At the beginning of every year, around the time holiday lights come down, there are flurries of headlines, many professing to make a “big” call or some other bombastic prognostication about where the economy or markets are expected to go. Most will go awry, or become obsolete, within weeks of their publication.
Let’s try to make this one different.
Here are three key talking points to guide you in your discussions with clients for 2016.
Slowing is Not Stopping
With headlines focused on a Chinese hard landing, the risks of ISIS terrorism, the death spiral of the Brazilian economy and yet another slowdown in U.S., European and Japanese economic data, the financial media is acutely focused on the downside risks to global growth. Beyond these worries, the reality of the world’s aging population is receiving increasing airtime as a key contributing factor for global weakness. That is no surprise: According to the United Nations, the proportion of the population older than age 60 in developed countries is expected to double from 15% to 30% by 2025. This demographic trend means people are spending and investing and borrowing less. In other words, they are drawing more from the economy than they are contributing. It seems everywhere we look, fears exist that the world is at best mired in a kind of secular stagnation, or at worst on the brink of another recession.
Without a doubt, the world has growing pains, and all of the above-cited factors are pulling down output potential. China does have some major overhangs to correct within the banking and housing sectors, and while they have the forbearance to stand behind bad debts, they are clearly resisting another “shock and awe” fiscal stimulus given their goal to restructure toward a consumption and services economy.
In the U.S., the Fed has come off the zero bound in interest rates, and there seems to be little political appetite for anything other than gridlock in addressing long-term structural issues like immigration reform, changes to the tax or Social Security system and income inequality. In Europe, countries remain under pressure to meet the Maastricht Treaty debt and deficit rules, and the impacts of the refugee crisis are becoming more and more complex. Japan continues to grapple with low confidence and deflation psychology, while at the same time trying not to make another near-fatal misstep with tax increases in support of budget consolidation as it did last year.
Yet even with these factors all in play and assuming there will be no improvements, the world is growing. U.S. GDP growth will likely be recorded at between 2% and 2.5% for 2015. Europe and Japan are expected to clock in at 1% to 1.5%. And while China has downshifted from 10.5% five years ago, its growth is still officially reported at 7% today. Putting the world together, it would seem global growth was still managing 3% to 3.5% in 2015, and doing so during just about every worst-case scenario. While it’s true a large random shock could always occur, and there exists limited policy ammunition, the most talked about concern—a Chinese economic meltdown—seems overplayed. The global economy has already adapted to weak growth in China, and the government still has plenty of ammunition to avoid a true hard landing.
Furthermore, there are none of the typical signs of rising recession risks. For example, while housing has boomed, especially in some trophy cities, other cyclical sectors remain low as a share of GDP. And while there may be small asset bubbles in some markets, there are not systemic bubbles similar to the tech bubble of the 1990s or the subprime housing bubble in the 2000s. Inflation is low, and it is likely to remain below target for an extended period. Finally, oil prices, a frequent factor in recessions, are well below levels that have triggered trouble in the past.
Slow growth is not the same as no growth, and certainly not a reason to shun the global markets. And upside surprises lurk as a result of sustained low energy prices that may be a boon to consumption trends.
Do Not Fight (or Fear) the Fed (or the ECB, BOJ, PBOC)
To be sure, 2015 drew to a close with monetary policy moving in opposite directions among the major central banks. The Federal Reserve began its path of policy normalization process with a 25 basis point rate hike at its December meeting. A few central banks, like Brazil’s, are expected to switch from a tightening to an easing stance over the course of 2016 as inflation softens. Meanwhile, the European Central Bank, the Bank of Japan and the People’s Bank of China are all expected to ease further within the next few months.
The Fed is hiking not because inflation is high, but because unemployment is low. The cumulative improvement in the U.S. labor market and faster recovery in growth supports the Fed beginning to normalize policy even as other central banks are still easing. Easing by the ECB and BOJ thus partly reflects that they are not quite as far along in the post-crisis recovery cycle as the U.S. The euro area double-dipped following the 2011 debt crisis, while Japan has not been able to get into high gear despite massive amounts of stimulus. Moreover, inflation has remained disappointingly low for these central banks that focus on price stability, and further policy easing will be aimed in large part at offsetting low inflation or deflation psychologies. In contrast, the tightening U.S. labor market is starting to nudge wages higher, and the Fed sees this as a step toward higher inflation over time. This dynamic is not yet engaged in the euro area or Japan.
Despite concerns to the contrary, the most well telegraphed Fed hiking cycle in ages was not a large shock to financial markets. As for currencies and capital flows, many emerging market economies are better positioned for Fed normalization than they were during the “taper tantrum” of 2013. While the U.S. dollar may appreciate somewhat further in 2016, arguably quite of lot of policy divergence has already been priced into the roughly 20% appreciation of the trade-weighted dollar since last summer. Moreover, the Fed’s communication has made it clear that its trajectory will be slow and steady, i.e., “lower for longer.” And easing by other central banks should stimulate their domestic demand, with positive spillovers to the U.S. and the rest of the world.
The World Is A Very Big Place (And So Are The Markets)
With an economic and monetary policy backdrop as convoluted as the one we have described, it would be easy to justify sitting on the sidelines without the benefit of discernment offered by valuations. With interest rates globally at generational lows, the choice between stocks and bonds on a relative basis is easy, even with the prospect of normal short-term corrections and market gyrations picking up.
While the argument for diversification may not have always been visible in recent years, as U.S. market returns so clearly dominated those of the rest of the world, the tectonics underneath a home-biased portfolio construction started to shift in 2015, as segments of the non-U.S. developed markets saw stronger results. There is likely to be a continuation of that trend in 2016, thanks in large part to catalysts from central bank action as well as attractive valuations across the euro zone, Japan and many segments of the emerging markets.
Peak margins, negative earnings growth and a forward P/E multiple at or slightly above the historical average makes the U.S. stock market vulnerable, though M&A activity and other shareholder-friendly initiatives could keep the markets trending higher. Put another way, if the equity story in the U.S. is that things are just OK, the story in Europe and Japan is that things are getting better. Those markets have been cheap for some time, but that cheapness was not unreasonable. Fiscal policies were tight, the offsetting monetary stimulus was slight, there was no quantitative easing, and the banks were reluctant to lend. These factors are all changing.
Emerging markets have more nuances to be sure, but when the valuations are trading at their largest discounts to those of developed-market peers in 12 years, it means there are benefits to some exposure, particularly in Asian countries like South Korea and India where reforms are showing tangible progress.
If we can all agree that economic and market cycles don’t just die of old age, that fundamentals paint a picture of at least muddling growth, and that monetary policy is on the whole supportive and has decent visibility around it, it seems reasonable to argue for a diversified portfolio tilted in favor of equities (with some bonds, depending on the time horizon and risk tolerance of the investor). That’s probably not breaking news. And maybe that’s just the point for our clients—that there is no complex narrative or implementation required, just a willingness to consider the full landscape of global investment opportunities and participate with the guidance of an experienced advisor whose good judgment can distill all the noise into some basic truths and invest accordingly.
Michelle Knight is chief investment officer and chief economist of Ropes Wealth Advisors.