New York (KWR) December 28, 2015 - Our approach to forecasting global markets in 2016 is that this is an educated guess. Hopefully, we do better than what Mark Twain noted of venturing a view: "It is better to keep your mouth closed and let people think you are a fool than to open it and remove all doubt." At the same time it is important to recognize while one may be right on forecasting long-term trends and outcome - dramatic movements and market "noise" in the short to mid term can cause doubt and have a significant impact on performance. This is true in respect to selecting optimal entry, to avoid getting shaken-out, and to realizing shorter-term profits in the face of interim volatility. And we do expect volatility through much of the year.
With that in mind if you thought 2015 was a challenging year, just wait for 2016. The past year was dominated by the Federal Reserve, China, commodity price deflation, and related Emerging Market pain. Geopolitical events abounded - a massive migration of people out of troubled parts of the Middle East and Africa heading to Europe, a number of key elections (the most recent being Argentina, Spain and Venezuela), a very profound political crisis in Syria which now involves Iran, Russia, Europe, Turkey and the U.S., an uptick in radical Islamic terrorist attacks (Paris and San Bernardino), and an unraveling of the old political order in Brazil.? And Puerto Rico's $72 billion debt crisis only deepened.
The combination of the above factors played out in?global equity markets. Investors were confronted with several rounds of volatility, a painful downward plunge in energy and commodity prices as well as related bonds and equities, increasing worries over the health of the high yield market, and?a cooling in U.S. corporate profits. Not to cast all of this in gloom and doom - M&A activity in a number of sectors did help investors see gains in their stock and bond portfolios. And investors did relatively well if they owned FANG, a combination of Facebook (FB), Amazon.com (AMZN), Netflix (NFLX) and Alphabet (GOOGL). In many aspects the U.S. stock market and plain vanilla investments were probably the best bet, while a star, Emerging Markets, was painful.
But it was in the energy and commodity sectors that the carnage was probably the most gruesome. If you had purchased energy producers Chesapeake (CHK) and Marathon Oil (MRO) at $19.76 a share and $28.60 a share respectively at the beginning of the year (January 2nd), you were looking at $4.01 a share and $12.70 a share by December 21st. If that was not enough pain - if you owned stock in Freeport-McMoRan (FCX), one of the world's largest mining enterprises (focused on copper), you saw your price go rom $23.55 to a little over $6 in late December.
Where does this leave us in 2016? What are the main risks facing investors? While we think the U.S. stock market and high grade corporate bond markets are going to function more as a safe harbor to a lot more risk factors, the big calls are going to be on energy and basic materials, Europe and then later, Emerging Markets. The first group is increasingly "interesting" from a valuation standpoint - prices have been crushed. Companies have responded by slashing costs and cutting production. At some point the energy survivors are also going to offer up a buying opportunity, though we may have to wait through much of 2016 before it is worth buying.
The same is true in metals and mining companies. Although much of the sector appears toxic at this stage and is likely to see more pain before gain, companies like FCX, BHP, Barrick Gold (ABX), VALE, and Rio Tinto (RIO) offer value. Most likely these companies are not going out of business and will be among the consolidators at the other end of the cycle (which is still heading down).
The main risk factors for 2016 are as follows:
How far and fast does the Federal Reserve move on the interest rate front? We think that the U.S. central bank will be lucky to reach 2.0% on rates, considering the fragile nature of global growth and the drag factor a strong US dollar is on U.S. exports. However, if the Fed advances too quickly in the face of greater accommodation in Europe, Japan and China, the out-of-sync nature of global central bank policies can have negative consequences. The Fed has a delicate balancing act.
Do advanced economies continue to grow? This is a major question. The International Monetary Fund (IMF) has advanced economies growing at 2.0% in 2015 and picking up to 2.2% in 2016. In this, the U.S. is expected to accelerate from 2.6% this year to 2.8% next, while the Eurozone goes from an exciting 1.6% in 2015 to 1.8%. Japan is forecast at 0.6% in 2015, picking up speed in 2016 to 1.0%. We think that the IMF forecasts, made in October 2015, could be a little optimistic considering the slowdown in trade and the wide range of potentially disruptive geopolitical events. The decline in trade does worry us. This has implications on keeping a strong dollar and a weaker euro, which means Europe's economic gains could come at the cost of U.S. trade and economic growth. The rising U.S. rate environment and the QE approach of the European Central bank could only complicate this. And there is a chance, albeit small at this stage, for a recession in global growth, which modest advanced economies will not stave off.
