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The investment outlook for 2016
2015 was characterised by three major trends - China's economic slowdown, sharp declines in commodity prices and US monetary policy normalisation. These trends continue to drive markets in 2016.
China's economy grew 6.9 per cent last year - the slowest in 25 years. Its on-going slowdown is due to a global manufacturing slowdown as well as domestic reforms to reorient the economy from manufacturing to services and from investment-led growth to consumption-led growth. The deceleration will impact industrial commodities and trading partners most for whom China is a substantial source of demand. Also, Chinese policy uncertainty and reform efforts will persist as a source of market volatility.
Turning to commodities, commodity markets have been oversupplied, due to new capacity coming online and strategic decisions by key producers to maintain production levels. On the one hand, low commodity prices are a windfall for oil-importing nations and consumers, and should benefit growth. On the other hand, commodity weakness is leading to job losses, lower capital expenditure and financial stress among commodity firms.
After nearly two years of anticipation, the US Federal Reserve commenced monetary policy normalisation with a 25 basis points rate hike in December. The focus has since shifted to the path of rate hikes, with the Fed expecting to hike a total of 100 basis points in 2016 and the markets pricing in 50 basis points. Should the markets be wrong, the risk is to the downside for most assets, similar to the taper tantrum episode in 2013, when the Fed indicated the possibility of tapering its bond purchases sooner than previously expected, causing volatility in bond markets.
With all that, what does this mean for financial markets?
The multi-year bull market for global equities looks exhausted in the absence of catalysts, while volatility has picked up owing to uncertainty over macro trends. Equities are likely to trade within a fairly large range with higher volatility. The eurozone remains a bright spot from a fundamental perspective; as growth is recovering, profit margins have room to expand and quantitative easing should support valuations. That said, eurozone equities typically trade in tandem with US equities, for which the outlook is less rosy as US revenue growth is slowing, profit margins are already high and rate hikes should pressure valuations. The relative performance of eurozone and US equities will be a point of interest in 2016.
Elsewhere, Japan appears undervalued but lacking catalysts for a rerating. The Bank of Japan appears reluctant to expand quantitative easing, pension fund buying appears done and structural reforms have been slow. For Chinese equities, it is important to differentiate between "Old China" (industrials, materials and energy) and "New China" (information technology, healthcare, consumer discretionary and consumer staples). Although "New China" firms are more expensive, they have better fundamentals and growth prospects.
In fixed income, credit markets are at risk of a spillover from the weakness in the energy sector. Forced closure of non-profitable US shale oil producers will see more stress in energy-related high yield credit, which could impact other market segments. Beyond any spillover, however, opportunities could arise. In the last US rate hike cycle, credit spreads stabilised or tightened well into the cycle. Intuitively, rate hikes typically coincide with economic expansion, which support debt repayment ability. Similar dynamics could see credit markets recover later in 2016.
Where currencies are concerned, the US dollar should remain strong given monetary policy divergence with most other major economies. Last year, emerging market currencies were mostly weaker than G-10 currencies, due to the higher dependence on commodity exports among emerging economies and the more direct impact of China's exchange rate regime shift. In 2016, emerging market currencies could face more pressure from further commodity weakness, Chinese policy uncertainty and gradual yuan depreciation. That said, should commodity markets stabilise or recover, emerging market currencies could see a rebound from depressed levels in the latter part of the year.
We have adopted a neutral stance on risk assets for 2016. In an environment of range-bound markets and higher volatility, the strategy of "buy-and-hold" presents a poor risk/reward proposition for this period. Instead, we advocate maintaining a cash buffer to take advantage of market corrections, adopting a more tactical approach and, for sophisticated investors, employing options strategies to make volatility work for them.
- The writer is chief investment officer and head of Investment Products and Solutions, UOB Private Bank