The deceptions of 2015 might be the surprises of 2016

2016-01-05

2015 has finally been a chaotic year ending with a lot of deceptions and one main surprise: the Government bond markets, the Investment Grade bond markets and the majors developed indices (quoted in USD) have ended the year almost where they started.

Asset allocation and diversification have not played their roles and investors may have felt that paying active asset managers was certainly not worth it.

This deception comes after a very positive 1st quarter where the stock markets reacted positively to the stimulus package's announcement from the ECB. This rally was followed by an important correction, led by China, on August and by the correction of all commodity prices in the 4th quarter.

While the main European markets closed positively (in Euro terms), London ends -6% - driven by the mining sector – and Wall Street closes the year with big dispersions: the Nasdaq closes up almost 7%, but the Dow Jones loses 1.5% and the DJ 100 International Index ends almost -10%.

However, there is one element that puts everyone in agreement: 2015 was the year of the Central Banks. As expected the ECB announced in January its ambitious QE program and both the Bank of Japan and the FED were active during all the year. In December, the FED finally stopped and announced its 1st rate's increase. This massive injection of liquidity has played a big role to maintain the 5-year and 10-year yields at low levels.

The anticipation that the FED would soon (or later) change policy has in fact pushed the US Dollar to rally amongst most currencies: the Euro dropped 9% this year and the consensus call for a same pattern in 2016.

China was under a big pressure in 2015 and the economic turmoil has influenced all financial markets. The slowdown has been bigger than expected pushing many Emerging Markets down and most of the commodity prices, too. The series of measures that the Chinese government has announced after the Black Monday (August 24) has not, yet, provided the support and comfort that financial markets needed. It probably also forced the FED to postpone the 1st rate increase, while all US economic data were going in favor of an early action.

As earlier mentioned, the other big correction came from the commodity world where the Brent closes down more than 30%. Reasons are known: an excess in the overall production while the global demand (in particular the Chinese's one) was reduced. Despite this, the countries of the OPEP have decided not to curb the production, giving no support to the Oil price. That said, economists expect a slight increase in the demand and a small decrease in the production (outside OPEP countries) in 2016, which means that the Oil price could start increasing around Q3.

It is now quite difficult to project what returns will the financial markets give in 2016. But one strategy could be to say that what did not produce any return in 2015 will … still not produce return and what produced negative returns could probably produce positive returns as there is the normal "return to the mean".

In Equities, we remain optimistic on the European equity markets. A modest earning growth with low inflation, coupled with the activity of the ECB should give positive effects; yet the Euro should drop in value and non-Euro investors should hedge their exposure. M&A and share buy-backs could also help the European markets during the all year.

The US market seems the most expensive and vulnerable of the developed markets. Earnings expectations are flat to negative. Only a thin part of the market should bring positive returns such as the Tech and Healthcare sectors, that are providing earning growth … and eventually the OIL sector that may rebound in the second half of the year (after some possible restructuration or defaults in the small/mid cap Oil stocks).

The outlook for the Emerging Markets remains negative. The fundamentals of emerging markets have deteriorated in the year and we see continuing outflows in funds and/or ETFs. The unwinding of the commodity cycle, the strong credit growth in a number of emerging economies, coupled with the higher US rates (and/or USD level), pause downside risk. We saw multi-manager EM funds increasing their allocation to safer countries, such as Korea and Mexico and reducing the most cyclical bets.

We would need to see improvements in the Chinese economy, a more stable geopolitical/macro situation in Russia and a Brazilian economy able to recover from recession, until becoming more positive on Emerging Markets.

This negative view stands for the EM equity and fixed income markets… but H2 2016 could see the return of these unloved markets.

For the Fixed Income market in general, moderate economic growth in a low inflation environment probably favours corporate bonds and high yield versus government bonds. But investors should expect that most of the returns will come from the coupon.

In the US, we are concerned about the High Yield market, due to weakening balance sheets and low OIL prices (energy related companies represent a good weighting in the US HY index), but we are positive on the US investment grade segment, where the 8-10 years average maturity bonds represent an attractive risk-adjusted return versus the Eurozone.

Our outlook is for a moderate increase of the FED rate that may have more impact on the 3-7 years maturity bonds than on the 8-10 years' ones.

In Europe, the ECB massive QE shall continue to benefit mostly the risky segments of the fixed income market, such as the European periphery and the High Yield. However, the investment grade bond market is probably already fully priced with yields close to the government bonds' yields.

Volatile markets have brought volatile returns in alternative investments, as well. But Macro Managers, CTA's and Multi-Strats should normally be able to outperform in challenging and volatile markets and now that the FED has a clear strategy of higher rates, this outperformance may be more visible.

With the increase in M&A activity, Event Driven Funds should also find the right opportunities.

Last, but not least, a strategic allocation to Real Estate and Private Equity managers should be positive: we favour European real estate and secondary Private Equity funds. These are two segments where market prices have still room for appreciation.

In terms of asset allocation, investors should adjust their strategic allocation by reducing US equity and European Investment Grade in favour of European Equities and US Investment Grade. They should also keep the same tactical allocation favouring developed markets over emerging markets and overweighting Tech, Healthcare and Real Estate.

Investors should also accept high volatility in 2016 and a possible rotation of strategy in 2016 to focus, again, on China, Oil and Emerging Markets.

I am taking opportunity of the Year Ahead note to wish everyone a happy and peaceful New Year 2016.

Mirko Visco

CIO & Managing Director