We expect fixed income markets to be increasingly volatile in the coming year. This environment is likely to be better suited to smaller, tactical trades than large-scale strategic positions.
Throughout 2015, market turbulence made for choppy waters for investors to navigate. Central bank policy forecasts grew increasingly unreliable. Global manufacturing and trade slowed as emerging market growth - particularly in China – continued to weaken. Commodity prices also struggled, and currency markets only added to the wider volatility, as the US dollar’s strength persisted and China devalued its currency.
This has left a great deal of uncertainty for markets in 2016. We believe that underlying economic stability will endure, but that the shadow cast by central banks will remain large. Overall, we expect the environment to be better suited to smaller, tactical trades than large-scale strategic positions in the coming year.
Is the Fed overcomplicating things?
The US economy is fundamentally in good shape. Manufacturing is certainly feeling the pinch from lingering excess capacity and weakening external demand, but strength is persistent elsewhere. The labour market is strong, the US consumer is active and there is even some evidence of wage growth building. Our concern is that the Federal Reserve (Fed) seems increasingly preoccupied with international developments – chiefly those in emerging markets - in setting its policy terms. This muddled reaction function has left investors twitchy, and is likely to trigger significant market distortion in 2016 until greater clarity is restored.
We still expect that the Fed will embark on its hiking cycle, possibly by the end of 2015, and would caution that short-dated Treasuries do not look ready for the move. We expect that as investors reassess the level of interest rate compensation offered by this portion of the market, prices are likely to cool off. Longer dated Treasuries – those in the 10-year bracket and beyond – look better supported. We expect institutional investors – particularly pension schemes - to lend sustainable demand to this part of the yield curve as these schemes look to de-risk.
UK policy set to echo the US
The US is not the only market susceptible to an overbearing central bank. In the UK, the growth outlook is similar. The stronger consumer sector is helping to sustain momentum even as deterioration in global trade impinges on the UK’s manufacturing sector. As in the US, short-dated gilts look more sensitive to the end of ultra-accommodative monetary policy and prices are likely to ease back as interest rate risk is reassessed. We do believe that the first rate rise from the Bank of England (BoE) is further away than in the US, but we also believe that the gap between rate moves is probably smaller than the market appreciates. Once the Fed moves, we anticipate that the BoE will shift its rhetoric, becoming increasingly hawkish to prepare markets for the tightening cycle ahead.
This time, the ECB is taking no chances
The European Central Bank (ECB) has responded to the increased downside risk to global growth by stating more clearly that it will be proactive in challenging any resurgence of deflation. The market has responded positively already. The exact policy measures that the ECB intends to use are not yet quite so clear, but we expect the deposit rate to be lowered again, and that the existing asset purchase scheme -currently running at a rate of €60 billion-a-month - will be extended either in term, pace, or both. The effect of the extended policy support would mean euro government bond valuations, already at historic highs, are likely to remain well supported. The euro is likely to weaken further against major currencies.
Tread carefully in corporate bond markets
Corporate bond markets may offer a degree of shelter from the murky policy environment. In the US, the stream of investment grade supply has been torrential in 2015. Overseas demand has remained strong, but the extent of the supply has still pushed yield spreads outwards. We believe that pockets of value have now emerged in the energy sector, as well as more generally in financials. Euro investment grade corporate markets have also grown cheaper during the year. Although the region continues to expand, inflation and growth remain fragile, and the market has also had the Greek debt crisis and several negative issuer-specific developments to contend with. However, we have always been of the view that with market stress often comes value. On a selective basis, opportunities are available.
High yield corporate bonds are even less exposed to policy changes, and as with investment grade bonds, the volatility and risk aversion of the third quarter has reset valuations to the point that certain areas look attractive. Commodity-sensitive sectors, particularly in the US, represent a range of prospects, provided the appropriate level of research has been undertaken.
China’s new normal
The key question then, is that if central banks are altering course (or not, as the case may be) due to China’s gloomy outlook, just how weak is the world’s second largest economy? China is clearly committed to the transition from its prevailing export and infrastructure-led growth model, to one of domestic consumption and service provision. We believe that China’s political will and policy tools are sufficient to support the economy as it traverses from one set of drivers to another. Furthermore, urbanisation and productivity enhancement are not over as growth themes, and will continue to contribute as the multi-decade transition unfolds. That said, while the process is set to continue, uncertainties remain regarding the timing and pace of the transition, as well as how China’s currency policy will develop.
China’s official growth targets remain ambitious and misses on GDP figures are, as a rule, detrimental to risk appetite. Further, the risks associated with elevated debt levels, as well as a mounting deflationary threat, may spill over to the rest of the world. Finally, China’s surprise devaluation of its currency this year has resulted in concerns about the magnitude and timing of any future devaluations.
Be cautious of bold trades
The global economy should remain resilient over 2016, but global markets may be a very different story. Investors continue to focus intently on central bank moves, given how integral they were in shoring up the financial system in the wake of the financial crisis. As such, until central bank decisions are less clouded by external factors, we believe investors should be wary of taking large-scale directional positions.
As a final point, 12 months ago we were rather more optimistic than we are today about the US dollar. Once again, history suggests the dollar tends to peak early into a Fed hiking cycle. This is contrary to popular wisdom, which suggests that in spite of a 25% rally in 18 months, the dollar remains a one-way bet. We tend to be wary of one-way bets as invariably they disappoint.
Equities appear richly priced
Our overriding view of the equity market is that it’s richly priced and has dubious internal dynamics, such as very narrow breadth (i.e. a small number of stocks leading the overall market higher). This combination doesn’t guarantee it will 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’s 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 reflects 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 why Fed tightening cycles haven’t historically assured outright equity weakness is because they usually get underway early enough in the cycle such that earnings growth effectively trumps the de-rating that almost always occurs (the tech sector in the late 90s was an exception). With the level of US profit margins close to record highs and with earnings growth already having moderated, we ought to be able to garner a greater return elsewhere. Our preference remains Japan and Europe where the above cycles are earlier in their evolution.
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 just a smidgen below target at 1.9% and a tight labour market, it may not take much of a spark from wages for the pendulum to swing away from this crowded 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.
We are trying to resist the urge of becoming too contrarian too early here. Being different is often crucial at turning points, but can also prove a drag in the latter stages of a cycle when momentum investing typically works best. As ever we remain disciplined and patient, but equally open-minded to change.
We ask for the same degree of pragmatism from our underlying managers, particularly those running absolute return funds (one of our alternative asset classes). 2015 has been a challenging and in many cases frustrating year for even the most experienced investors we monitor in this space. We have no reason to believe the current higher volatility regime will not persist into 2016.
It has been the correct decision for us to stand aside of the commodity markets in recent years. This initially drew some criticism on the basis that we run (amongst other things) mandates benchmarked against inflation, and commodities are generally considered an effective inflation hedge. Inflation hasn’t been a risk the market has seen fit to hedge in recent years. As indicated earlier, we’re mindful that this could change in 2016.
For now, we continue to blend a number of fund managers in the alternatives portfolio who have historically proven adept at growing capital in weak markets. Sometimes this has been through contrarian positioning, sometimes through bold directional exposure, either long or short. Importantly the aggregate views expressed here are always in harmony with our wider portfolio themes. To summarise, these are to approach the bond markets with caution, to carry equity risk primarily outside of the US, and within equity markets to increasingly lean in favour of strategies that will benefit from a shift away from the low growth - low inflation beneficiaries. These views are expressed through both long only and long-short strategies.
Past performance is not a guide to future performance.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.