- The Issue
- The Outlook
- Domestic Equities
- Domestic Fixed Income
- Global Equity Outlook
- Investment Strategy Recommendations for Investors
- The Fine Print
2016—No Easy Answers
In December the Fed started the transition from "very easy and accommodative" monetary policy to "easy and accommodative" monetary policy. As the Fed unwinds a record level of monetary easing, uncertainty about how the economy and capital markets will react to higher interest rates has increased market volatility. Globally, central bankers are likely to continue to use non-traditional monetary policy tools, such as quantitative easing, in an attempt to boost tepid economic growth. Since the financial crisis, no central bank has successfully raised and sustained higher rates. The unconventional monetary policy triggered by the 2007-09 financial crisis has tested central bankers, and the cycle is not over. Investors are wise to appreciate that monetary policy is in untested waters. Economic recessions and severe market corrections are often associated with tightening monetary conditions; investors are fortunate that neither is a condition evident worldwide today.
Understanding broad economic trends provides insight to the potential path of capital markets. The past few years clearly demonstrated how difficult it is for forecasters to separate signals from noise as they attempt to predict the global economy's future trend rate of growth. Global economic indicators such as financial capital flows, trade, monetary and fiscal policy, inflation, and industrial production are individually complex, interrelated and dynamic, making the job of identifying annual trends difficult enough. Add exogenous risks such as terrorist attacks, sudden policy regime changes, and natural disasters, and forecaster attempts to predict the short term behavior of equity, fixed income and commodities prices can seem futile. Unprecedented accommodative monetary policy adds a separate layer of complexity because forecasters have no historical trends on which to rely. Forecasters need to work within this framework of uncertainty and consider a wide range of outcomes. Wall Street annual forecasts in 2015 were widely off the mark for year-end estimates for oil prices, equity markets, and 10 yr. treasury yields. Forecasting 2016 will be equally challenging.
We know that the U.S. economy and equity markets are eight years into a recovery and now face the headwind of less accommodative Federal monetary policy. These factors create uncertainty, higher volatility, and an increased potential for an equity market correction or drawdown. While the U.S. economy is steadily growing, improvements in corporate profits are not evident because the strong U.S. dollar is reducing the competitiveness of exports and overseas revenue when converted back to dollars. Against this economic backdrop, and with neither fiscal nor monetary tools available to boost growth, we see U.S. equity market returns ranging from 6.5 to 7.5 percent over the next decade, about 1 to 2 percent below long run average returns.
Total returns from U.S. bonds are also expected to be modest over the next decade, averaging around 3 percent as coupon income and not price appreciation drives returns. (Coupon income plus or minus price changes equal the total return of bonds.) Since 1981, falling interest rates boosted the price of bonds, a phenomenon not likely to be repeated from today's low interest rates. The recent sell-off in high yield bonds could create a good buying opportunity once there are signs that corporate balance sheets and default rates are stabilizing. Municipal bonds continue to provide attractive after-tax total returns for taxable investment portfolios.
Expect volatile market performance in 2016. Global economies are lagging behind the U.S. recovery, which means there is room for corporate profits to improve and support higher equity valuation. However, the global economic recovery remains fragile and has yet to enter a virtuous circle where rising wages encourage consumers to spend, leading to more growth and further wage increases. Expect choppy market performance over the next few years.
Emerging market equities and commodities, which are highly correlated and among the most punished strategies in 2015, are worth monitoring, as they are poised to outperform in the next few years, although it is early for investors to take meaningful positions in these strategies.
|Existing home sales widely expected to rise through 2016 (up 5–6 percent in 2016);||The strong U.S. dollar will continue to undermine overseas revenue;|
|All employment measures show stronger and more favorable conditions;||Demographics are slowing labor force participation and could negatively limit trend economic growth;|
|U.S. equity projected annual revenue growth rates for 2016 and 2017 are in the mid-single digits: S&P 500 (4.1 percent, 6.0 percent), S&P 400 (5.1, 5.0), and S&P 600 (5.4, 6.1);||Falling existing home sales at year end (worth watching, but thought to have been caused by an increase in regulatory reporting requirements which temporarily slowed sales);|
|Forward revenue outlook is relatively upbeat across all sectors of the S&P 500 with the exception of Energy and Materials;||Equity market valuations are at or above long run averages;|
|Core PCE is hovering around +1.3 percent, well below Fed's target of 2 percent supporting very gradual rate increases;||Global economic and fiscal challenges are the largest threat to U.S. domestic equity performance. Markets will continue to be choppy through year end.|
|Current U.S. equity valuations suggest that total returns in the next few years will be modest single digits.|
Domestic Fixed Income
|In December the Fed started the transition from "very easy and accommodative" to "easy and accommodative" monetary policy. The current stance is a long way away from normalized policy, and even further from restrictive conditions;||Services inflation is on the rise: 2.9 percent year-over-year excluding food and energy;|
|The median Fed dots forecast suggests that the Fed is expected to follow a historically gradual rate hike trend with gradual increases of 25 bps. per quarter, although Yellen stated in her press conference that "gradual does not mean mechanical" and the Fed will be data dependent;||U.S. headline inflation could be triggered as low gas prices fall out of the annual data set, and as wages adjust up. The Fed's plans to move gradually could be upended;|
