Market Outlook 2016
First Quarter 2016
Well, 2016 has started with a vicious down move in global equities with some extreme volatility in virtually every market including; large currency movements, bond rallies despite the US interest rate hike, crude oil falling to new lows and gold surging higher. Doomsday forecasts are gaining traction as prognostications focus on multiple risks including; global recession, the failure of monetary policy, significant Chinese currency devaluation, an increase in a deflationary cycle via the commodity collapse, the end of the post-WWII credit cycle and now possibly the UK initiating the collapse of the European Union. That’s not even an exhaustive list, but it’s a good start.
There has been a wide range of commentaries on what policy makers globally could, would and/or should do, varying between doing nothing to more nuclear options like ‘helicopter money’ and debt jubilees. We have our own views, but that will not change the outcomes. As managers, we need to ask more important questions and then focus on where to invest. Certainly preservation of capital is important, but typically investors want returns as well. Traditional means of capital preservation may not in fact preserve. With low to negative interest rates, coupled with the possible repercussions of low (or no) inflation currently, may well be followed by a period of high inflation to wash away mountainous debt at both the government and private level. However, we think this is years away and probably preceded by some very harrowing times given the viability of some nations.
Our opportunity resides in the ability to quickly alter investment positions between equities, currencies, bonds and commodities; essentially, the full universe of investment options including 100% cash and/or short. Investment options aside, we still need to get it right or that opportunity provides no value. Views on the current and future state of the market and economy are important- but so is our ability to change when presented with new evidence or extreme volatility.
It may be best to start with interest rates. We, like many others, think that interest rates will stay very low for a long time. Post Great Depression, rates stayed low into the 1960’s. Given that, the nadir of the Depression may have been 1932. The impact of low rates is uncertain, however we suspect that returns across asset classes will be enduringly slim. Extremely low to negative interest rates are not a great idea in our view, but we do not set policy so we will take it as it is.
Rates and Quantitative Easing have affected investment markets, but in our opinion, this has been primarily a placebo effect. That is, investors believed an effect would occur or was occurring and jumped onto what appeared to be a moving train. The underlying effects appear to have been small, but with significant market reactions. We believe that markets were wrong to over interpret, likely outcomes and myths have been created and accepted.
For example, there is a view that QE inflates asset prices. However, PE ratios are not particularly elevated globally. The leading light in monetary experimentation, Japan, has not been able to raise their equity markets for years. We may be wrong in our assessment, but, if anything, we think QE and ZIRP depress asset prices over the medium term.
Regarding currencies, we have similar views to equities, in that QE may actually be supportive of a currency and currency traders have possibly been tricked into believing the opposite. Observe the strength of the US Dollar AFTER the Federal Reserve indulged in three rounds of QE (or four depending on your view). With this considered, it may highlight a potential direction of the Yen and the Euro. We are focused on any trend change in this space and interested to see the outcome.
Currencies will always be ‘the tail that wagged the dog’; so most of our efforts are dedicated to what is going on in the currency space and consequent impact on other markets. It is no coincidence that the Yuan devaluation in August last year took down equity markets. Similarly, fears of further Yuan devaluation are impacting markets now.
In the commodity space, our belief is that it is almost purely a US Dollar story. The decline in the US Dollar post 2000 and compounded post 2003 ignited commodities and also financialised them for a time. The US Dollar rally from 2011 onwards has subsequently smashed commodity markets. The countercyclical nature of these two assets with the enhanced production justifies today’s commodity prices. What is the effect of China on commodity prices? We think China has an almost zero effect on commodity prices- but many disagree with that.
So the direction of the US Dollar will be very critical. We think the US Dollar weakens and ironically that would benefit the world even though multiple central bankers appear adamant on devaluing. We believe these devaluations are misguided (and evidently so do the equity markets which have fallen on continued ‘stimulus’), again, we may ultimately be wrong.
Direction for 2016
So where does the year 2016 go? We often hear that making predictions can be unwise, but we make them all the time- and we change our mind when it appears to be incorrect.
- Equity markets globally are currently reasonably priced. They should end the year higher despite the gloom.
- The US economy comes out of a soft patch and performs for the rest of the year.
- Rates stay very low, but long-term bonds are not worth holding.
- Gold has a better than even chance of outperforming almost everything else- however, we think gold is a hopeless investment long term.
- The Yen and the Euro stage tremendous rallies confounding some central bankers and demonstrating that they never had the slightest clue as to cause and effect of their actions. Kudos to the Federal Reserve; Ben Bernanke and Janet Yellen in particular who segued between tapering QE and then finally raising rates at what will be historically viewed as the right time.
- Defensive stock plays get hammered and growth areas (including technology) explode higher, devastating the ‘global recession’ camp.
- UK leaves the European Union. We think this is a full gone conclusion even though polls show support for staying. UK markets including the British Pound fall, before a blistering upside move.
- Emerging markets bottom out and crush trend followers who remain short EM currencies, debt and equities.
- Volatility remains high in the short term before returning to normal levels late in 2016.
- Commodities turn, but we are not overly interested as we think technology ultimately kills demand particularly in fossil fuels.
As a consolation to anyone really short right now, if we see further economic deterioration we might join you, but probably not in a broad sense as many problems have at least been partially priced in. Most equity markets have been falling for around a year and in some Emerging Markets, four years or more.