Where does China go? No matter how you look at 2016, the direction of the Chinese economy is a major factor. The IMF is calling for 6.3% real GDP growth. Considering the questionability of Chinese statistics and the challenging business environment facing many Chinese companies (look for more consolidation in the state owned enterprise sectors), real GDP growth is probably much lower. China's authorities have rolled the dice in getting structural reform right, but major challenges leave this one of the most significant big risk stories in 2016. We do not see a crash in which there is blood in the streets; yet we will come close to that and the strong arm of the state will seek to maintain control. Scary times ahead.
The high yield market fall-out. In 2009, the rating agency Standard & Poor's marked 222 global corporate defaults, which was well above the five-year average. However, that default rate quickly declined over the next several years in large part due to the easy access to debt capital markets helped along by the highly accommodative policies of the Fed and other major central banks. The drastic plunge in energy and commodity prices has been a blow to many high yield companies and could show up on the balance sheets of some banks. In September, S&P noted that in the first nine months of 2015, 99 global companies had defaulted, with 62 in the U.S. and two-thirds of those in energy and natural resources. The problem is that more defaults are on the way and the risk is contagion to non-oil and non-natural resource-related companies, with an eventual contagion to the high-grade corporate bond market. Currently that risk is probably overstated. However, markets often run on animal spirits and liquidity in the bond market is much less than in the past due to Dodd-Frank forcing many of the banks out of what is considered "high risk." The biggest problem in high yield bonds is that in 2008-09 the ability of banks, central banks and investors to keep debt markets open to many companies meant that there was no massive wave of bankruptcies that often accompany economic downturns. The risk now is that investors are underestimating the number of high yield bankruptcies that are looming.
A full geopolitical menu for 2016. While a number of portfolio managers maintain that it is company fundamentals that matter and geopolitical risk really doesn't, they are missing part of the new normal in global investing. Global terrorism has a cost; war has a cost; and changes in government can complicate the business climate. In this the Middle East looms large, but geopolitical factors are likely to impinge on company fundamentals in countries like Argentina, Brazil and Venezuela. China, Russia, Turkey and South Africa can also be added to the list of geopolitically challenged business environments. Three other risks are worth considering - the U.S. presidential elections, the U.K.'s vote on whether to remain in the European Union (Brexit), and Spain's parliamentary elections and what happens in Catalonia. Clinton is likely to win the U.S. elections (though she has a lot of negatives), the U.K. is likely to remain in the EU, and Spain is likely to have to go to the polls again in early 2016 and Catalonia will emerge as a bigger issue as the year moves along. To this could be added risks associated with the South China Sea, Taiwanese-Chinese relations, and North Korea's erratic regime.
2016 is going to be another challenging year for investors. We think the big call will be energy and basic materials stocks and bonds, but investors could benefit from opportunities in a diverse range of overseas venues, such as Ireland, northern Europe and India. In the U.S. we like small and medium-sized regional banks- they have gotten better at risk management, know their customers, will benefit from a modest rise in rates, and do not have to contend with the volatility linked to involvement in debt and equity trading and issuance. Technology also remains a favored sector, especially those companies that are increasingly linked to the consumer sector.
As noted above, however, one not only has to get the trends and issues correctly, but also the timing. Therefore, even if one believes in the validity of the energy, basic materials and other themes we have highlighted, one could have made similar arguments over some of these earlier this year and seen significant declines.
Therefore one needs to be cognizant of volatility, both to minimize the dangers of being too early or late, and if you are temperamentally inclined, to take advantage of periodic declines and short-covering rallies. This could mean adoption of a cost-averaging strategy, occasional harvesting of profits, use of covered options or even short sales if that is part of your mandate.
Whether the long-term buy-and-hold strategies that served so many asset managers and older generations will remain the optimal approach remains to be seen. If nothing else, be prepared with a lot of volatility in early 2016, possibly carrying through to the middle or even late in the year.
Those are our humble thoughts for 2016. We wish you all the best.