Outlook for 2016: Risk assets still attractive, but expect higher volatility

With the US Federal Reserve at last initiating its first interest rate hike in almost a decade, investors should be prepared for higher volatility across global financial markets, as central bank monetary policy divergence is set to widen.

But looking ahead to 2016, the key message from wealth managers is that the seven-year bull market has not run its course yet.

Risk assets still look attractive, if not for a lack of better options.

“We don’t think 2015 marked the peak for risk assets,” states Simon Smiles, chief investment officer for Ultra High Net Worth at UBS Wealth Management. Next year equity returns will be more muted, but still positive, albeit with heightened volatility, he adds.

The bank expects modest growth acceleration both in the global economy, predicted to expand from 3.1 this year to 3.4 per cent in 2016, and in corporate earnings. Encouraging signals have also emerged from UBS recent research on large, global entrepreneurs, with more than 50 per cent stating their intentions to invest and grow their business.

“This is a very different scenario to a contraction in the economy, typically associated with the peak of a bull market,” says Mr Smiles.

Finally, stock valuations are not cheap but not excessively high either to the point of justifying fears of major market corrections, according to UBS.

However, as the end of year approaches, equities and other risk assets are taking a hit, as investors are seeking safe havens. Swings in sentiment have driven some big ups and downs in markets this year, with the more recent sell-off in risk assets triggered by renewed fears over global growth, as oil prices hit new lows on concerns of oversupply. This fuelled worries of rising default rates in high yield debt, where energy companies make up a substantial proportion of issuers, particularly in the US.

 “We see market jitters as a largely sentiment-driven spill-over from the sharp falls in assets that have a more direct relationship with commodity prices,” says Alan Higgins, CIO at UK private bank Coutts. Though falling markets can provide good long-term opportunities when declines are not justified by underlying fundamentals, it is of course going to be painful in the short term, he says.

“Every decline in oil price has generally been positive for global growth with a lag, as it represents a big tax cut to the global economy,” he explains, stating that low energy prices should also help keep a lid on inflation and allow the Fed to tighten policy very gradually and only in small increments.

Also, the Fed rate hike should be seen as an endorsement of the positive outlook for US growth, which has been the driver of the current global economic recovery.

Both UBS and Coutts are overweight equities and in particular, in line with consensus, European and Japanese stocks, which are predicted to continue to outperform wider global equities next year. Both markets are expected to retain the support of the corporate earnings recovery cycle, which remains at an early stage versus the US, as well as ongoing central bank stimulus.

ABN Amro Private Banking also favours equities, having held an overweight position on the asset class for the past seven years. “As the correlation between equities gets lower, the equity market becomes more of an alpha game, rather than a beta game,” says Didier Duret, CIO at the Dutch bank, making a strong case for active management and long short hedge funds.

He prefers European to US stocks and believes Japanese equities, on which the bank has a neutral position, may continue to surprise investors positively in 2016 too, with corporate governance improving under ‘Abenomics’.

“Equities remain attractive in this very low yield environment, as investors are driven by a search for return as opposed to income, as central banks’ monetary easing has exhausted all sources of yield or made them volatile,” he explains. Indeed, decent yield today can only be found in high duration or low quality bonds, or in non-transparent asset classes such as infrastructure funds, says Mr Duret.

In the bull market since 2009, growth stocks have outperformed value stocks and this dispersion is now at extreme levels. But the situation may change, as the gap widens between high valuation, momentum stocks, in sectors such as IT and healthcare, and low valuation stocks in cyclical sectors, including basic materials, energy and financials.

“We can expect strong rotations across industry sectors next year, because of this huge valuation divergence,” predicts Mr Duret. The trigger may be a stabilisation in the oil price, or a change in expectations around the impact of Fed interest rate rises on emerging markets or another factor. As a result, ABN Amro is planning to broaden its investment style base, and reduce its current bias towards growth stocks.

Light at the end of the tunnel for emerging markets

In 2016, a reversal in sentiment is likely to take place with regards to emerging markets as well, believes Mr Duret, where significant outflows in the past few years have contributed to an enormous valuation gap with developed markets stocks. ABN Amro is neutral on emerging market equities but has a strong bet on Asia, in particular China and India.

UBS also sees light at the end of the tunnel for the emerging world. The bank was underweight emerging market equities for much of the last two years, but more recently has moved to a neutral position. Its two biggest recent changes within this space were to take Brazilian equities from an underweight to a neutral position and increase exposure to Chinese equities to an overweight stance.

“Since 2010, emerging market equities have underperformed developed market equities by about 60 per cent, but we see 2016 as potentially the end of their significant underperformance,” explains Mr Smiles at UBS WM.

