"An economist is a surgeon with an excellent scalpel and a rough-edged lancet, who operates beautifully on the dead and tortures the living." - Nicolas Chamfort (1741-1794)
FOR all that happened in 2015, one has to wonder if it will be lost in the textbooks as a pretty uneventful year. Sure, it was the year of Ukraine, the Volkswagen scandal, "unicorns", ISIS, China's slowdown, Fed "liftoff" and another chapter in the Greece drama, but what really changed? We believe US and world stock markets will open 2016 within a few percentage points of where they opened in 2015.
Valuations, as measured by P/E ratios, have moved very little. In the bond market, 10-year yields in both the US and Germany are virtually unchanged from 12 months ago. Positive, yet sluggish growth remains the economic background for the US, eurozone and Japan. China is still managing its slowdown, the Fed is tightening, and Greece still isn't out of the woods. You'll forgive us if this year's outlook has a lot in common with 2015.
That said, there are some important transitions occurring in 2016 that colour our views. Fed tightening will move from theory to practice, emerging markets will adjust to a slower China, and global consumers may finally feel the tailwind of lower energy/commodity prices. With that as background, and with Chamfort's admonition above, here are our Outlook & Themes for 2016:
1. Developed market growth improves (a bit)
Macroeconomics 101 teaches that growth is a combination of consumption, investment, government spending and trade (or net exports). In varying degrees, and across varying geographies, we see modest tailwinds for each of these factors.
It is currently hard to find concrete evidence that lower energy prices are boosting global consumption, but consumers don't typically change their spending habits until they are convinced lower energy costs are sustainable. With the world awash in oil, gas and other natural resources, lower prices now look more sustainable so consumer spending should pick up in 2016.
Excluding the energy sector, capital investment should improve as the cheap debt/stock buyback trend slows. While fiscal headwinds remain, government spending should pick up as populism grows and austerity fades. Lastly, global trade should rebound as exchange rates stabilise. We expect none of these factors to rebound significantly, but to improve at the margins. This should boost overall growth across the US, Europe, and Japan, but only by 0.5 per cent to 1.0 per cent in real GDP terms over their current levels. Nominal growth (including inflation) should improve by slightly more.
2. Central banks: Words louder than actions
Our base case is that the key central banks around the globe do very little to alter their current paths. While the current "dot plot" is forecasting four 25-bps rate hikes in 2016, we expect only three as the US Fed has consistently overestimated growth and inflation - this is the so-called "dovish hike" scenario. The European Central Bank (ECB) will likely remain supportive of risk assets while continuing to make minor adjustments to its QE programme, but we expect no significant increase in the size of the programme next year. The same could be said of the Bank of Japan (BOJ).
Lastly, the Bank of England (BOE) will remain in limbo as inflation continues to underwhelm. Only at the People's Bank of China (PBOC) do we see enough downside growth risk, and the flexibility to address it, to continue to push rates down materially (supported by low inflation in China). In the end, while policy moves will likely create additional volatility (fear) in a world addicted to low rates, we see the impact of central banks as a bit more muted in 2016.
The Fed and BOE will remain dovish (frustrating bond bears) and ECB and BOJ won't significantly expand QE (frustrating bond bulls).
3. Global equities gain ground, but not much
Here, our 2016 view is not significantly different from our 2015 outlook - principally because many of the variables haven't changed very much. We continue to expect a relatively range-bound outcome. A slightly stronger global economy (See #1) should push corporate earnings up at the margin. However, wage growth (wage costs) will keep profit margins in check.
Energy prices may remain under some pressure, but earnings in the sector will not represent nearly the same drag as they did in 2015. Overall, we see earnings growing by 5 per cent to 7 per cent on global equity indexes, only slightly better than 2015.
On the valuation side, a broad set of metrics tell us roughly the same thing - stocks are fairly valued, perhaps slightly overpriced vs long-term averages. As in 2015, we see no reason for valuation multiples to materially expand or contract, especially in an environment of only gradual Fed tightening.
However, investors should expect this very "average" (or "slightly below average") outcome to be earned in a very unstable state. While mid-single-digit return expectations are very much the consensus across Wall Street today, consecutive years of single-digit returns are fairly anomalous.
A market correction (-10 per cent peak to trough) or even a bear market (-20 per cent) is likely, eventually giving way to a rally back to average. The most likely culprits of a broad equity sell-off include a Fed tightening scare, illiquidity spillover from the high yield market, or a refugee/Brexit crisis in Europe.
4. Rates dull, but credit lively
The noise around interest rates is unlikely to amount to much action for bond investors. We believe the combination of little meaningful central bank action (See #2), secular stagnation with modest upside growth (See #1), and only slight increases in inflation premiums means that interest rates will be pushed up only slowly.
The dominant force holding global rates in place will be continued QE from both the ECB and the BOJ. In the high quality/sovereign bond market (US, UK, Japan and core Europe), investors can expect small principal losses (slightly higher rates) to eat up current income. Pretty much our view from last year.
More interesting will be the action in the credit markets. Corporate bonds, both investment grade and high yield globally, have been lagging the sovereign indexes for the past six-plus months. We expect this to continue in the near term as markets grapple with the perceived pace of Fed tightening.
The level of underperformance to date (outside of high yield energy names) hardly qualifies as a crisis or bottom. We expect bouts of illiquidity will continue to plague the markets in the near term. However, similar to our (incorrect) forecast last year, we expect the credit sectors of the market to outperform high quality sovereign/agency debt over the course of the year. If credit spreads simply stabilise near current levels as the economy slowly improves, we would expect credit to outperform lower-yielding sovereigns.
5. Emerging markets rebound
Emerging markets, particularly on the equity side, remain under pressure from a nearly perfect storm of well-known factors including China slowing, a global commodity rout, and Fed tightening.
As these factors have unfolded, emerging market equity indices have underperformed their non-US developed market counterparts for five years running (on a local currency basis).
At this point, market prices already adequately reflect these risks. While the relative valuation gap between EM and developed equity is not large, it does represent some price support. We expect EM to outperform in 2016 with most of that coming in the latter half of the year. We still expect another shoe or two to drop before EM sentiment bottoms (or EM hatred peaks).
2015 was a difficult year for investors. Across stocks, bonds, currencies and commodities, most asset class returns were flat-to-negative. We expect better opportunities for investors in 2016, but returns won't come easily. The storm clouds brewing at the end of 2015 are likely to persist into the first half of 2016, so the best asset to have might be patience.
David Lafferty is senior vice-president and chief market strategist and David T Reilly is vice-president and investment strategist for the Investment Strategies Group of Natixis Global Asset Management.
This article was first published on January 6, 2016.
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