Whither markets in 2016? - Perspective from a crystal ball

Perspectives from the Crystal Ball – 2016

As the year starts, the one thing the financial community seems to find a consensus on has been best explained below by Lewis Carroll in Alice's Adventures in Wonderland and Through the Looking Glass

“Down, down, down. Would the fall never come to an end? “I wonder how many miles I’ve fallen by this time?” she said aloud. “I must be getting somewhere near the center of the earth. Let me see: that would be four thousand miles down, I think—” (for, you see, Alice had learnt several things of this sort in her lessons in the school-room, and though this was not a very good opportunity for showing off her knowledge, as there was no one to listen to her, still it was good practice to say it over) “—yes, that’s about the right distance—but then I wonder what Latitude or Longitude I’ve got to?” (Alice had no idea what Latitude was, or Longitude either, but thought they were nice grand words to say.)”  

I did look long and hard into my Crystal Ball and after much ado I saw visions of the future, hazy, smoky a bit wobbly perhaps but here I go

•  Increasing complexities seem to be the overarching theme as well looking ahead. Divergence in monetary policies and hydrocarbons emulating Alice still searching for that bottom. Inflation falling sharply may seem like the tidings of good times for consumers in energy importing countries however the lull before the storm isn’t really what it seems. The central question remains, where are we off to this year? Where I say are we in the US, European and Global economic cycles. The visions indicated there’s some ways to go; there are signals of a pick up when we look at employment numbers and such statistics from the US in particular; BUT numbers and the quality of the numbers are different things and the employment pick up is at the lowest send of the ladder… hence hold the cheers for now!!
• The weakness in markets in the year gone by was more a mid-cycle correction and one that the realists were waiting for, the balloon had been floating ever higher for 5 years and the inevitable must happen. The knee jerk reaction to Chinese devaluation again was something which took the hopeful by surprise, the truth is that Chinese numbers have always been suspect and despite the commencement of the peeling of a layer of the devaluation onion by China; there is still a lot of structural stress viz. the shadow banking system. But then again, there’s no such ailment in China that a medicine cabinet filled with over US$ 3 trillion of reserves can’t fix.
• Monetary policy is likely to remain center stage this year and adjustment will keep the environment fluid; China will remain on the airwaves, mostly playing the sounds of the further peeling of layers of the devaluation onion.
• What might then we see happening to investments? We know that nothing really happened in the Fixed Income space last year – it was paralyzed by waiting for Janet Yellen and the Fed to decide. Now that we are up and away with a 25bps increment and by all means more indicated in the course of this year; short term rate hikes seem inevitable. But remember we are still midstream in the credit cycle which indicates better performance for the riskiest end; dare we say Emerging Market Debt and High Yield.
• Free money meant a bonanza for Private Equity and what a run it’s had. Playing to the tune of ‘Chariots of Fire’ this asset was driven by inflating asset prices and increasingly aggressive capital structures. Well, like all good movie themes; this one slowed and almost stopped amidst the volatility of 2015. The warriors sheathed their swords and quelled their aggressiveness. The tone now is more of caution; conservatism in Capital Structures and Lowering of Valuations. The spreads have widened and this is likely to offer sparkle for investors in illiquid and distressed credit as well as special situations.
• Hedge Funds were blindsided by a unique and temperamental set of events in 2015 leading to poor performance in general. Unique and temperamental wouldn’t be so if it repeated often and hence we would expect 2016 to be better for this asset class and indeed bring some opportunities to the table; especially for the more nimble amongst investors.
• To be a rewarding investment, the investment must produce wealth for which it should generate earnings. This was flat for S&P 500 constituents and unexpected at the same time last year. Sluggishness in global growth coupled with dollar strength were the main causes. This year we could see an improvement but one restricted to mid-single digits. Profit margins in the US are now at an all-time high led by wage pressure to the downside and almost free money and super low commodity prices: therefore where can the topline growth come from? One place where margins could expand is Europe in addition to economies which saw greater market turmoil and some sort a mean reversion seems highly likely there. However a sanguine investment sense is key and focus on individual corporate financials is where the opportunities would like, hence it’s going to be hard work to sniff out those gems for investment this year.

For investors hoping to cling to a fad or a manager who’s been kind of good in the past and expecting to make money, well their portfolio performance expectation can be really well described as Alice describes the horseman below:

“Whenever the horse stopped (which it did very often), he fell off in front; and, whenever it went on again (which it generally did rather suddenly), he fell off behind. Otherwise he kept on pretty well, except that he had a habit of now and then falling off sideways; and, as he generally did this on the side on which Alice was walking, she soon found that it was the best plan not to walk quite close to the horse.” ― Lewis Carroll, Alice's Adventures in Wonderland and Through the Looking Glass

                           Where do I put my piggybank this year?? 

 The old continent, Europe could be once such destination. At least for equities. The opportunity for growth here is backed by benefits accruing by continued or perhaps an expansion in Quantitative Easing and the joys of a Weaker Euro (at least for the Germans and other exporting members of the community). Japan, which was the darling for a couple of years is now more a cause of caution since not all of Abe’s arrows (there were 4 when he started off) fired and even fewer found their mark as would be ideally desired and China unpeeling that dreaded onion has also caused a bit of a stink in Japan. Treading with caution in the US would be a smart idea, given the valuations, the dollar and the Fed. 

The age of the spread in Fixed Income is the one appealing element in this asset class. I would believe that Yellen & Co. will handle the tightening of monetary policy with kid gloves given that the underbelly of the economy is still weak, which means that you the investor should be ready for increased volatility. Looking at credit based investment on the back of modest economic growth and attractive spread levels could be rewarding. High yield looking appealing again due to the appeal of the wide spread driven by commodity related weakness and credit quality within the high yield space seems quite healthy. In Emerging Markets the fundamentals for credit remain strong, driven by improvements in policy making, growth of regional markets and much better situation regarding reserves. This being said, expectations for this year would be flat due to softening domestic demand in major Emerging Markets and hinge on the longer term developed market recovery. 

Hedge funds which tripped over and went nowhere last year might have a better time now especially the directional strategies which could benefit from volatility. Valuations for Private Equity on the other side still remain elevated and the growth cycle tends to be much longer as well. 

Commodities fell from grace with a resounding thud last  year, and although the fall is still hurting, the bottom or thereabouts is perhaps where they are now resting at. Increased interest rates and mandatory Capex investments should be able to put a floor under this asset class, but then again it seem a while before they start their long uphill journey. 

Hence the future is uncertain (haven’t we all head that one before!!). But this time the uncertainties are highlighted by Janet Yellen & Co with future monetary policy and ditto for ECB, Japan, China and others; geopolitics, especially that of the Middle East and the Far East where China is flexing it’s muscles via it’s OBOR (One Belt, One Road plan – in case you are not familiar I have written a paper on this which you can refer to) and US with it’s TPP (Trans-Pacific Partnership) and we find ourselves in the midst of the latest edition of the great game being played out. 

The Fed will tighten but perhaps less than we believed 3 months ago but stocks still remain the best bet for the year ahead.

 Once again, Lewis Carroll explains it best between Alice and the Dutchess (with some assistance from this author): 

 Alice told the markets : “You've lost your muchness”

 And the Dutchess who heard her responded: “Every story has a moral you just need to be clever enough to find it”

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