January 2016 – Finding Opportunities in a Changing World
Risky assets took somewhat of a breather in 2015, following the near-tripling of the S&P 500 since March 2009, as the aforementioned conditions weighed on markets. The general market consolidation was evidenced by the clustering of returns for the S&P 500, Barclays Global Aggregate Bond Index and cash, which returned between -3.15% and 1.38%. Commodities dove 25.5% as measured by the S&P Goldman Sachs Commodity Index. According to Bianco Research, there had only been one year since 1995 when the best performing of these assets did not return 10% or more. This past year was the second.
What does this mean for the next twelve months? Our 2016 Outlook, Finding Opportunities in a Changing World, will be published this month and contains our macroeconomic outlook and investment views. The main thesis is that a still accommodative monetary policy environment combined with a steady acceleration in global growth will produce positive returns for risk assets. The Federal Reserve is embarking on its first rate hiking cycle in ten years and volatility is expected to be higher as a result.
Still, structural forces including technology and demographics are likely to keep inflation rates at lower levels and will lead to a gradual process of interest rate normalization in the U.S. Elsewhere, the rest of the world’s most important central banks, the European Central Bank, Bank of Japan and People’s Bank of China, will continue along their expansionary paths of monetary policy. Investor sentiment has also been eroded and any upward bounces to growth are likely to draw in more cash from the sidelines.
We expect the acceleration in growth to be the strongest in Europe, while the U.S. expansion grinds higher led by domestic demand and the services sector. China’s transition to a more-consumption driven growth path will be rocky, but we do not anticipate a “hard landing”. Only when the market is convinced of this fact will commodities find their equilibrium price level and emerging market risk assets move higher.
In terms of asset allocation, a higher volatility regime requires a more selective, tactical and nimble approach to take advantage of relative value. While we cannot control volatility, we can certainly prepare for it. Generating positive returns in 2016 will require a more active approach to portfolio management in order to take advantage of relative value opportunities.
On a geographic level, we prefer European equities given a more supportive monetary policy backdrop, macro tailwinds and the potential for further margin expansion. To a lesser extent we are also constructive on Japanese equities given relatively attractive valuations, Bank of Japan policy and shareholder friendly reforms. We think high-yield bonds offer an attractive risk-reward profile but are more cautious given our expectations for a pick-up in defaults among commodity-issuers. That being said, yields at close to 9% are pricing in a more dire U.S. economic outlook than we envision, suggesting investors are being adequately compensated. Within high yield, we prefer Europe over the U.S. given the earlier phase of its credit cycle and expect mid-single digit returns. We continue to remain underweight commodities and emerging markets until expectations for China’s growth improve.
The principle risks to our view reside in the U.S. and China. Given the extent to which markets are betting on a continued U.S. economic expansion, a major growth disappointment would severely impact the global outlook. This could come from another sharp appreciation in the U.S. Dollar or the retrenchment of the U.S. consumer given economic uncertainties. The second risk consists of a further downgrade in Chinese growth or a sharp devaluation of the renminbi (RMB). The latter would constitute a shock to emerging market competitiveness and could set-off a series of competitive devaluations further igniting the deflationary impulse. This would alter our pro-risk stance and merit a migration from equities into lower-risk fixed income assets, including government bonds.
Globally, policymakers are confronting the challenges of low-growth amid secular technological and demographic shifts. While monetary policy has gone a long way towards staving off crisis and lowering the cost of money, markets have grown less convinced that central bankers can solve the low-growth issue alone. On this basis, we believe fiscal policy and investment in productivity will receive increasing attention among investors as ultra- low interest rates are deemed as necessary, but not sufficient to stimulate real economic growth in large parts of the world.
This more complex landscape will produce deeper and more frequent bouts of volatility. In our view, generating positive returns requires increased flexibility and the ability to look through these periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.