As 2016 gets under way, we observe a US central bank desperate to move away from zero rates without distressing financial markets; an international economy trying to digest a stronger US dollar; a corporate sector that has engaged in aggressive financial engineering, issuing huge volumes of low-yielding debt to retire large volumes of equity; global bond yields close to record lows, and global equity markets close to record highs.
Our general view is that almost all assets are priced for continued low growth, low inflation and low (if not negative) real interest rates. If that is the outcome, no great shakes.
However, if the outcome is higher growth and/or particularly higher inflation, then we could see some big swings in the absolute and relative prices of bonds, equities, currencies and commodities. We are alive to this prospect as we are beginning to see accelerating wage growth in a number of economies whose labour markets have tightened meaningfully.
Traditional fixed income tends not to do well in a rising rate environment. Our bias is for history to repeat itself in this respect considering how low current yields are. If we are wrong, and longer-term yields fall as the Federal Reserve and potentially other central banks’ hike, it would be suggestive of a policy misstep, making us more cautious on the economy.
Either way, we expect bond markets in 2016 to be fairly turbulent.
Corporate credit spreads (not just commodity related) have widened over the past year, suggesting increased investor concerns about the potential for credit stress among highly leveraged borrowers. This is noteworthy, as history suggests credit spreads often narrow when the Fed begins to raise rates.
Importantly, however, the Fed does not usually wait seven years into an economic cycle before raising rates. Typically, it starts normalising one to two years into a recovery when earnings growth is strong. A key reason why risky assets have done well this cycle is that investors have been encouraged to move out along the risk curve.
How many investors who bought investment grade credit and high yield this cycle in pursuit of a higher return will retreat to less risky assets when the Fed begins normalising?
We strongly believe that when this credit cycle ends the lack of secondary market liquidity will be a major issue. Until these markets are properly tested we do not know how they will cope under current poor liquidity conditions.
So although we can be modestly more positive on credit than we were a year ago, as the degree of compensation has theoretically gone up, we have opted to retain a healthy cash balance across our portfolios. Cash has been the hot potato asset of the last seven years but we believe it will become more desirable over the course of 2016, as the headwinds for fixed income intensify.
Meanwhile, our overriding assessment of the equity market is that it is richly priced and has dubious internal dynamics. This combination does not guarantee it is going to go down a lot. But nor do we believe our base case should be that it shoots up a lot either. Of greater curiosity to us at present is the relative opportunity set that has emerged within the market.
We expect the trend of US equity leadership to flip in 2016 and for international equities to begin to outperform in both local and common currency terms. This speaks to US economic, margin and valuation cycles that are more mature than elsewhere.
In addition, Fed tightening is historically not good for US equity valuations. The reason Fed tightening cycles have not historically assured outright equity weakness is because they usually get under way early enough that earnings growth effectively trumps the de-rating that almost always occurs (the tech sector in the late 1990s was an exception).
However, with the level of US profit margins close to record highs and with earnings growth already having moderated, we ought to look elsewhere for greater returns. For as long as the US dollar remains a reasonably strong (although not necessarily strengthening) currency, our preference is likely to remain Japan and Europe where the above cycles are earlier in their evolution.
As mentioned at the outset, we consider investor positioning within the equity market to be heavily skewed in favour of the low growth, low inflation narrative. Yet with US core inflation bang on target at 2 per cent and a tight labour market, it may not take much of a spark from wages for the pendulum to swing away from the popular group of “secular stagnation” stocks towards higher inflation beneficiaries. The oil price bottoming around current levels would clearly be beneficial to this idea as well.
In summary, valuation dispersion across and within asset markets today is historically extreme. We expect 2016 to be a year of mean reversion.
Robin McDonald is fund manager, multi-manager, at Schroders