The following outlines our market and economic outlook for 2016. Keep in mind these are projections are based upon current available information and may change as the year progresses.
- Developed economies should continue to see sluggish but somewhat better growth in 2016. We expect a continued global economic expansion in 2016 even though the world economy is vulnerable to downside risks. U.S. growth has averaged 2.2% this expansion and somewhat similar results can be expected in 2016. A slow pace of Federal Reserve rate hikes should contain upside potential in U.S. growth but not derail it as feared. We expect the current economic expansion to be elongated in nature. As monetary policy begins to normalize, fiscal policy should move from a headwind to a tailwind to growth conditions.
We see growth improving in Europe and Japan, driven by weaker currencies, better domestic demand, and fiscal stimulus. As in the U.S., upside potential in the pace of growth is constrained. Potential growth rates appear to have slowed around the world due to elevated debt levels and aging populations, particularly in developed markets. Unlike
last decade, service-oriented sectors are now driving growth, which tends to be domestically oriented and consistent with slower global trade.
- Global stocks remain in a longer-term bull market which began in 2009. We continue to believe market weakness should be viewed opportunistically. While prudent diversification is essential, a bias toward equity over fixed income exposure is warranted longer-term given modest projected returns for fixed income. We expect a choppy uptrend in 2016 with broader global participation. The S&P 500 has advanced on average 6.6% during election years (positive returns 69% of the time) and 7.0% during 6th year of the decade cycle (positive returns 77% of the time).
We believe U.S. valuations are relatively expensive and expect to see waning leadership and international stock outperformance. Valuation upside is constrained in the U.S. and higher rates should put downward pressure P/E levels. Furthermore, S&P 500 consensus earnings growth estimates for 2016 of 18% are likely too high in todays slower growth environment even though comparisons get easier as the year progresses. It appears international earnings have attractive recovery potential longer-term. We favor stocks over bonds and international over domestic equities.
- Sentiment is pessimistic which bodes well for a continued uptrend in global equities. Risks may elevate in 2017-2018 given Federal Reserve policy actions, the credit cycle, age of the economic expansion, political/election risks, and the presidential cycle. History suggests markets tend to struggle during times of high optimism/clarity and perform better when sentiment is negative and fear/uncertainty reign. We are currently closer to the latter.
- Global policy is supportive of growth. Expect a slow Fed tightening cycle combined with aggressive stimulus overseas. We anticipate a modest increase in interest rates in 2016 and a flatter yield curve. The pace of interest rate increases should be slower than the four hikes projected by FOMC members (we expect 2-3 moves). As they have communicated, the Fed should maintain a larger than normal balance sheet. We believe the market should be able to digest a slow tightening cycle for now.
More policy stimulus can be expected from China both in terms of currency depreciation and interest rate cuts. Policy should also remain very accommodative in Europe & Japan and we anticipate rates will remain low in these regions for years. Policy stimulus and the economic outlook favor international real estate.
- End of fiscal austerity is at hand in the developed world. We believe developed economies (particularly in the U.S. and Japan) are hitting the limits of quantitative easing. Fiscal policy is likely to play a greater role going forward as policy makers push for growth ahead of 2016 U.S. elections and 2017 elections in Europe.
- Policy makers continue to have an outsized influence on financial market leadership and returns, resulting in an unusually uncertain environment. We recommend investors stay diversified with an emphasis on markets with the strongest long-term return potential.
- The U.S. dollar bull market appears intact, but the pace of appreciation should be slower. The U.S. dollar appears overvalued but remains supported by monetary policy divergences. We are likely to see more divergences in the dollars advance rather than the broad strength seen in 2014 2015. We expect further weakness in the Euro as policymakers in the region attempt to spur growth. Emerging market currencies have declined nearly 40% since 2011 and are extremely cheap, but have yet to show signs of bottoming (which may coincide with a bottom in commodities). Expect steady weakening of Yuan as China seeks to stabilize exports and manufacturing.
- High yield spread widening may be overdone in the short-term if global growth improves but cyclical risks remain. Lower liquidity and higher energy sector exposure is increasing volatility for the assets class. We expect a reprieve in selling during 2016 and believe the asset class could outperform the broader bond market, but suggest investors stay conservative with credit exposure on a cyclical basis since spreads tend to widen in the later phase of economic expansions. We believe an attractive buying level for high yield exists when credit spreads reach 8% or more. As a result, we suggest a conservative approach to high yield, while favoring investment grade credit and floating rate strategies to benefit from higher short-term rates.
