2015 will be remembered as another year of disappointing growth. There were huge changes in both the global economy and the geopolitical landscape, making investment decisions all the more difficult. To remind you, some of the big events of the year were:
- Risky assets continued to perform as interest rates remained low
- Oil prices reached a multi-year low
- The slowdown of growth in China changed the dynamics of financial markets
- Syria and Iraq generated huge geopolitical interest
- Greece had numerous bailouts
- A varying approach to monetary policy emerged across Europe, the US and Japan
Many of these themes are likely to continue in 2016, and upcoming economic and political events may trigger further change in marketplaces. But, as is always the case with investing there are some risks worth considering.
The global economy looks stable. Global GDP expectations for 2016 are 3.3%, the average between 2010 and 2015 was 3.8%, but this is an improvement on the 3% estimate for 2015. Inflation is expected to be 3.2% in 2016, below the post-financial crisis average, but higher 2015’s 2.9%. Anaemic growth in Europe is likely to persist and inflation may rise gradually as the energy drop effect declines. The UK will lead the pack in Europe in terms of growth. Given this macroeconomic outlook the investment menu for a bond investor looks bleak, with higher rates in US/UK (so potentially losses holding bonds) and zero/negative rates in Europe/Japan. Italian bond holders of high maturities might enjoy positive returns given the European Central Bank’s (ECB) support and investors’ quest for yield.
Green light for monetary policy divergence. The US economy has grown faster than Europe and Japan since the financial crisis in 2008; the US Central Bank’s decision in December to increase interest rates by 0.25% is just the beginning of further monetary policy tightening in 2016, although it will be a slow moving process and potentially a drag for upside in US equity. The Bank of England may start to tighten, but only later in the year. The ECB and Bank of Japan should respond to anaemic growth and low inflation with further monetary experiments, this might increase interest in risky assets and assets outside of the Euro and Yen. This scenario hints further appreciation of the US Dollar, although it is still considered a very crowded trade.
China’s slowdown will not lead to an apocalypse. Further easing from the People’s Bank of China Bank, the Chinese central bank, and more expansive fiscal policy should alleviate deceleration in China (consensus for 2016 GDP growth is 6.5%), but the new reality will bring defaults or takeover among firms, mainly in energy and mining, that have relied more on debt to serve high-cyclical businesses in China. Markets have already priced in the news demanding very high credit spread, especially in US high yield bonds (from 2015 high we have a -6.5% return in Dollar terms). This could offer an interesting entry point because the tightening of the US monetary policy could be offset by a very high yield and a deja-vu of the 2015 commodity nightmare is unlikely.
Oil might be risky. China’s slowdown and Saudi Arabia’s attempt to put American frackers (shale gas producers) out of business, by refusing to pump less oil, had a relevant role in the oil collapse of 2015. Inventories could reach full capacity creating additional downside risk in the short term, potentially even a sharp correction if demand falls short. Oil consensus for 2016 year-end (Brent price) is still above $50 a barrel from the current $37 a barrel. Low oil is hurting many of the Organisation of the Petroleum Exporting Countries’ (OPEC) producers that might push harder to decrease production at the next OPEC meeting in 2016. Moreover, Iran, free from sanctions, should unleash an extra half-million barrels a day in 2016 on top of the current total world production of 95 million barrels per day. The US production decline will help to reduce global supply later in the year, potentially creating the conditions to reach the end-of-year forecast.
Emerging markets are still Cinderella. Emerging markets, excluding China, reached a debt-to-GDP ratio above 110% and oil uncertainty will be a further drag to oil-producing economies. Although equity valuations look attractive, Emerging Markets remain hostage to growth and earnings downgrades that don’t help improve investors’ sentiment. However, Emerging Markets seem better when compared to the crisis of the late 90s: total reserves/short-term external debt, a ratio to measure short-term country liquidity risk, is well above levels seen in the 90s, moreover most of the borrowing is in local currency, thus less risk in case of currency devaluation. Investors need to go through the first monetary policy divergences and assess the consequences of them for Emerging Markets before turning positive on the asset class.
The US Election, the next autumn blockbuster. Americans vote for presidential and congressional election in 2016, it is expected to cost $5 billion, more than double the cost of the previous election. In July, Republicans and Democrats will come together to choose their respective candidate. Hillary Clinton, the former secretary of state and first lady, is likely be the party nominee for the Democrats. Among Republicans the potential outcome is less clear, several candidates could compete for the nomination, with Donald Trump, the real estate magnate, the outsider. In the short-term there are no real implications on the economy, but the pre-election period could be characterised by a very soft approach to foreign policy, especially in Syria.
Brexit? The UK might decide to hold a referendum regarding the European Union membership in 2016. David Cameron, the UK prime minister, has promised to hold it by 2017, but there are several reasons to expect this in 2016: France and Germany will have elections in 2017, so they are not going to provide so many concessions to Britain to stay in during the pre-election period. Moreover, Britain holds the EU’s rotating presidency. Strong economy and immigration concern might polarise swing voters, but economic risks (as well as further independence woes from Scotland) would be clear in case of Brexit. This political uncertainty might trigger a lot of volatility during the year for Britain in the currency, equity and bond spaces.
Middle East geopolitical meltdown. Syria will continue to be a geopolitical playground, but the main instability may come from ISIS if there is not an agreed action plan among all the parties involved (Russia and NATO). Moreover, if Saudi Arabia, the biggest oil producer in the world, faces a spillover effect from the civil war in Yemen, and the oil price remains at the current (or lower) level for a prolonged period, the impact on the largest ever budget deficit will be dangerous. Social unrest will be the natural consequence, potentially culminating with a military coup attempt. This might trigger severe oil price jumps.
Equity prices face the reality of no more US monetary stimulus. If the US economy drops, it is likely that we will see a risk-off environment. The S&P 500 Index grew by 14.3% between 2002 and the beginning of 2007. From March 2009 until the end of December 2015 the S&P had annualised growth of 17.7%. Between 2002-2007 earning yield was growing in line with price appreciation, from 2009-2015 there was subdued earning growth and strong price appreciation. It seems that monetary policy, and indirectly corporations through buybacks, was the only reason to invest in equity. Now we face the tightening cycle and the equity derivatives market doesn’t show any signs of good news: the contracts to protect against the index drop are the most expensive in the last 15 years. A severe equity drop in the US could spread across all risky assets, especially on Developed and Emerging Equity Markets, again, making German bonds the only safe, although negative yield, asset.
2016 will offer several investment opportunities, given the abundance of themes and events. Market volatility is quiet at the moment, but last summer the Greek crisis and the Chinese equity bubble pop reminded us that the markets can always surprise, so capital preservation will still be our strong focus this year.