2015 Review providing guidance for 2016 outlook?
11 December 2015
We have reached that time of the year when numerous outlook piece for the following year float across my desk. Somewhat surprisingly their generally rather optimistic economic outlook for 2016 does not quite tally at the moment with market action. For a second week equity markets have declined heavily, while government bonds have rallied. The jury is out whether the further falls in oil prices or the looming US rate rise is to blame. Fact is that oil prices fell to their 2008/2009 recession lows of sub $40/barrel and that markets now expect with a 78% implied probability that the US central bank will – for the first time in a decade raise rates in the coming week.
I would observe that it is very much the same factors which have driven market uncertainty for most of 2015 – the timing of the onset of monetary tightening (read: 1st rate rise) and falling commodity prices. Given markets appear to have already known for a while now that US rates will go up next week and lower oil prices should be a stimulus for the global economy, what’s the fuss about then?
I believe it is a concoction of end of year resignation of those who misjudged markets all year long, fears that yet lower commodity prices will hurt (some) developing countries. Most importantly, however, it is still the fears surrounding the US rate rise. Not that they will go up by just 0.25% next week, but rather that there is currently a stark discrepancy between the Fed’s official statements, that next year’s further rate rises will be very slow and gradual and the view of the rate settings committee’s members, the so called Dot Plot.
This chart shows where committee members expect rates to be at different points in the future. As can be seen from the chart, half the committee members expect rates to be above 1.5% by the end of next year. This would require 6 hikes of 0.25%, which is not just many more than the Fed’s words would suggest, but also much higher than markets are currently pricing in. Much will therefore hinge next week on the words chosen in the Fed statement the press conference messages and… the latest Dot Plot. I expect the Fed to do a better job at it than the ECB the other week. It should provide more evidence for their intent to increase rates very slowly in 2016. This should gradually calm markets and reduce their fears that fast rising US interest rates will have a devastating effect on debt burdened developing (commodity) economies, whose subsequent financial sufferance derails the Global economic cycle.
Sadly I cannot be certain that A. the US Fed will find the right tone of words and B. that the markets will interpret the Fed statement sufficiently positive, given their current nervous state. I therefore ascribe only a 50/50 chance to markets moving up significantly after the statement. It is therefore quite possible that we will end the year more or less where we stand at the moment – with low single decimal, to slightly negative returns for mixed asset investment portfolios.
Does such a result for 2015 therefore project towards what we should expect for 2015? By no means! 2015 was plagued by a formidable number of headwinds, which the global economy has weathered very well. I find myself in agreement with the outlook statements mentioned at the beginning – the highest probability economic growth outcome for 2016 is a continuation of the steady, but slow growth we have witnessed over the past year. The shocks of 2016, namely: Waiting for the first rate rise, the end of the commodity super cycle and the downward price inflation movement it brought, the strength of the US$ and the surprise over slowing Chinese growth momentum will all be headwinds which either can’t repeat themselves in 2016 or are very unlikely to do so.
From this perspective the look-back to what undermined market confidence in 2015 does indeed provide guidance for 2016. Without them, the corporate sector should continue to expand and private consumers should grow confident enough to start spending more of their commodity related savings, rather than using them to paying down their debts or saving them. This in turn has in the past instilled confidence in stock markets to look more positively into the future which drives them higher.
While my outlook for 2016 is therefore on balance positive, there will once again be events which upset the markets and some which could turn the positive scenario negative. More frequent terrorist assaults in the West and/or an emerging market debt crisis are 2 of such low probability events which we will be watching out for. Overall, however, I expect stock markets to do much better in the 1st quarter of 2016, compared to what we experienced during the 2nd half of 2015. Once the rate rise is out of the way and the realisation that the economy is still expanding materialises, markets will really struggle to ignore growing company result and future opportunities.
My main concern for 2016 will continue to be the high likelihood of poor returns from low risk assets like government and corporate bonds. Just like in 2015 they are most likely to only offer very meagre returns and at best have utility as risk (shock) absorbers against the volatility of equity markets which is likely to stay with us for a while. As rates and yields slowly rise, they will for the foreseeable future be relegated to risk management purposes, but investment portfolios’ return will come from risk assets like equities.