A macro outlook for 2016

Paul Niven, Manager, Foreign & Colonial Investment Trust.

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Looking into 2016 market risks abound and the start of a US tightening cycle raises new challenges for investors. Divergence in monetary policy between the US and other major central banks should lead to further dollar strength and we will likely see the global economy struggling to reach escape velocity. Despite the fragile backdrop further ongoing improvement in the Japanese and European economies should be evident in 2016. China is clearly on a path towards lower, and perhaps more sustainable, rates of economic growth and market expectations there are, once again, likely to be considerably more volatile than are the underlying fundamentals.

It is important to note that, in each of the past five years, the consensus has entered each new year with an expectation for an upturn in global growth, recovery in global trade, generally limited movements in foreign exchange markets (with flat to rising commodities) and for disinflationary pressures to abate. Expectations for 2016 look very similar (and optimistic) but, in each of the preceding years, these bullish economic expectations have been dashed and investors have subsequently had to content themselves with mediocre and uneven growth.

On policy, there is a clear divergence between the US and the UK, where liquidity will likely be tightening and Europe and Japan, where further easing looks probable. Emerging Markets, while a heterogeneous group, face common macro headwinds which will likely persist for some time. One may take the view that modest rate rises in the US will be more than offset by easier policy elsewhere but there are clear risks in such a view given the importance of US dollar liquidity for financial markets.

Nonetheless, while we remain on a shallow growth trajectory and are vulnerable to shocks, the surplus liquidity from the European Central Bank, Bank of Japan and the People’s Bank of China should enable the global economy and financial markets to avoid some of the more concerning potential scenarios. That said, volatility in financial markets was an easy prediction for 2015, and a similar prognosis makes sense for the next twelve months as well.

Making the assumption that the US avoids a material downturn over the coming year and that growth elsewhere continues to improve, for the time being we continue to back, on a geographical basis, Europe and Japan. We have higher weightings in these areas than was the case a year ago and most of our borrowings are in Euros and Yen – the currencies where the central banks are most likely to be easing policy further. The US has shown narrow breadth, in terms of stock leadership and, at the wider level, there are troubling signs of a potential topping in margins and profitability. Conventional wisdom may suggest that, after a disappointing and prolonged period of underperformance, rate rises will help ‘value’ stocks to begin to lead. There is little sign of such an inflection point being reached yet and, if the broader macro environment prevails, modest rate rises may well not be sufficient to divert investors’ focus from quality and growth attributes, which have been richly rewarded up to this point.

In addition to these issues, Emerging Markets and commodities remain key considerations for investors. In recent years, a bearish stance on these areas would have assured strong relative returns. With performance of these sectors being so poor, the question must be when, for the contrarian investor, the time is right to enter long positions. Aside from shorter-term tactical considerations, my view currently remains that 2016 will not be a vintage year for commodity producers. Given the extent of price declines it may be the case that a bottom has been found but I see little prospect yet of a sustained upturn in performance. With divergence in global monetary policy, smaller central banks may well struggle to control flows and diminishing US dollar liquidity represents a challenge. In addition, despite the devaluation in 2015, China’s currency has appreciated materially against competing nations and there remains a risk of downward currency adjustment there. Within Emerging Markets it remains appropriate to focus on those markets with relatively low levels of external vulnerability, decent domestic liquidity, a stable political environment and prospect for structural reform.

As we navigate through 2016, there is every chance that the odds of a US downturn will begin to rise, particularly if the labour market continues to tighten and corporate margins come under further pressure. The bull market is getting long in the tooth, leadership (geographically) has changed but risks (and volatility) are rising. 2016 looks set to be a challenging year and we continue to focus on quality corporates with secure and dependable earnings, supported by reasonable valuation levels.