Six for 2016

Six questions for 2016

To invest successfully in our world in transition, it is important to ask the right questions.

Here, we try and identify “6 for 2016”: six of the key questions, the answers to which could define the outcome for financial markets next year.

Did 2015 mark the peak of the cycle for risky assets?

In short: No. We are overweighting equities as we head into 2016.

As we enter 2016, global equities and high yield credit remain below their peaks reached in 2015. Are we merely part way through a correction, or did 2015 mark the year of transition from bull to bear?

No bull market can last forever, and fears mounted through 2015 that the post-crisis upswing in risk assets is finally running out of steam. The sheer duration of the rally has stimulated suspicion that we could be “overdue” for a decline: the US equity surge is now in its seventh year, making it the longest bull run since World War II uninterrupted by a more than 20% fall. Confidence was shaken in August and September by worries over China’s growth, despite the fact that, at least according to official data, growth is meeting expectations.

Rallies in risk assets do not typically end for no reason. And today, none of the traditional catalysts for a bear market seem present:

Economic recession?
No. Global growth disappointed expectations set by the IMF in 2015. But the miss was marginal (3.1% growth vs. 3.5% originally expected). We expect a modest reacceleration in 2016 to 3.4% from 3.1%, driven by stabilization in emerging markets (even if China goes on slowing), and modest increases.

Corporate profit recession?
No. US earnings were temporarily depressed in 2015 by a strong dollar and the hit to energy companies from low oil and gas prices. These drags are likely to abate in 2016 (we actually see a slightly weaker dollar and higher oil prices through the year), and consumer spending remains robust. We expect 6–10% earnings growth. Elsewhere, improving growth in the Eurozone and Japan, accompanied by ultra-loose monetary policy, will support profits, and more stable economic growth and commodity prices should limit the pain on emerging markets.

Aggressive central bank hikes?
No. The Federal Reserve and Bank of England are both likely to raise rates, but only gradually. Both have proved in 2015 that they remain responsive
to economic conditions, and although inflation is likely to rise in 2016, central banks are unlikely to respond aggressively, given still-high structural deflationary forces.

Bubble valuations?
No. The MSCI All Country World Index is trading on a trailing price-to-earnings valuation of 18.4, relative to a long-run average of 16.9.

Expensive?
A little, but far short of the valuations usually associated with a valuationdriven sell-off. The index valuation peaked at 30.6 in 2000.

We will continue monitoring the incoming data closely. Recessions are difficult to forecast, and corporate profits could be vulnerable to falling profit margins, in particular in the US, if wage growth starts to pick up. Similarly, a sharp rise in commodity prices could suffice to force central banks’ hands. But these seem more like tail risks than forecasts on which to base investment decisions.ts on which to base investment decisions.

We are overweight equities as we head into 2016, with a focus on the Eurozone and Japanese markets.

Where do we stand on monetary policy?

Answer: It depends. But in general, central banks are likely to err on the loose side in 2016.

Today there are simultaneous calls for the US Fed to tighten and to ease. 

Similarly, the ECB is due to end quantitative easing by September, but there are also calls to expand the program. Where do we stand in the monetary policy cycle? Will the world finally transition away from central bank life support?

Last year’s Year Ahead publication was entitled the Diverging World, in part due to our expectation that 2015 would see monetary policies diverge: between higher rates in the UK and the US on the one hand, and quantitative easing in the Eurozone and Japan.

But central bank policymaking has seemed far from predictable in 2015. So, how can we more effectively read the central banks’ stance as we head into 2016?

We need to remember that:

  • Central banks care about avoiding deflation. Since the financial crisis, the world has faced four significant deflationary forces: bank deleveraging, China’s industrial oversupply, the use of new oil extraction techniques, and new technologies which have improved price transparency. Generating inflation against such forces is not easy, and in a world of high levels of nominal debt, central banks will look to ensure that a deflationary spiral does not ensue, and will fight this with determination if it appears close.
  • Central banks are not compelled to act while wage inflation is low. Although economic data is decent and unemployment is low in both the US and the UK, and we expect the Fed and BoE to hike interest rates in December 2015 and May 2016, respectively, we note that neither central bank is strongly compelled to act while wage inflation is so low. Without higher wages, their man- dates of meeting inflation targets over the medium term and maximizing employment can be fulfilled without changing rates.
  • Central banks don’t have to follow market expectations. It might be comforting to believe that the central banks can be “forced” to act by the markets, but 2015 proved that there is no particular desire among the current cohort of central bank chiefs to dance to the markets’ tune. The Fed surprised the market by leaving rates on hold in September, the ECB did not announce any new action to prop up a declining bond market in April and May, and the Bank of Japan has not added to its easing program, despite the Japanese economy disappointing expectations.

Our base case is for the Federal Reserve to increase interest rates to 1.25–1.50% by end-2016, for the European Central Bank to prolong quantitative easing beyond the scheduled end-date of September 2016, and for the Bank of England to commence hiking in May 2016.

