced quantitative easing, the EUR has been broadly stable through the year.

We expect another near-term downward step. The ECB presently has no incentive to restrain monetary easing. Unemployment is still high, and inflation is low. ECB President Draghi has recently indicated that near-term monetary policy could become even more accommodative.

Longer term, we believe that EURUSD would be close its bottom at 1.05. It is already around 15% undervalued against the USD and 10% against the GBP on a purchasing power parity basis, and over the long run the persistent low inflation that the Eurozone encounters should be positive for its currency.

Swiss franc – after the cap

After dramatic appreciation in early 2015 following the Swiss National Bank abandoned its exchange rate floor against the euro, the CHF has been trapped in a narrower range against the EUR, and steadily weakened against other major currencies since.

We believe the franc is set for another year of range-bound trading against the euro in 2016. On the one hand, the Swiss currency is unlikely to depreciate against the euro while the European Central Bank is biased toward easing. On the other hand, while the Swiss economy has been relatively resilient in the face of currency strength, there have been signs of strain. SNB officials have hinted that they would seek to offset the impact of further ECB QE on the Swiss franc.

A EURCHF trading range of between 1.05 and 1.10 is likely for 2016, in our view. 

The other G10s

The Canadian dollar has suffered from the decline in the oil price, and is currently trading close to its weakest against the US dollar in more than a decade. We expect a more stable oil price in 2016, and Canada's currency is now undervalued against the USD.

Meanwhile, we expect the Norwegian krone to rebound significantly in 2016 as the economy recovers from the recent slowdown induced by the fall in the oil price. Elsewhere, we believe the Swedish krona will remain range bound against the euro. The Riksbank is eager to avoid a harmful appreciation.

We have a negative outlook for the Australian and New Zealand dollars, given the slowdown in commodity demand from China, and the effect on key raw material and dairy prices. After 10% and 8% respective trade-weighted depreciations in 2015, valuations are now fairer, but we think there is scope for some further weakness in 2016 while commodity supply is cut back.

APAC – negative outlook

After a negative year for most Asia Pacific currencies against the USD in 2015, we retain our generally negative outlook on APAC currencies for 2016.

This outlook will be largely guided by events in China, which accounts for almost half of the region's economic output. We believe the country is likely to continue cutting interest rates, if necessary, to prop up its economy, making the CNY less attractive, and potentially provoking other countries to follow suit. We expect the CNY to depreciate very slightly, trading at 6.8 by end-2016.

The most vulnerable currencies in the region are the Indonesian rupiah and the Malaysian ringgit. Indonesia’s high inflation and current account deficit are structural negatives. Malaysia meanwhile has small and shrinking foreign exchange reserves, making it hard to support the currency if a crisis emerges, although a recovery in oil prices in 2016 would help.

Among the more attractive currencies is the Indian rupee. However, even this is unlikely to repeat its strong total return performance in 2016, particularly if energy prices stabilize and rise.

And Beyond

Cash is important, but it’s also a drag

Cash can be used to meet expenses without transaction costs, so even in the most difficult market environment, it should generally be accessible. In most cases, it also has no volatility: barring government action or bank default, investors can generally trust that the nominal value of cash is protected. However, safety comes at a price. Cash acts as a drag on long-term portfolio returns.

Also, since bonds and equities diversify one another better than cash, investing cash in other assets can sometimes actually reduce portfolio risk. For instance, using data over the past 20 years, a 50% US government bond, 50% USD cash portfolio would have suffered a worse maximum drawdown (2.5%) and a lower annualized return (4.6%) than a 3% equity, 50% bond, 47% cash portfolio (max. drawdown 2.4%, annualized return 4.8%).

Relative appeal of cash is low

The consistent increase in equity valuations and decline in bond yields in recent years have undoubtedly lowered the appeal of financial assets relative to cash. However, valuation metrics suggest that – adjusted for the low returns on offer in cash – financial assets are not notably more highly valued than in the past.

For instance, the difference between the dividend yield on the S&P 500 and the real Fed funds rate is +3.7%. Historically the difference has been negative at times of market peaks. US bonds are also attractively valued relative to cash: the difference between yields available on US government bonds of a medium maturity and USD cash are at 1.1%, favorable when compared to the 20-year average of 0.8%.

