New year, same old question: how to make money in financial markets? What’s changed beyond the obvious combination of a holiday-depleted bank balance, horrendous weight gains and a new calendar?
Often the answer will be: nothing much. However, 2016 has some crucial differences compared with the years since the financial crisis.
US interest rates are rising for the first time in a decade. UK rates also might rise. And emerging markets, in particular commodity-producing countries, are drawing down rainy day funds to balance domestic budgets or defend weakening currencies.
The central bank asset purchases that have fed financial markets are peaking. The free lunch is not over, with central bank chefs Mario Draghi in Europe and Haruhiko Kuroda in Tokyo still serving up generous quantities of food. But investors should expect sauerkraut and sushi, rather than a sumptuous global buffet.
As the monetary policy buffet serves up fewer dishes, investment outcomes should increasingly depend on quantifiable fundamentals such as growth trends and valuations
The feast has been munificent, with many asset prices fully valued or expensive. Markets essentially have borrowed investment returns from the future.
Watch the business cycle
Investors’ focus, therefore, should turn to the sustainability of the business cycle and the state of play in the profit, credit and valuation cycles.
The news is mixed here. The west is in a long, flat business cycle, with the US economy tracking the typical recovery after a financial crisis and the eurozone underperforming.
Japan teeters between recession and growth. Emerging markets are slowing and, in some cases, in actual downturns. Corporate profit cycles look to converge downward, with the exception of Japan. The credit cycle appears most advanced in the US, whereas we see it having a lot more runway in Europe.
Government bond valuations generally leave little room for upside without further monetary anaesthesia, whereas equities range from fully valued in the US to cheap in emerging markets.
It is important to look beyond the average, however. The ‘cheapness’ of emerging market equities is caused by lagging financial markets and resources; quality stocks are expensive.
The good news: there are few signs of the types of excesses that tend to end in tears.
Central to our outlook in 2016 are the intertwined strands of commodity prices, emerging market debt levels, and the path of the US dollar.
Headwinds for emerging economies
It is difficult to expect much respite for emerging economies until commodities recover. Low commodity prices and falling currency values press down on the budgets of emerging countries, their financial markets and, subsequently, world growth.
The supply of commodities needs to shrink for prices to recover given China’s economic transition from investment-led to consumption-led growth and the US shale revolution’s impact on the economics of oil production.
These headwinds are also challenging for high-yield bonds.
None of this is news – and many investors are betting heavily against emerging markets and commodities. This sets the scene for sharp, but likely temporary, rallies in these despised assets.
A few wild cards include Brexit, with the UK referendum to quit the EU potentially coming in the third quarter; war in the Middle East and its attendant risks of terrorism and refugee movements; and the US presidential election.
Testing market conditions greet 2016
Market volatility is here to stay, experts have said, urging defined benefit trustees to assess their risk management frameworks and eliminate unintended exposures as the year kicks off.
Markets saturated with monetary stimulus have long disregarded such risks. This pattern may not hold in 2016.
Share buy-backs and cash-funded merger activity already started yielding decreasing returns in 2015. Many equity markets once again relied on multiple expansion for (meagre) returns. We see top-line growth mattering a lot more in 2016.
Fixed income looks like hard sledding, although the need for safe, income-producing assets from long-term asset owners will likely dampen any yield rises in long-end bonds.
Prime real estate looks attractive for the same reason, alongside dollar-denominated emerging market sovereign debt.
As the monetary policy buffet serves up fewer dishes, investment outcomes should increasingly depend on quantifiable fundamentals such as growth trends and valuations. This calls for a change of tools with which to navigate investment markets in 2016.
Ewen Cameron Watt is global chief investment strategist at BlackRock
