A sweet ‘16?

Multi Asset
Matt Sherwood

Matt Sherwood

Head of Investment Strategy, Multi Asset
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The long-awaited US interest rate rise finally arrived in December 2015. But what does it tell us about the prospects for 2016?

The US Fed finally raised rates, but emphasised the gradual nature of their monetary policy tightening cycle which enabled financial markets to be confident that rising US rates will not threaten the recovery. While that is constructive for portfolios, it is important to put the policy increase into perspective:

  • It was the first US rate rise since 2006 and rates are now at only 0.25%.
  • This is the eighth tightening cycle in the past four decades and this time the US central bank had a more difficult job. Typically when lifting rates, the US economy is growing strongly, inflation is above the +2% target and asset markets are rising strongly.
  • None of these factors are evident today. The current 6-year US recovery has been the weakest in history with a total expansion of +14% since 2009 relative to a historical average of +35% in the last 20 business cycles dating back to 1871. The US Fed’s preferred inflation gauge is around half the 2% target and sharemarket valuations are high, but not extreme.

Joining the dots

These numbers suggest this is no normal tightening cycle. That’s why we’ve been at pains to point out that the first rate rise wasn’t what mattered – it’s the pace and nature of the tightening cycle that will be telling and in this way the second policy hike is more revealing than the first. Here we have our first sign of divergence between the Fed and the markets.

The US Fed’s “dot diagram” – a graph outlining its views on rate movements from US Fed officials – suggests four rate hikes in 2016. This is less than the historic norm, but markets are expecting only two increases and if the Fed had to hike again in the first quarter 2016, there could be a volatile market reaction. It may well shake the markets out of their dovish expectations. On the other hand, it may suggest a stronger than expected US economy, which is constructive for US earnings which in the long run drives sharemarkets.

The only game in town?

The obsession with Fed movements at the end of 2015 and in early 2016 is telling in a number of ways. Firstly it reflects the relative strength of the US economy. Despite an anaemic recovery, the US is still by far the strongest of the major economic blocs. However, the rate rise universally reflects emergency policy settings implemented during the global financial crisis are no longer appropriate, rather than the US economy is overheating.

Secondly it reflects the human tendency to give too much weight to what’s right in front of us. For much of 2015 we worried about China, emerging markets and oil. None of these issues have gone away. Yet they might influence the trends of the global economy in 2016. No doubt there will be other issues, as yet unforeseen, that tilt 2016 in directions yet unknown.

Investment implications

  • US shares likely to underperform

Even though the US economy is doing well, it’s unlikely their sharemarket will deliver stellar returns in 2016 as earnings growth remains anaemic and interest rates weigh on valuations. US Fed policy may also appreciate the US dollar further which will negatively impact earnings from the numerous global-leading US firms. Regional equity valuations have risen from their lows of the past decade, but there are pockets of value which investors can exploit.

  • Japan may surprise

The market most likely to perform strongly in 2016 is Japan. Unlike the Greenback, the Yen is cheap and that helps Japan’s fabled exporters. The Japanese government is also continuing with pro-market reforms, equity valuations are attractive and Japan benefits more than most from declining commodity prices (especially from cheaper oil) given its large imports of raw materials.

What can investors do?

There are several things investors can do in the current investment terrain. Firstly, examine valuations to determine the long-run opportunity set. This suggests that given current valuations, not all regional sharemarkets offer solid returns with low risk. Secondly, be aware of cycle risk as some assets may be value traps, even though they appear attractive on a relative basis. Indeed, while the Emerging Markets trade at a lower multiple relative to their advanced economy peers, their 2016 outlook is poor as forecast double digit earnings growth is completely unrealistic given regional economic growth is subdued, the US dollar is appreciating, the US Fed is raising interest rates and a multi-year deleveraging process is about to begin. This tells us that investors in this region either have to wait for the cycle to become more favourable, or assets have to become serially cheaper to circumvent cycle risk.

Thirdly, investors can be more discerning in their portfolio construction and accept that relationships between variables change over time. Indeed, Emerging Markets exposure may mean that you have to travel down a steep chasm this year before you reach the bottom and it may take considerably longer to recover any loss given the changing growth dynamics of the region.

The conclusion here is that the world is not accelerating at all as modest growth improvements in advanced economies are offset by structural declines in the Emerging Markets. Accordingly, investors need to be more cautious as valuations are elevated, forecast earnings growth is far too optimistic and the US Fed will continue to increase US interest rates. How the year plays out is unclear but the only surety is that volatility will increase and your best defence against this is the quality of the assets that you hold, whether it be a stock, a sector, a market or an asset class. These assets give investors downside protection should things deteriorate and upside potential should the earnings outlook turn out more favourable than current expectations.

This analysis has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information and is not intended to provide you with financial advice. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.