- Expect divergent fundamentals among emerging markets. After several years of poor performance, emerging market valuations appear inexpensive and offer favorable long-term return potential. However, cyclical risks remain elevated. Deleveraging and structural reforms are still needed in many emerging market economies and a collapse in commodity prices and slower global trade are pushing growth rates lower. The outlook remains challenged for those reliant upon commodity production (Brazil, Russia), exports, and dollar-denominated debt funding. Energy consuming markets (Asia) and those exposed to U.S. growth (Mexico) should benefit from global commodity/consumer trends. EM trends depend heavily on China where policymakers are navigating period of slower growth and a transition to service-based economy, which will likely occur over many years.
- Energy prices are likely to remain low for the foreseeable future. Oil and commodity prices are still searching for the bottom end of what should prove to be an extended trading range. Given the likelihood of continued financial stress, investors should focus on quality within oil/commodity-related areas.
- Favor large over small caps. While the valuation gap has narrowed, large caps remain inexpensive relative to small caps and are likely to generate equal or better earnings growth. Periods of volatility and rising credit spreads have historically posed challenges for small caps.
- Maintain a balance between value and growth styles and be careful not to overpay for growth. Growth stocks appear expensive relative to value, but not extremely so. Style leadership often does not change until bear markets/recessions, so markets may maintain a growth-bias over the intermediate-term with intermittent pauses in leadership. The handful of companies leading recent market returns (i.e. Facebook, Amazon, Netscape, Google etc.) are expensive and warrant caution. A growth-at-a-reasonable-price (GARP) approach appears prudent given valuations and the broader economic environment.
- Favored Sector Themes:
Technology – The sector should benefit as companies seek to raise productivity to offset higher wages and consumer electronics/software benefit from innovation and household spending.
Financials – Global financials should benefit from somewhat better growth conditions in 2016 and higher short-term interest rates in the U.S.
Consumer Discretionary – Consumer spending remains a key driver of global growth. In the U.S., the consumer discretionary sector should benefit from favorable household formation, rising wage growth, low interest rates, and ongoing improvement in the labor market.
- For investors seeking yield, emphasize dividend growers and international payers. High dividend payers in the U.S. remain exposed to the interest rate cycle and appear more expensive, warranting a bias toward companies able to grow dividends. This recommendation may change as the Fed approaches the end of tightening cycle. International dividend-paying strategies remain attractive on a valuation and yield basis and are poised to deliver attractive total returns in our view.
- Key Risks: There remain multiple risks to the investment outlook, including (1) the Fed is forced to tighten faster than expected due to a change in the inflation outlook; (2) an emerging market related crisis stemming from dollar strength or the collapse in commodity prices; (3) a hard landing in Chinas economic growth and policy errors associated with its transition toward more consumption-based growth; and (4) geopolitical developments. Further dollar strength, ongoing spread widening, and a continuation of extremely narrow market leadership would be warnings signs for the market advance. On a longer-term basis, inflation expectations appear very low with 5 & 10 year implied inflation of 1.3% and 1.5% respectively.
Bottom Line: Despite broad pessimism and caution, we expect improved results from diversified portfolios in 2016. Policy stimulus should be very accommodative and we are probably entering a new phase of increased fiscal spending as policy makers push for growth ahead of 2016-2017 elections. Continued sluggish global growth, while better in 2016, will likely limit
the extent interest rates will increase this cycle.
Investors should remain diversified and emphasize asset classes with the strongest long-term return potential: stocks over bonds, large over small caps, and international over domestic equities and real estate. Low rates suggest modest return potential for bonds, while international stocks remain attractively valued and have favorable recovery potential in our view. Upside gains in U.S. stocks may be restrained by valuations. We see the potential for mean reversion in cyclically-sensitive areas and caution against chasing the handful of recent market leaders. Instead, we suggest favoring an approach oriented towards large caps and growth-at-a-reasonable-price (GARP).
Technology, financials, and consumer discretionary remain attractively valued and appear as the best positioned sectors for 2016 in our eyes. For investors seeking yield, we suggest a conservative approach to corporate credit, continue to like floating rate strategies, and recommend dividend growers and international dividend payers.