Global economic update
What does 2016 have in store for investors and what can we learn from the performance of global markets last year?
It was a turbulent end to 2015, with many of the most significant events taking place in December. As we start the New Year, we are already seeing a major divergence in monetary policy between the Federal Reserve (Fed) and European Central Bank (ECB), which is likely to dictate the direction of markets in 2016. For now, markets appear to be in ‘wait and see’ mode. Following the Fed’s first interest rate hike in over nine years in December, the more hawkish members of the Federal Open Market Committee (FOMC) are very much in ascendance. In contrast, the ECB is moving in the opposite direction.
Cautious optimism in the eurozone
The outlook for the region continues to steadily improve, despite facing ongoing economic and political headwinds. However, the recovery remains fragile and the ECB sees downside risks to both its growth and inflation forecasts. An empowered Mario Draghi has set his stall out with strong messaging that the ECB will strengthen its efforts in the fight against deflationary pressures in the eurozone. Draghi has raised market expectations, so now he needs to deliver.
Clear forecast for the UK
Chancellor George Osborne delivered a politically astute Autumn Statement, with favourable revisions to public borrowing and tax revenue from the Office for Budget Responsibility (OBR) allowing him to ease back on controversial austerity measures. The big picture for the UK economy remains bright. The Chancellor still expects a budget surplus by 2019/20 and although economic growth remains unbalanced and driven almost solely by consumption, forecasts have held steady. The OBR expects growth of 2.4% in 2016. Wage growth has shown early signs of running out of steam, easing back towards the end of the third quarter. However this does warrant attention at the moment, as the UK remains in a sweet spot of low inflation (core CPI at 1.1%) and positive real wage growth, which continue to boost disposable incomes and support consumption growth.
Ultimately, there’s little pressure on the Monetary Policy Committee (MPC) to move on interest rates and, after a dovish Inflation Report in early November, interest rate expectations in the UK remain benign. We don’t expect a rate rise in the UK until at least the middle of this year. Moreover, given the ECB’s venture further into negative territory with interest rates, the MPC will be aware that a more hawkish tone will be deemed a relative tightening, and risk strengthening sterling further against the euro.
The FTSE 100 and its large sector exposure to commodities (through energy and materials) is likely to continue to drag on overall performance. We are reluctant to call a bottom for commodity prices, however, any rebound in prices and further evidence of stabilisation in China, could mean the FTSE begins to outperform after years of lacklustre performance. But for now and while the outlook remains clear, we continue to prefer the more domestically-focused companies.
US tightening cycle on the way
Following better than expected US labour market data in October, the Fed raised interest rates by 0.25% in mid-December. The Fed’s positioning, although clumsy at times, has no doubt shifted towards a more hawkish view of the US economy where a firming of the labour market is expected to finally trigger a return of inflationary pressures, and the need to raise interest rates. In recent months, the Fed shifted the focus from the timing of the first hike, to that of managing expectations over the path and magnitude of subsequent interest rate rises. The market is currently anticipating a shallow and gradual tightening cycle. Consequently, we expect the Fed to bring its forecasts for longer-term interest rates more in line with the market’s current view, but the messaging from Janet Yellen will be highly scrutinised by markets.
Analysis of recent US tightening cycles (1977, 1986, 1994 and 2004) shows that after a brief period of heightened volatility, equity markets continue to push higher following an increase in interest rates. This is a reflection of a stronger US economy and a supportive backdrop for companies. We are hopeful that this scenario plays out, but our view remains that the US economy is yet to fire on all cylinders and the Fed can afford to wait for firm evidence of inflationary pressures to come through. Although there’s little doubt the US economy can absorb a marginal interest rate rise, the risk that the move is deemed a policy mistake by markets cannot be ignored.
Clear tailwinds for markets over the next 12 months
Looking ahead for this year, the main risks for financial markets are likely to be a continuation of some of the key themes that dominated 2015. The environment of lower nominal GDP growth and inflation is likely to persist. Although, we could see inflation pick up marginally in the New Year as the anniversary of the sharp fall in oil prices causes year-on-year comparisons to increase. To date, we have seen little evidence of inflationary pressures coming through. Lower nominal GDP growth implies lower revenue growth for companies. This remains an additional concern for companies in the US who are already facing headwinds from a stronger dollar. Should there be another notable leg up in the US currency, emerging markets will continue to feel the squeeze, particularly those commodity exporters with sizeable current account deficits. Although emerging equity market valuations look relatively attractive, too much uncertainty surrounds the dollar, commodity prices and China to have high conviction at the moment.
While there are numerous risks facing markets, the clear tailwinds for markets as we start 2016 should not be ignored. Lower commodity prices remain a positive for consumption in the developed world and are likely to keep inflationary pressures subdued. In this environment, interest rates are likely to remain lower for longer and with ongoing financial repression, equity markets remain attractive for both income and capital growth. The eurozone and Japan markets appeal thanks to a combination of favourable valuations and ongoing quantitative easing are likely to produce better returns relative to the US next year.
Should sentiment continue to improve towards China, commodity prices begin to rebound and the US economy gather steam, then some of the unloved sectors in recent years, mainly those that are more cyclical and commodity-related, could come back into favour in 2016.
For more information, contact:
Smith & Williamson, UK
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