|CPI below 0.2 percent year-over-year, excluding food and energy, core CPI is 1.8 percent year-over-year;||Ahead of the Fed's December decision, spreads of high yield credits to Treasuries rapidly widened, from an average of 170 bps. in 2014 to 700 bps. The pattern and size of the gap suggest stress and trouble if defaults remain modest;|
|No signs of wage pressures despite tightening labor market;||Higher than potential trend real GDP growth could erode the inflation, dampening output gaps, and a tightening labor market could trigger wage inflation. One or both could cause the Fed to abandon its plans to gradually raise rates, which would risk shocking the financial system.|
|Strong U.S. currency tightening monetary conditions;|
|Any number of factors could force the Fed to reverse course and cut rates all over again: anemic U.S. economic growth, a shock to the U.S. economy from abroad, persistently low inflation, or a risk of deflation. A cut in rates would likely benefit bond investors.|
Global Equity Outlook
|Globally, developed economies making the transition from debt-induced economic stress to sustained economic growth, although economies remain fragile, with results ranging from cyclical highs in Germany to cyclical lows in France and Italy;||Resource dependent countries such as Russia, Venezuela, Canada, and Saudi Arabia will continue to struggle economically until oil prices stabilize;|
|Japan's exports and jobs are expanding, and corporate profits are up sharply. Its economy is still vulnerable to downside risks, but the government is likely to ease monetary policy further in 2016;||Forward revenues for the All Country World Ex-U.S. MSCI have been trending down, and forward earnings have been flat since mid-2010. Much room for improvement;|
|China's new economic plan released at year end affirms the government's commitment to shift from an export-led economy to a consumer-led economy;||The World Trade Organization downgraded its global trade forecast from 3.3 percent to 2.8 percent for 2015, half the annual average of 1990–2008;|
|Falling currencies are boosting export competitiveness of many countries;||Structural factors will impede global economic growth in the next decade at least: high debt levels, slow population growth and an aging population all negatively impact GDP trend growth;|
|As central bankers stick to their extra low interest rate regimes, foreign sovereign and corporate bond returns could benefit;||Devaluation of the Chinese yuan is a deflationary factor on global inflation, and is making export trade difficult for competitive emerging market exporting countries;|
|Among the emerging economy nations, China seems to be successfully avoiding an abrupt economic correction, albeit not without some badly executed capital market control measures which jolted the markets in early 2016.||China's 6 percent growth rate could be overstated. With China producing about 13 percent of Global GDP, a growth rate of 3 percent would be complicated for its largest trading partners (Germany and other EU countries) to absorb;|
|After eight years of aggressive policy actions, central banks have achieved limited results with limited policy actions. Their toolkit may not meet the demand of more stimulus should it be considered necessary to sustain even modest economic growth.|
Investment Strategy Recommendations for Investors
In a tough capital market environment, comprehensive wealth planning and tax sensitive investment strategy are keys to maximizing and protecting the balance sheet of private investors.
Optimized wealth plans include
- consideration to taxes (income, gift and estate)
- risk management strategies (personal, home, auto, and umbrella)
- estate transfer strategies
- management of short and long term cash needs
- consideration to sources of liquidity in a tail risk environment (a severe capital market downturn). Investors with uncertain cash flows could benefit from refinancing their home and/or putting into place a Home Equity Line of Credit to access when unexpected cash needs arise
- asset protection strategies, and
- financial planning to track success toward ultimate retirement and legacy goals.
Innovation sector investors typically have complex balance sheets, uncertain cash flows, and are often in high tax brackets. To maximize the returns from their liquid portfolios, these investors need to
- mix asset classes and managers utilizing passive strategies if they do not have access to low cost active managers with proven success of beating the market;
- monitor investment fees and taxes paid to manage liquid assets (manager fees, advisor fees, and trading/reporting fees) which can significantly reduce gross returns;
- avoid allowing equity market drawdowns to trigger sales of managers or strategies by understanding what level of volatility to expect in short and longer term periods consistent with implemented investment strategies;
- avoid replacing managers before their investment thesis has had time to mature. Sticking with an under-performing manager can be tough, but every actively managed strategy has periods of under-performance. If the four "Ps" are solid (Philosophy, Process, People, Long Term Performance) then the manager is likely to meet long run objectives. Selling before they are given the chance to do so is akin to selling low and buying high;
- monitor but do not actively trade your long term investment portfolio. Leave the management of your liquid assets to professionals who are 100% focused on picking stocks and or bonds. Keep a small trading account if necessary but do not risk your family's long term financial stability.
These are complicated times. Managing private client wealth requires a holistic approach. Applying comprehensive wealth and investment planning techniques to investor balance sheets will increase the success rate of individual investors.
If you'd like to understand how these domestic and global forces can affect your investment strategies, email us at email@example.com.
We'd be happy to discuss with you.