QUARTERLY INVESTMENT STRATEGY: ASSET ALLOCATION
One of the greatest market risks for 2016 lies in the expected step-up in US interest rates, particularly since this tightening of financial conditions comes relatively late in the business cycle. Even though the Fed has promised to tighten gradually, the market response needs not be gradual.
IN A NUTSHELL
- 2016 asset returns will be low and volatile for both equities and bonds – we favour a contrarian and disciplined approach.
- When the oil price does stabilise, base effects will come into play and inflation expectations begin to rise, driving up government bond yields (bear flattening).
- Investment grade credit should outperform the sovereign space in both the US and Europe. High yield markets could offer decent returns in Europe, but (commodity-related) risks remain high in the US.
- Emerging markets should begin to outperform at some point during the year, on the back of a stabilising US dollar, but risks remain elevated in the short term.
With the valuation of most assets looking stretched and, from a more fundamental perspective, potential economic growth lower than in the past, investors should prepare for an environment of greater volatility rewarded by generally low returns. The question of exposure to (higher yielding) emerging assets is bound to arise again, following what has now been more than five years of de-rating. Overall, we expect a year of range-bound financial markets, during which tactical positioning and discipline in profit taking will be key.
The change in volatility regime observed during the past quarters can be viewed as a first consequence of tightening US liquidity conditions, albeit through the US dollar channel – which mainly hurts trading partners – rather than through an increase in the refinancing rate – more likely to impact the domestic economy. The relatively dovish tone of the December Federal Open Market Committee statement, taking a step closer to market pricing, suggests that the greenback stability that we envisage may materialise going forward. That said, year-end market pricing shows little consensus and still remains short of what both the Federal Reserve (Fed) and we expect, suggesting that a market adjustment to a steeper than anticipated rate upcycle remains a risk. With the rhythm of rate hikes to be determined by inflation data, upward wage pressure and/or oil price stabilization would lead to two potential outcomes. The dollar could appreciate again, justifying our continued partial hedge of foreign currency exposure in US dollar-based portfolios, and the recently observed flattening of the US yield curve may accelerate, impacting banking sector financing conditions, hence also the quantity of credit offered to US corporates and households.
Indeed, at the long end of the curve, inflation expectations are stable, dampened by low commodity prices. For now, the risk on oil still seems skewed more to the downside than to the upside. While we had no strong expectations regarding the Organisation of the Petroleum Exporting Countries (OPEC) meeting held early December 2015, the lack of guidance on a production quota did underline the discord between members, sending the price of the commodity into freefall. Moreover, the absence of an agreement about how to accommodate higher Iranian production (the decision uncertainties will remain over the course of the coming year.
Medium-term, we maintain our scenario of a gradual reduction in the supply glut and an equilibrium price that is set by the marginal cost of the US shale industry. As such, acknowledging the consequences of cost deflation within the sector, we have revised our oil price target down to USD 55/barrel by the end of 2016. The major trigger will be the pace of decline in US shale oil output. This trend is clearly already underway, but all-time high inventories make for a definite headwind, particularly giving the pending negative seasonality, suggesting that our scenario might take longer to materialise. Note, however, that the longer the oil price remains low, the larger the cuts in US production will be. The second-round effect is that the physical market might face a shortage sooner than anticipated, making for a stronger than expected price rebound.
As already mentioned, wage increases and fading base effects from the energy component of price indices could drive up inflation expectations and, in turn, nominal rates. We thus maintain our underweight position in sovereign bonds, particularly within euro- and Swiss franc-based portfolios. With a fair value for German Bunds around the 0.8-1.0% level, expected returns look unattractive. That said, peripheral bonds should remain resilient, supported by investors’ relentless search for yield. In US dollar-based portfolios, Treasury Inflation Protected Securities (TIPS) are a possible hedge against the risk of normalising inflation expectations.
While we generally prefer the credit space to sovereign bonds, we remain cautious on high beta segments. In US high yield, fundamentals are fast deteriorating in the energy and materials sectors, with default rates that reached 6.5% last month, compared with only 1% (and stable) for the rest of the universe. At this point, the risk of contagion from distressed energy/materials sectors to other sectors seems limited, although the correlation amongst sectors is bound to increase in the event of risk-off episodes. We will thus be keeping a close watch, particularly were investor sentiment to worsen again. In the Emerging segment, the deterioration is marked in regions that are dependent on US dollar financing, such as Asia and Latin America, while still at reasonable levels in Emerging Europe.
As already expressed last quarter, currency and commodity stabilisation are pre-conditions for greater risk-taking. For now, we maintain a neutral equity positioning, viewing year-end market losses as an opportunity to build new positions. Valuation is definitively not cheap and already discounts positive earnings growth – which we anticipate in the high-single-digit territory for most regions, taking into account the impact of share buybacks. That said, the valuation picture is less worrisome if one excludes the energy and materials sectors.
At the global index level, we see modest upside to our fair value, arguing for a 2016 total return of some 8% in local currency terms. Monetary policy divergences and their consequences on the interest rate environment do, however, argue for greater selectivity in regional terms, favouring those where ample liquidity precludes a de-rating of multiples and where margins still have some room for improvement. We thus favour Switzerland, the Eurozone and Japan over the US and Emerging Markets. As regards the latter, while we still consider it too soon to call for an overweight position, the cheap valuation in spite of heavy downward earnings revisions, as well as the extreme negative investor positioning, make for a symmetrical risk. We thus would not be surprised to see emerging markets begin to outperform during the course of 2016 and will closely monitor currency developments to determine the most appropriate entry points.
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