2016…dealing with “the new normal”

Jan Straatman (pictured), global CIO at Lombard Odier Investment Managers, shares the firm’s 2016 outlook.

This time last year we predicted that 2015 would be a year of very difficult economic and market conditions and labelled our base case scenario “kicking the can forward.”

On reflection, we could argue that it was the year “central bankers took over the world.”

We saw the central bank in Switzerland drop the Swiss franc peg to the euro; China allowed the renminbi to drop, creating havoc within markets; while the Fed created a great deal of anxiety around when and by how much they would raise interest rates.

In addition, we saw both equities and bonds simultaneously produce poor performance in the US for the first time since 2008. Was 2015 a year of exceptional circumstances or can we expect a continuation?

At Lombard Odier IM we believe that actually, episodes of sharp volatility and cyclicality within capital markets are likely to persist in 2016. We have labelled this “the new normal” and expect turbulence to remain for some time.

What does “the new normal” look like?

As we move into the new year, we expect to find ourselves in an environment of continued low asset returns, subdued inflation in both the US and eurozone and a persistent structural slowdown in China, coupled with geopolitics shaping up to be the 2016 wildcard.

Against this background we have identified a number of key themes that we believe have the ability to create dislocations in both the economy and capital markets.

These themes could largely influence our environment and impact how we deal with investors’ portfolios in 2016.

We have grouped these themes into two categories, Economic “the five Ds” and Investment “the five Ls.”

Economic themes

  • Disinflation
  • Decoupling
  • De-leveraging
  • Differentiation
  • Political disparity

Investment themes

  • Low yields
  • Low risky asset returns
  • Lower liquidity
  • Lower certainty
  • Lower diversification

Global macro outlook

Keeping “the five Ds” in mind, we have established three economic scenarios, not too dissimilar to our views in 2015.

1. Base economic scenario – “Japanisation” of Europe and slower US decoupling (60% probability)

Our base case scenario sees interest rates in Europe remaining low for the foreseeable future (similar to Japan post the 1990s crisis), very slow recovery, continued disinflation and a relatively “stop and go” effect created by quantitative easing (QE).

Within this scenario we expect to see the US economy/markets continue to decouple more gradually, leading to a very slow cycle of rate hikes.

2. Alternative economic scenario (30% probability)

This is a very positive scenario which sees the success of QE in Europe, leading to increased inflation, fuel for the economy and a sustained increase of demand, coupled with continued moderate growth in the US and a more synchronised shift in monetary policy stance across the globe.

3. Tail-risk (10% probability)

This scenario witnesses a collapse of QE, with implementation issues leading to the reopening of political divisions. The Bundesbank has already made its views (unfavourable towards QE) clear.

If growth remains subdued and/or QE faces implementation challenges, then a sharp move back towards political polarisation cannot be ruled out.

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