Business

Not so great expectations

  • The mediocre growth environment is likely to continue, with the strong consumer/weak capital investment environment more helpful for developed markets than emerging markets.
  • Economic growth is scarce, the outlook for earnings is challenged, and geopolitical risks are as elevated as they have been for a long time.
  • While prospects for earnings growth aren’t too exciting, the combination of low single-digit earnings growth and a dividend yield could still take equities to a real return of 6-7%.

Two months ago I wrote that financial markets were facing their own version of Groundhog Day. Issues that had troubled investors all year—namely the lack of meaningful global economic growth despite years and years of policy stimulus, the macroeconomic slowdown in China and the precise timing of the Fed’s first rate rise—were all weighing on investors’ minds and showing few signs of being resolved to anyone’s satisfaction. Fast forward to now and the first Fed rise is out of the way with relatively little fanfare, but the other issues remain as murky as ever. Perhaps more worryingly, all this has occurred against a backdrop of worsening financial market liquidity, with some credit markets in outright “sell what you can, rather than sell what you want” mode.

To the outside observer, the environment described above does not sound particularly healthy for risk assets such as equities and credit. This caution is reflected in sell-side analysts’ estimates of earnings growth for equities: after several years of forecasting double-digit earnings growth, the consensus expects global earnings growth of just 6.5% in 2016—not a disaster, but unlikely to set the world alight. In our EMEA-managed asset allocation portfolios, we have continued to emphasize equities over bonds but with reduced conviction, and we have been trimming exposure to stocks on the days that markets have rallied as a risk reduction measure.

In hindsight, Wall Street’s cautious outlook for 2016 and the broader mood of despondency probably reflect the belief that the past few years were the easy ones, even though they didn’t seem that way at the time: economic growth was very modest but steady, inflation was very subdued, central bank policy was extremely supportive, and the world was awash with dollar liquidity. While inflation does not appear to be a medium-term risk (unless we see a spike in oil prices—more on that below), the other supportive factors have started to turn. Indeed, some observers are talking about the risk of a U.S. recession in 2017. Cynics would argue that the Fed has only raised rates so that there is some scope to cut them again when the next slowdown arrives. Other central banks might not have that luxury.

So what does this mean? The mediocre growth environment is likely to continue, and the strong consumer/weak capital investment environment is likely to be more helpful for developed markets than emerging markets. However, that is not to say that developed markets will be off to the races —sovereign wealth funds are likely to make further redemptions from developed markets as the oil-producing nations, in particular, continue to face major budgetary challenges. There is also the possibility that the Fed might stop reinvesting the proceeds of its QE program at some point in 2016 —that could mean another $200 billion of liquidity being withdrawn from markets. M&A and share buybacks undoubtedly provide some support for equity markets although an environment of rising volatility and richer valuations may be enough to make some companies think twice before engaging in such activity.

One of the bigger challenges for investors over the coming months will be how to deal with the evolving geopolitical landscape and, in particular, the knowledge that technological change means it is now much, much easier for fringe and radical groups to destabilize the world should they choose to do so. In Northern Europe, there seems to be a growing realization that ground forces will be required to defeat Islamic State, but appetite for another potentially protracted conflict in the Middle East is limited at best. In the meantime, the deteriorating geopolitical environment and growing immigration problem in Europe make a fertile environment for right-wing and extremist parties; the growing popularity of the National Front in France in particular is worrying. A state of emergency seems sensible following the attacks on Paris, but the same scenario under a more nationalistic or extreme leadership might not look quite so palatable.

I continue to think that oil prices could have a major impact on financial markets in 2016. The consensus view is that oil prices will remain weak, and while prices may stabilize in the near term, they will not return to the heady $115+ levels seen just a few years ago. However, just as markets have been slightly complacent in treating U.S. interest rate rises as an issue that only affects the U.S., it is dangerous to assume that oil prices will remain low forever. Saudi Arabia, the world’s largest oil producer, has spent a huge amount of its wealth in recent years in order to support social and housing programs, but these schemes (which help to legitimize the government) are now under significant pressure due to the slump in the oil price. Inevitably, lower spending will weaken the government’s popularity at a time when it is already engaged in expensive wars and jockeying with Iran for regional supremacy.

The evidence would suggest that oil prices should be firmer. Certainly any signs of frailty in the Saudi government could see oil prices bounce in very short order—although fans of Keynes will point out that markets have a tendency of staying irrational for longer than investors can remain solvent.  If oil remains weak, there is a real risk that Saudi could abandon its currency peg to the dollar and in that event, an oil price of $20/barrel or lower is not unthinkable. A few months ago, such ideas may have seemed far-fetched, but now they need to be on our radars.

Longer term, there will be a heated debate about the role of oil in a low-carbon or “decarbonized” world. On the one hand, countries need energy security (hence the ongoing debate about shale and fracking in the U.K. and other countries). Balanced against this will be the growing evidence of climate change. Oil bears are keen to point out that in years to come oil fields could become “stranded assets” that no one will want to own—which perhaps partly explains Saudi’s desire to keep producing, despite low oil prices. The stranded asset talk is perhaps a doomsday scenario, although it does serve to highlight the pressure that the oil industry is under.

Taking everything together, we are left with a world where economic growth is scarce, the outlook for earnings is challenged, and geopolitical risks are as elevated as they have been for a long time. The one bright spot in the world, from my perspective, is Japan. With a fair chunk of the yen’s depreciation likely behind us (particularly if U.S. macro data begins to soften), there are still grounds for optimism for earnings growth, aided by the growing realization within Japan that companies should be run for the benefit of shareholders, not just management and staff.

With the notable exception of Europe (which has also benefited from currency weakness), it is hard to get excited about the broader prospects for earnings growth in 2016 although the bulls would say that the combination of low single-digit earnings growth and a dividend yield could still take equities to a real return of 6-7%. That might not look quite so bad in a world where the real return on cash (and many shorter-dated bonds) is likely to stay negative.

Link to “A fork in the road,” by Colin Moore: “A fork in the road”
Link to “Credit triggers: When will the long-running credit cycle end?,” by Jim Cielinski and David Oliphant: “Credit triggers: When will the long-running credit cycle end?”