Cash not suitable to protect against inflation

We think a well-diversified portfolio of financial assets is better placed to protect against inflation than cash. Today, there appears to be little risk of inflation. But given high levels of debt, and a desire among central banks to deal with its consequences aggressively, it remains an important tail risk to consider.

Equities should benefit from moderately higher levels of inflation, as companies are able to pass increases in general price levels through to their consumers and grow earnings. Meanwhile, riskier credits could also benefit somewhat as higher levels of inflation allow companies to pay down debt more easily. Of course, these assets are significantly more risky than cash, but can be complemented in a well-diversified portfolio by safer assets, such as bonds.

Real Estate

In 2016

Much has changed since the financial crisis, but on average, real estate prices are now higher than pre-crisis peaks. Some housing booms stand out. London and Hong Kong face highest risk of correction. Zurich and Geneva seem only modestly overvalued, while New York looks fairly priced.

The UBS Global Bubble Index 

The UBS Global Real Estate Bubble Index combines measures of house price valuations with indicators of market activity, and compares them against the long-term norms for individual cities.

The price-to-income component measures how many years' gross income would be needed to pay for a centrally-located 60m2 dwelling. In London, this is 14 years, while in Frankfurt it is just five.

The price-to-rent ratio measures the expense of buying a flat compared to the cost of renting it. This ranges from over 30 years for Zurich, Vancouver, Hong Kong and Geneva, down to 20 years or below for Amsterdam, San Francisco, Boston and Chicago.

The index also includes measures to detect market momentum – including the change in the outstanding mortgage credit to GDP and the change in the construction share of GDP.

Finally, we measure the prices of city properties compared to the rest of the country – which can indicate if a metropolis is decoupling from its surrounding areas.

Zurich, Geneva, and New York not in bubble territory

Zurich’s index score indicates a moderate degree of overvaluation. In the last five years, prices  have climbed 25%, while rents and incomes stagnated. But, in line with the broader Swiss housing market, prices have increased more recently at a slower rate. House prices in Geneva have fallen by 5% in the last three years as countrywide prices rose.

New York’s residential market scores indicate fair valuation. Real house prices in New York bottomed in 2012 after a five-year severe correction following the subprime crisis. Despite the recent rebound, the price for an average house in inflation-adjusted terms is currently still more than 25% below its 2006 peak. Both price-to-income and price-to-rent ratios reverted to their historical averages. 

London and Hong Kong appear most overvalued

Hong Kong's record-high price-to-income ratio of 21, and a price-to-rent ratio of 33 indicate high risk of correction. Fueled by a credit boom, Hong Kong’s residential market performed comparatively well during and after the financial crisis. Without any long-term correction, property prices are now 60% higher than in 2006, and almost 200% higher than in 2003. Rents, in contrast, have grown by only 35% in real terms. 

London looks even more exposed, with the highest bubble index score in the world. In real terms, London house prices are 6% above their 2007 peak, despite nationwide prices having declined by 18%. 

The decoupling of the London real estate market from the rest of the UK is even more drastic considering that in the same period real average earnings fell by 7% both in London and UK-wide. 


In 2016

We expect commodity prices to stabilize in 2016, with an overall upward move in the high single digits. Crude oil will likely drive most of the improvement, although an ongoing economic deceleration in China should keep base metals weak. We expect the outlook for gold to improve next year as US real interest rates sink deeper into negative territory.

Oil – a more positive year

After signs of bottoming in 1H 2015, oil prices have suffered again in the second half of the year, amid concerns of continued oversupply and Chinese demand leveling off. At the time of writing, Brent crude is down by more than 20% year-to-date.

We expect oil prices to stabilize and partially recover in 2016, and forecast USD 63/bbl (Brent) and USD 60/bbl (WTI) in 12 months’ time.

Low prices have curbed capital spending around the world, in particular in US shale wells. As a result, we expect oil production outside of OPEC to contract by at least 0.3 million barrels per day (mbpd) in 2016.

Meanwhile, oil demand growth should stay robust as drivers change habits in response to cheap fuel – driving more and buying energy-consumptive vehicles.

