2016 equities: watch the E's and R's

FOR equities, 2016 looks like it will be defined by the three "E's" and the three "R's" - energy prices, earnings and the economy on one side; and, on the other, rates, recovery and the referendum on Brexit. The big question going forward is which of these will exert the greatest influence?

All are inter-related - for example, whether or not low energy prices can help economies recover via enhanced consumer spending is still open to debate, while a reflated and recovering economy can lead to improved earnings.

Furthermore, there are other "E's" to consider - elections in the US, with the possibility that another "R" comes into the reckoning, namely a Republican presidential victory for maverick candidate Donald Trump. If this occurs, it would be fair to say markets would struggle to properly evaluate the implications and consequences, given Mr Trump's controversial stand on many social, political and economic issues.

Wild cards aside, the core "E's" and "R's" for now are those listed above, though the movements and interplay between them is by no means straightforward. For example, it would be obvious to most market players that falling energy prices have not had the hoped-for benefits - or rather, instead of focusing on consumers being better off, the market has chosen to focus on the slump in earnings of the offshore/marine sector and possible deflationary effects.

Recall that when a fall in oil to below US$30/barrel combined with worries of a China hard landing in January and February, the outcome was an 11 per cent loss for the Straits Times Index and similar weakness in stocks all over the globe.

A rebound in oil to above US$40 in March and April helped stocks recover but that bounce appears to have run its course over the past week - the failure of talks over the weekend in Doha to limit supply has once again brought pressure to bear on equity markets.

In the months ahead, though, our view is that the relevant "E" is not so much energy prices or earnings but the economies of the US and China, since the fortunes of both will determine the fate of one "R", namely interest rates. This much the US Federal Reserve has repeatedly spelled out in its statements, and the futures market, whilst attaching a zero probability to a rate hike at next week's Fed meeting, thinks there is a now a 19.6 per cent chance this will occur in June.

At the start of this week, this figure was 13.7 per cent, so the futures market increasingly believes the Fed will move in June.

If a Republican victory in the US presidential election represents a complete unknown for financial markets, so would an "exit EU" vote in the UK in the June referendum. This is the "R" which investors should beware of as it has the potential to plunge financial markets into a period of heightened uncertainty, reminiscent of the weeks leading up to Greece's referendum a year ago. There are major differences though - Greece was bankrupt and in desperate need of EU, IMF and German generosity to bail it out of trouble and there were many who thought a temporary exit or "Grexit" while the country got its finances in order before returning to the EU fold would have been good for all EU members; the UK, on the other hand, is a solvent member whose departure could have profound economic consequences.

As it stands now, a British exit is a 50-50 probability - too close to call. The last time the UK voted on a similar issue was 1975, when the outcome was to remain in the European Common Market; a "leave" majority on June 23 this year could provoke a large upswing in volatility as markets try to come to grips with what a UK departure could mean.

There are, of course, two more "R's" worth bearing in mind. A contracting world economy inevitably raises the spectre of recession - there is already the worry of an earnings recession present - in which case, the smart thing for investors to do would be to retreat.