The crucial allocation question for 2016
On the headline numbers alone, 2015 appears a rather dull year by historical standards: the S&P 500 closed down just 70 basis points (bps) over the year, US 10-year yields were little changed at 2.27%, and the VIX closed the year at 18—all suggesting a becalmed market.
Even the trading ranges will give market historians, in years to come, little hint of the gyrations investors endured in 2016; the 14.1% high to- low trading range of the S&P 500 was well below the average high-to-low trading range of the last 30 years of 28.8%. But in terms of market events, 2015 was anything but dull—the first US rate hike in nearly a decade, the start of European quantitative easing (QE), the de-pegging of the Chinese currency, a 30% slump in oil prices, and the worst year for US high yield since 2011. Headline numbers might imply a sedate version of history, but to appreciate the significance of 2015 “you really had to be there”.
We view 2015 as an important year in the evolution of what we expect will become the longest period of US economic expansion in history. It remains to be seen whether the US will successfully transition from seven years of zero interest rate policy (ZIRP) to a more normal policy setting, but we are optimistic. The financial adrenaline of QE and ZIRP drove the S&P 500 to its second longest bull run of the last half century. While it is true that we may have “borrowed” some returns from the future, we would not bet against further, modest upside to US equities in the next couple of years given the broad-based strength of the US consumer.
The final quarter of 2015 was an important barometer in gauging US policy. We started the period under no illusion that the current Federal Reserve (Fed) is more sensitive to international conditions than its predecessors, and ended it with a rate hike that demonstrates it is the domestic economy which ultimately sets the Fed’s agenda. The market may have expected a “dovish hike,” where a lowering of policy projections blunted the 25bps hike in the fed funds rate; instead we got a “bullish hike,” where upbeat projections of growth and normalising inflation justified tighter policy.
The great unknown for market confidence remains the global growth outlook. In many ways, 2015 was going well until the summer, when a scare over emerging markets (EM) and, specifically, Chinese growth hit global markets. We are optimistic about the European economy for 2016, and near-term economic momentum in Japan is turning, albeit from a low base. The major question remains when economic stress in emerging markets will start to clear. The commodity price slump over the year is probably the best indicator of the current dominance of developed market (DM) over EM growth. Tumbling prices for bulk commodities like iron ore (-22.6% in 4Q15) and metals like copper (-8.8% in 4Q15), together with the ongoing malaise in global manufacturing, reaffirm the bifurcation between goods-producing emerging economies and services-consuming developed economies.
Sluggish manufacturing and trade may dampen global growth, but they do not represent a large enough component of US GDP to seriously threaten recession in 2016. Instead, the US dollar and oil will be crucial determinants for markets in 2016. We don’t expect the oversupply of crude oil or the interest differentials that drove the US dollar to miraculously vanish as the calendar ticks over, but we do see a path for these stresses to ease.
Low risk appetite and poor sentiment amplified the impact of oil weakness and dollar strength in 4Q15, so the clean slate that the New Year provides will certainly help. But it will be more important to see global policy divergence hit its high water mark in 1Q16—we should know by March whether or not the Fed will carry through with its planned four hikes in 2016. At that point the hiking cycle should be priced into the US dollar and there is scope for the currency to stabilise, in turn providing relief for EM economies.
In 2015 high yield acted as the lightening rod linking EM and commodity fears to the US domestic economy. This was especially evident in the fourth quarter as spreads blew out and fund liquidations caused even the most resolute bulls to pause for thought. We maintain our view that, absenting a US recession, high yield spreads are now excessively wide. Liquidity is a concern and we don’t anticipate a return to the heady credit bull market that accompanied the latter stages of US QE.
The outlook for energy and resources high yield is bleak, but away from these sectors we see low default risk and generous compensation for liquidity. If credit spreads are signalling a recession, as some believe, it is likely well contained in the energy sector. If anything, the rest of the economy has yet to reflect the positive effects of cheap oil.