The Year Ahead 2016 Monitor these key factors to guide investment decision making in 2016 2016: The highs and lows of the global investment landscape The lows Global growth Economic growth is expected to be close to long-term historical trends, with possible downside risk as central bank and government policy options are limited. Inflation Inflation is likely to remain low, even though the downward pressure from depressed commodity prices is likely to fade on a year-on-year basis in 2016. Interest rates in developed markets and Asia As a result of tame inflation, central banks in developed economies and Asia can afford to maintain low interest rates to support growth. Commodity prices Commodity exporters are likely to remain challenged but commodity consumers should enjoy a windfall as soft demand, excess supply and high inventories are expected to prevent significant price hikes. The highs Global liquidity Quantitative easing (QE) by the European Central Bank (ECB) and the Bank of Japan (BoJ), supplemented by low interest rates from other central banks, could be expanded or extended in 2016, flooding the global financial markets with liquidity. Volatility Policy divergence between the U.S. and other central banks, structural adjustments in emerging markets (EM) and downside risk to global growth could all add volatility to financial markets in 2016. The extra volatility would require investors to take a more prudent approach on risk diversification and asset allocation. The U.S. dollar The strength of the greenback is likely to persist, given the Federal Reserve s (Fed s) relatively hawkish policy stance compared to other central banks.
In 2015, investors worried about issues such as the Greek debt crisis, the Fed s policy rate liftoff and China s economic stagnation and its effect on the rest of the world. This glass half empty sentiment could prevail into 2016. The Fed s path to interest rate normalization is uncertain. Chinese policy makers must deal with structural reforms and revitalize a lagging manufacturing sector. Emerging markets, which have gone through three difficult years under the shadow of the Fed s prospective liftoff and China s slowdown, have largely avoided financial crises but still lack catalysts for growth. This paper uses 14 charts* from the Guide to the Markets Australia to spotlight the highs and lows that we believe investors should monitor to formulate an informed and rational view and guide investment decisions in 2016. We wish you a prosperous 2016, and may a high Sharpe ratio be with you! Tai Hui, Managing Director, is the Chief Market Strategist, Asia, based in Hong Kong. With over 15 years of experience, Tai formulates and disseminates J.P. Morgan Asset Management s views on the market, economy and investing to financial advisors and investors in the Asia region. With his knowledge and experience, he is able to explain and illustrate complex economic and financial issues in a digestible way, primarily via the Market Insights program. He also regularly appears on international and local financial media, including as a guest host on CNBC Asia, as well as Bloomberg TV and Reuters TV. Tai Hui Chief Market Strategist, Asia Prior to joining J.P. Morgan in 2012, Tai served as the Regional Head of Research (Asia) with Standard Chartered Bank in Singapore, covering the economic and financial development of the Asia region and delivering his analysis to corporate and institutional clients. Tai obtained a BA in Economics from Cambridge University and a Master of International and Public Affairs from the University of Hong Kong. *Data of these 14 particular slides selected from the 4Q 2015 Guide to the Markets reflect most recently available as of November 6, 2015. 2 YEAR AHEAD 2016
The lows: Growth, inflation, interest rates and commodity prices The risk of global recession is low as momentum suggests 2016 is likely to be a year of average growth. As the downward pressure on inflation from the oil price plunge in 2014-15 starts to fade, headline inflation should rise moderately, while remaining low by historical standards. The measured pace of rising inflation should enable central banks in developed economies and Asia to maintain low interest rates while the Fed gradually normalizes U.S. rates. GLOBAL GROWTH: STEADY DEVELOPED MARKETS, SHAKY EMERGING MARKETS Growth momentum in the U.S. is steady, helped by consumer spending. Corporate investment was affected by the oil price plunge, but it has been resilient in non-energy sectors. Consumers in Europe are starting to spend again, and this has helped to improve corporate sentiment. China is still feeling pressure from the slowdown in the manufacturing sector, even though the service sector and consumption are both holding up. Commodity exporters are unlikely to get much relief from low prices in the near term, while commodity consumers enjoy the windfall of cheap raw materials. UNITED STATES: MID-CYCLE GROWTH AIDED BY THE FED S CAUTIOUS STANCE U.S economic growth, well supported by consumption and corporate investment, should reach 2%-2.5%. Consumer spending is underpinned by healthier household balance sheets as well as a strong labor market. While investment in the energy sector fell in 2015 because of low commodity prices, capital expenditure overall is robust. The labor market is approaching full employment as the unemployment rate is poised to fall below 5%. However, wage inflation is still contained, a factor that could persuade the Fed to go slow with monetary policy normalization. J.P. MORGAN ASSET MANAGEMENT 3