Investment conclusion

We should prepare for another year of potential central bank surprises, and with deflationary forces still persistent and little sign of significant wage inflation, we should also expect policy to err on the side of “loose” in case of doubt.

Can China control its slowdown?

Answer: Yes and no. It cannot stop a slowdown, but should avoid major disruption. 

A disorderly crisis in the China remains outside of our base case, but ranks as one of the most serious potential tail risks to financial markets in 2016. In the first year of its 13th Five Year Plan, can China shift its growth model and control its slowdown?

Make no mistake. China has a lot of problems.

  • Leverage is too high and growth is over-reliant on credit. Total credit-to-GDP has risen to around 250% by 2015 from about 150% in 2008, and we now estimate that around 14% of total GDP is spent on interest payments to creditors. With nominal growth slowing, debt service is becoming an increasing challenge for Chinese companies, who are already among the most overleveraged in the world on a corporate debt-to-GDP basis.
  • Property is in vast oversupply. During a real estate boom between 2010 and 2012, construction outpaced demand for new properties – leaving a large inventory of unsold homes. If home sales remain strong, this glut will recede over the coming year and construction spending will recover. If not, house prices will resume their slide, consumer confidence will suffer and construction firms will run into financial trouble. China’s financial sector is also heavily exposed to the housing sector and property development.
  • China has a legacy of industrial overcapacity thanks to prior short-term, growth-boosting stimulus efforts. This leads to three key problems: a) large swaths of the manufacturing base are unprofitable and need increasing sums of government money to keep them operational; b) China’s employment base is too heavily linked to these unprofitable industries, and needs retraining; c) overcapacity in old industries is crowding out newer, potentially more efficient solutions.

From here, China clearly needs to find new drivers of growth. Yanking the old levers of increased property and industrial development will only lead to ever-greater debts. But these old industries need help adjusting: China cannot afford mass unemployment and/or a banking sector crisis.

Ominous as it sounds, we do believe the Chinese government stands a good chance of managing this process. We expect growth to slow, to 6.2% in 2016 from 6.9% this year. But notably, despite the concerns mentioned above (which we also had a year ago), growth in 2015 actually exceeded our expectations.

Chinese authorities have the advantage of a state-controlled banking system. A market economy investment boom is typically followed by a wave of bankruptcies, with knock-on effects on consumer confidence, business sentiment, and wider lending standards. China can support failing firms by doling out cheap loans, so staggering corporate failures and averting disruption.

The Chinese government also has the resources to backstop the financial system – with USD 3.5 trillion in currency reserves and a debt-to-GDP ratio of just 40%. That reduces the threat of a Lehman-style contagion event.

Investment conclusion

In short, we expect China to slow, but not to disrupt the wider picture for risky assets. We are overweighting equities in 2016, and have recently upgraded emerging market equities to neutral, and Chinese equities to overweight, in the context of an emerging markets.

Are we close to the bottom in the EM/commodity downturn?

Answer: Yes. But the emerging market hype is unlikely to return.

After underperforming developed markets for three years, and with Brazil and Russia in deep recessions, the gloom on emerging markets seemed all-consuming at times in 2015. Commodities have plumbed multi-year lows. Is this this dark before the dawn? 2016 could provide us the answer. 

Emerging markets have lost much of their shine since 2013. Their equities have lagged developed markets by almost 50% over that period, and GDP growth has more than halved since a 2010 peak. A combination of waning investor enthusiasm and cash outflows by residents means that EM are set for their first net capital outflow in 27 years in 2015, according to the Institute for International Finance.

With China slowing, commodity prices tumbling, and political and economic crises in Russia and Brazil, EM equity valuations have been left close to their lowest level since 2008, and the extreme currency weakness through 2015 has significantly improved external competitiveness. Whether 2016 truly marks a turning point will depend on several factors.

  • China avoiding a hard landing: If China’s government engineers a gradual slowdown, EM confidence overall will benefit. China accounts for 24% of the MSCI EM Index. It is also the top export destination for Brazil and Malaysia, and the second-largest customer for Russian companies.
  • A return to profit growth: EM corporate profits have contracted by 26% since 2011 in US dollar terms and 2% in local currency terms. In the tough market conditions of recent years, many firms have focused on preserving market share, rather than maintaining earnings or profit margins. A pick up in earnings and margins would provide solid evidence that the worst is over for EM investors.
  • Moderate tightening by the Federal Reserve: A rapid accumulation of debt has made EM firms more vulnerable to rises in US interest rates. The International Monetary Fund calculates this load has now risen to USD 18 trillion, four times its level in 2004.
  • A steadying of commodity prices: While top EM including net importers like China and India benefit from lower commodity prices, , many developing countries are highly reliant on raw materials exports. The likes of Brazil, Russia, Indonesia and South Africa have been harmed by tumbling commodity prices.

All of the above are consistent with our base case. We expect a slowdown, but not a hard landing, in China. We expect 4–6% profit growth for EM companies. The Fed is likely to remain cautious, and we believe commodity prices will move higher, overall, through 2016. This suggests that the worst is probably over.