We expect oil consumption to rise by 1.1–1.2 mbpd in 2016. This should almost clear the current market surplus by 2H 2016.

Industrial metals – grinding along 

Industrial metals suffered again 2015, due to weaker-than-expected demand from China. Now 50% below their 2011 peak, prices are in line with 2008 lows. Most industrial metals are trading into their cost of supply.

However, we expect a flat year in 2016. Supply cuts are still needed to balance the market: Demand growth from China will probably remain sluggish. Copper and iron ore are most at risk.

Gold – reaching a floor

After a strong start to the year, buoyed by a new quantitative easing policy announced by the European Central Bank, gold prices then ebbed lower through 2015. Prices are down –8.6% year-to-date at the time of writing, marking the third year of decline in a row.

Looking ahead, while the Federal Reserve is likely to raise interest rates, we believe inflation is likely to increase more quickly (from 0.2% to 1.6% in the US, for instance), boosting the relative appeal of gold as we go through the year. Added support could come from emerging market central banks.

That said, with few signs of inflation rising rapidly, and a lack of momentum to support ETF buying, there is little reason to expect significant upside, either. We expect relatively flat prices in 2016: our 12-month target stands at USD 1,100 an ounce.

Agricultural commodities – little excitement

Agricultural commodity prices fell in 2015 for the third year running, with the Bloomberg Index down 11% year-to-date. The sharp rally in the drought summer of 2012 seems distant; prices are down 50% since.

We believe the worst of the decline is over, and expect prices to stabilize in 2016, and returns to average 2–3%. El Nino-related climate disruptions could increase prices for palm oil. In contrast, soybeans may post another surplus. Production in Brazil is heading for a record above 100 million tons, and stocks are huge.

And Beyond

Diversified commodity exposure has not added value

In order to earn a place in our recommended Strategic Asset Allocations, an asset class must be expected to add value to multi-asset class portfolios. We do not expect commodities’ risk-adjusted return to match that of global equities over the long term. But we also believe that because commodities’ prices have already fallen so far, the case for their inclusion in a portfolio of stocks and bonds is stronger than it’s been in recent years.

Over the past 10 years, the broadly diversified Bloomberg Commodity Index has delivered a return of -5.1% annually, with a volatility of 18.1%. This performance compares unfavorably over the same period to other risky asset classes, such as global equities (return 5.7% annually, volatility 16.9%) or US high yield bonds (return 7.6% annually, volatility 10.5%). Furthermore, commodity indices have failed to offer much portfolio diversification. Their correlation to equities was 61% over the past decade.

Over our Years Ahead horizon, reductions in major commodities supply may provide the base for better returns. Counterbalancing this are important performance factors, such as roll costs (upward slope of forward curves) and unfavorable cash collateral returns (interest rates near zero). In addition, the demand outlook from Asia is uncertain.

Lower supply vs uncertain demand

With many commodities’ prices now at multi-year lows, we expect supply to slow or even contract in the Years Ahead. We have already seen capital expenditure cuts of more than 20% from major energy companies in recent quarters. It will take time for these spending cuts to feed through into actual supply cuts, but it is increasingly likely that we will see a relative scarcity of commodities over a long term time horizon.

In contrast, however, the demand outlook is uncertain. China’s transition toward more consumer-led growth and the relatively high debt burdens in some Asian countries likely indicate slower demand growth for major commodities. Another potential risk stems from the needed improvements to energy efficiency, and developments in battery technology, as well as additive manufacturing.

Considering these potential risk factors, we advise caution to those expecting commodities to match the risk-adjusted returns of other global risk assets.

Less downside for gold

In the Years Ahead, we believe that gold prices are likely to move modestly higher. Global interest rates are likely to remain below inflation for at least the next one to two years, and such situations have historically been supportive of gold. Furthermore, central banks in general are no longer reducing gold holdings; indeed, China and Russia in particular have been consistently adding to their gold reserve.

That said, gold may have some limited further downside, as both real and nominal US interest rates move gradually higher, albeit from very low levels. We currently do not recommend a significant strategic exposure to gold in long term portfolios.

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