Markets favour clarity and while clarity seems easy with hindsight, it’s rarely as stress-free when looking ahead.
It’s interesting how that can be forgotten — in particular at moments of transition for markets and the macro economy. We are at a transition point currently and transitions are bumpy. As an investor, it’s important to determine the implications of being right or wrong about a particular path. What should never be in doubt is the need for long-term money to stay invested.
We have seen several strong double-digit-return years since the financial crisis. Higher than normal returns become expected and they shouldn’t be. We’ve entered the later stages of the investment cycle and, in reality, it offers less clarity than investors have come to expect from an ageing bull market. The outlook is good, not great, and the risks have risen. Return expectations need to be managed lower.
Global growth slowed last year, stalled by emerging economies. The US and China are the foundation economies for sustainable moderate global growth. We do not believe that the US or China will fall into recession in 2016. China falling into recession would, in our opinion, be more damaging to global growth than a more aggressive path of Fed tightening.
The US is furthest along in expansion, with Europe and Japan in recovery but clearly disappointing in momentum. Emerging markets are recovering from a credit crunch and an overextended investment boom. We have had meaningful debate about whether emerging markets will be the tipping point that stalls the global economy in 2016. While not our base case, we remain concerned that there may be additional spillover effects from developing economies that can weigh again on global markets.
Should commodity market rebalancing get worse, the non-linear effects of lower commodity prices may lead to a significant rise in financial stress, defaults and possible contagion. Latin America, the Middle East and Africa stand out as ongoing concerns. Asia continues to look better positioned to navigate the year ahead but we expect local currency markets to be a great deal more volatile and pressured. Fed tightening and China’s response via currency depreciation will be the drivers.
It’s easy to point to the drumbeat for Fed tightening as the culprit behind challenging equity markets. In reality, high valuations, as well as disappointing sales and earnings, have more to do with it. While we are not overly concerned about current valuation levels, returns need to be driven by earnings growth.
Earnings dispersion remains an important driver of sector returns but the year ahead is going to be more nuanced and company-specific. That should favour active managers.
It is central to note that portfolio diversification becomes more important the later we get in a cycle — there is less of a value cushion to allow for being wrong. That puts greater emphasis on the need for diversification of investment risk across a portfolio. Asset allocation, at its core, is about measuring and managing investment risk. The further along in a cycle, the more important it becomes.
Investors should expect low single-digit returns from fixed income and, hopefully, mid-to-high single-digit returns from equity markets. Equity market returns will be driven by earnings growth and dividends. If earnings disappoint, valuations will be under pressure as investors demand a higher risk premium for a less certain earnings stream. That will lower returns. A lack of clarity is discounted by markets in the form of higher risk premia — whether wider credit spreads or lower equity multiples.
Across portfolios we are overweight global equities and alternative investments versus fixed income. Coming into 2016, the size of our equity overweight versus benchmarks is lower. We are overweight developed equity markets, avoiding emerging markets for now and continue to invest in hedge funds across portfolios that can own them. We currently hold no direct investment allocations to commodities.
Market and macro expansions tend to run longer and we believe we’ve entered the later stages of the investment cycle, an important transition point. The path of least resistance for markets is to move higher — but at a slower and bumpier pace.