Challenges still remain though, not least the need to find new drivers of growth and deleverage the private sector. So while the worst for EM has probably passed, we do not expect the exuberance of the mid 2000s' hype over the BRICs – Brazil, Russia, India and China – to return.

Investment conclusion

We recently upgraded our stance on EM equities from underweight to neutral, to reflect the more favorable outlook.

Is 2016 the year inflation returns?

Answer: Probably. But it also probably doesn't matter.

Bank deleveraging, commodity crashes, technological change, oversupply, secular stagnation... Pick your reason, but inflation has been absent since the financial crisis, despite central banks' efforts. Will inflation move higher in 2016?

The hyper-inflation that some economists feared from central banks’ money printing after the 2008 financial crisis did not materialize. Instead, price rises have fallen persistently below official targets in recent years. Three-quarters of the 34 OECD nations had inflation of 1% or below in late 2015. Ten OECD nations were even experiencing falling prices as of August. That compares to a 2% target set by most developed nations.

We think next year is likely to see inflation return toward more normal levels, especially as oil prices stop falling. Lower oil prices will exert progressively less drag on year-over-year headline rates of consumer price inflation starting next January. And while core inflation rates theoretically exclude energy, sharp moves in oil prices can still have an impact on almost all prices, given that they represent an input cost for a vast range of goods. As the energy effect wanes, inflation should increase.

Overall we expect inflation in 2016 to move up to 1.6% (from 0.2%) in the US, and to 1.0% (from 0.1%) in the Eurozone.

A modest rise in inflation would be welcomed, helping reduce the threat of deflation. But what will matter most to asset prices is central banks’ reaction. In theory, central banks should react to higher headline inflation rates by tightening monetary policy. But in reality, most monetary policy setters tend to look through the effects of varying energy costs, as was the case when oil prices increased in 2011.

Rather than an energy-driven rise in inflation rates, what might be more troubling for markets would be an increase in prices driven by higher wage agreements. This is most likely to occur in the US or the UK, where unemployment rates are low enough to seem consistent with workers beginning to demand higher pay. Should this occur, central banks would take notice, and markets could have cause for concern about the outlook for corporate margins. But with a relatively high share of underemployed or part-time workers available to rejoin the labor force, and with labor’s bargaining power having diminished relative to capital in recent years, the prospect of a significant wage-price spiral still seems distant.

Investment conclusion: So, overall, while we believe that inflation probably will move higher in 2016, it will largely be driven by energy prices and so represents little cause for alarm.

Will politics affect markets in 2016?

Answer: Yes. But we expect drama without tragedy.

The US presidential election, Brexit, a migrant crisis in the EU, and an economic crisis in EM. Politicians and electorates will play a crucial role in 2016. Will unpleasant political surprises in 2016 put economic growth at risk?

Potential dramas will likely come from:

  • Mainstream politicians losing ground: Anti-establishment candidates have been launching a strong challenge in both the Republican and Democratic primaries ahead of November’s US elections. In Europe, more extreme parties have been on the rise in France, Italy and Spain. That could further slow the pace of reform. A similar peril is present in EM, where falling commodity prices have strained many political systems. Investors will also be alert for signs of a deepening political crisis in Brazil.
  • Anti-immigration sentiment causing more disruption: A wave of refugees from the Middle East has been adding to the political angst in Europe. German Chancellor Angela Merkel’s commitment to open borders has increased the threat that she will be displaced. At the end of 2015, Poland elected an anti-immigrant government, while the power of the political right has also been on the rise in Denmark, Switzerland, the Netherlands, and Belgium.
  • Questions about security: The terrorist attacks in Paris and the further rise of the Islamic State could hurt consumer confidence and spending. The West’s stance on Syria is also now more complex.
  • Britain moving toward an EU exit: The anti-immigrant spirit also appears to have undermined support for British membership in the European Union, which will be put to a referendum either in 2016 or 2017. Mounting support for an exit could take a heavy toll on financial markets – undermining confidence in both the UK and the Eurozone. Without Britain, the EU would be more likely to drift away from market- friendly policies.
  • Concerns about the end of Abenomics: Reforming Prime Minister Shinzo Abe could have his wings clipped by legislative elections, expected around July 2016. Winning a majority in the Upper House is critical to ensuring that the structural reforms he has promised can be delivered. With the Abe administration’s approval rating falling below 40% after unpopular national security bills, victory is not assured.

These trends are undoubtedly worrying and will most likely cause market noise in 2016, but we do not expect to see any major upsets. Consumers have historically shown remarkable resilience against terror threats. The US primary campaigns often throw a spotlight on the most extreme wings of each party, but they would be unlikely to prevail against a centrist in a general election. Meanwhile, the political establishment in Britain is lining up in favor of continued membership in the EU. And the pro-EU Prime Minister David Cameron has the advantage of being able to choose the timing of a vote. Finally, in emerging markets, while there are many political perils, Argentina’s recent shift away from populism is an encouraging sign that economic hardship can also propel voters toward more promarket policies.

Investment conclusion: In short, we do not expect politics to create a long-lasting market impact in 2016, and remain broadly confident in our pro-risk stance.

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