He cites a number of underlying drivers, including trough valuations, almost at 2008 levels, stabilisation of commodity prices, supported by expectations of China’s growth at around 6.2 per cent next year, no headwind from the US dollar for the first time in a long time, as it is expected to depreciate slightly late next year, and earnings growth finally coming through. 

In general, investors worry that higher US borrowing rates, following the Fed’s interest rate rises, may be bad news for indebted emerging market economies, as not only will interest rates rise but repayment costs in local currency terms will also go up as the dollar strengthens. This could mean further stockmarket underperformance from emerging market economies, particularly from those that rely on commodity exports for much of their foreign earnings.

However, this interest rate hike may not significantly impact emerging markets, after all, as it is largely priced in.

“This is the most televised, rehearsed interest rate rise we have seen and it won’t be a factor for emerging markets. We expect a very dovish interest rate rise.”

Indeed, Fed Chair Janet Yellen suggested that future rate hikes will be slow and gradual and dependent on incoming economic data.

Coutts advises clients to be selective and focus on the cheaper and “hated” markets for macro-economic reasons, such as China and Russia, which are largely under-owned.

Lim Say Boon, DBS Group Wealth Management

Bringing the prospective of an Asia-based institution, Say Boon Lim, chief investment officer at DBS Bank in Singapore, explains the bank has been underweight emerging market stocks for the past couple of years but is turning more positive towards Asia.

“In Asia valuations are very cheap, earnings are already in contraction, so it is not a bad time to start thinking about repositioning,” says Mr Lim. The longer the contraction lasts, the more structural changes take place within companies, as they clean up their act, review their business model and growth prospects, and get leaner and refocus. “I have seen this through many cycles in Asia,” he explains.

One of the biggest disruptions in 2016 will be around currencies, says Mr Lim, predicting the US dollar could weaken in the later part of 2016. He says the US economy is not so robust to support a two year or even an 18 month cycle of rate hikes. The currency adjustment on the contrary is already fairly well advanced in emerging markets. “Much of the bad news is already priced in, in emerging market currencies, but not in the US dollar.” Also, a bottoming out of the commodities down cycle could help support emerging market economies, in particular Asia ex Japan, which is less commodity-driven.

Because of the divergence in US and European monetary policy, European stocks could be possibly more resilient to a possible sideways or bear US market, he expects.

“But fundamentals don’t give you much to cheer, simply because if the US dollar starts weakening in the second half of 2016, it is going to take a big driver off the European stockmarket, which is essentially a cheap euro,” says Mr Lim.

Caution on the US market

Looking at 2016, Mr Lim says he may turn more cautious on global equities – on which the bank holds a neutral position – as he turns more bearish on the US market, where corporate earnings growth has come to the end of its acceleration. Private markets represent good alternatives for investors, he says, with the focus being on private equity, private credit, mezzanine finance or convertible bonds.

ABN Amro’s Mr Didier believes, however, that investors should not be too negative on the US. “Europeans in particular have a kind of natural pessimism towards the US market but have been proven wrong several times.”

High valuations and an ageing earning cycle are key issues for the US stockmarket, warns Jim Paulsen, investment strategist at US firm Wells Fargo Asset Management, and investors should increase their exposure to non-US stocks.

Source: Wells Fargo

Compared to the rest of the world, US economic performance, company fundamentals and stockmarkets have directionally diverged by more in this recovery than in the last 20 years, explains Mr Paulsen. But should the current global economic recovery persist, non-US stockmarkets may begin closing the gap with the US.

Because the US economy is nearing full employment, faster global economic growth would likely aggravate cost-push pressures, worsen profit margins and accelerate the pace of interest rate hikes. On the contrary, as most non-US economies are not at full employment, they will benefit from continued economic growth.

 “The US earning cycle is much older compared to non-US economies, US profit margins are near post-war highs and cost-push pressures are likely to intensify. On the contrary, because non-US economic recoveries are still in an earlier phase of the current recovery cycle, companies in non-US stockmarkets will have a great ability to improve fundamental performance during the balance of this recovery,” he explains.

Also, since non-US stocks have been underperforming the US stockmarket for years, they are probably significantly underweighted in most portfolios, explains Mr Paulsen.
Finally, (see chart) non US markets have become increasingly attractive on a valuation basis relative to the US and because the US stockmarket has been so popular in recent years, it may be more extended on a risk basis than almost any other global market, he says.

As a result, within an equity overweight, Mr Paulsen recommends to maximise overweight to non US stocks – and prefer mid/small caps to large stocks – while adding some real asset exposure.

“I would stay overweight stocks, but a lot of it is by default, because where else are you going to go?”