EUROPE: WILL RECOVERY STAY ON COURSE? Despite the Greek sovereign debt saga, Europe s economic recovery has been relatively steady in 2015. It reflects the effectiveness of the ECB s QE program in keeping borrowing costs low, which in turn has encouraged banks to lend. Going forward, bank lending needs to remain supportive. Improvement in domestic demand has played an important role in offsetting weakness in China and other emerging markets. Consumer confidence has translated into growth in spending and car sales. Domestic and regional politics present some risk to Europe s recovery. The refugee crisis, which has exposed differences among European Union (EU) members, could be a source of uncertainty. CHINA: REFORM-LED RECOVERY China s two-speed economy is likely to persist into 2016, as shown by the trend in the country s manufacturing and service purchasing managers indices. Consumption and services will likely drive any rebound. Real estate activity should pick up speed both in terms of transactions and construction after monetary policy loosening in 2015. Manufacturing will probably stabilize to some extent in 2016 but there is not yet a catalyst for a strong rebound. We expect Chinese authorities to further reduce policy rates and reserve requirement rates to promote growth. Next year inaugurates the 13 th Five-Year Plan, which should carry forward reforms and liberalization. We expect structural changes, such as manufacturing upgrades, environmental protection and living standard improvement, will dominate China s investment opportunities. If China s liberalization of its capital and financial account continues, as forecast, it will require a stable currency. 4 YEAR AHEAD 2016
INFLATION: LOOSE MONETARY POLICY TO PREVAIL AS INFLATION STAYS LOW As oil prices stabilize at around USD 50-60 per barrel, the headline deflationary impact is likely to fade in 2016. Mediocre economic growth, however, means demand-side inflation is likely to remain in check. Low levels of demand-driven inflation means that central banks in developed economies, Australia and Asia can afford to maintain loose monetary policy. Strong external balances among Asian economies also imply steady currencies, allowing central banks to set their interest rates to support growth. Real interest rates in many developed markets and Asia remain low, even negative. This implies that investors hunt for yield to protect their purchasing power will be a key investment theme. OIL: DEMAND AND SUPPLY DYNAMICS COULD CAP PRICE SURGE Low energy prices have forced producers to cut back on capital investment. Subsequently, production growth, as forecast by the U.S Energy Information Administration, should slow dramatically in 2016. Consumption growth should remain steady. Consumers have adjusted to lower prices, which should lead to positive net demand growth and set a floor on oil prices. A sharp rise in energy prices could be mitigated by high inventory levels and potential for investment to rebound. The downbeat investment cycle in China and high inventory levels would also cap a rebound in industrial metal prices. J.P. MORGAN ASSET MANAGEMENT 5
The highs: Liquidity, volatility and the U.S. dollar Low inflation and downside risks to growth will encourage central banks to keep policy rates low. Europe and Japan are expected to maintain their QE programs for much of 2016. In fact, they could extend or expand the scale of these programs. Despite ample liquidity in the system, investor anxiety, policy uncertainties and elevated valuations in some asset classes could make for greater market volatility in 2016. While it is debatable how much further the U.S. dollar can appreciate, the greenback should still retain its strength as the Fed leads global normalization of monetary policy. LIQUIDITY: MORE QE ON THE CARDS FROM EUROPE AND JAPAN The ECB s QE program, scheduled to end by September 2016, could be extended and expanded. The region s inflation is still far below the ECB s target and the central bank is also worried about potential impact from the slowdown in China and emerging markets. The case for more QE from the BoJ has strengthened. While demand-side inflation has picked up, the economy has yet to deliver consistent growth, and corporate inflation expectations are declining once more. Further QE from the BoJ and ECB, and low interest rates from other central banks in Asia, would likely add to already significant global liquidity. In the medium term, this could lead to pockets of rapid asset inflation, or even asset bubbles. VOLATILITY: BE RATIONAL AND FOCUS ON THE FUNDAMENTALS It is important for investors to consider how to manage their portfolios volatility via asset allocation, as well as being mentally prepared for a choppier time in the market. The market correction in the summer of 2015, with the benefit of hindsight, was driven more by fear and risk aversion rather than a material deterioration in economic and earnings fundamentals. Such market sentiment could return in 2016 with lingering concerns over the downside risks to growth and the limited range of policy response available to policy makers. In some markets, such as corporate debt, the change in market structure could also lead to temporary liquidity squeezes, exacerbating short-term volatility. 6 YEAR AHEAD 2016
U.S. DOLLAR: THE GREENBACK STILL HAS THE UPPER HAND Both the U.S. dollar index and the U.S. dollar real effective exchange rate show that the valuation of the U.S. dollar is now broadly in line with 40-year averages. We expect that the dollar will remain strong, supported by the Fed s policy normalization and other central banks loose monetary stance, but we anticipate a slower pace to further appreciation. A strong U.S. dollar is particularly relevant to emerging markets, because the risk of capital outflow can often burden EM economies and their investment outlooks. Once the dollar peaks, it could herald a better time for emerging markets. Investment implications After appreciating some of the highs and lows that would have an impact on our investment landscape in 2016, it is important to translate that into asset allocation implications. PREPARE FOR FALLING RETURNS AND RISING VOLATILITY As the chart shows, a diversified portfolio delivers a middle-ofthe-rank performance among an established group of asset classes. Investors will need to take a more dynamic approach to asset allocation. Absolute returns have deteriorated as fixed income valuations have risen, along with valuations for some developed market equities. Equities will continue to serve as an important source of return to the overall portfolio, especially as return from fixed income declines. Fixed income still has a critical role to play, however, as an anchor of stability and a source of better return than cash. J.P. MORGAN ASSET MANAGEMENT 7
EQUITIES: EARNINGS OUTLOOK STILL FAVOR DEVELOPED MARKETS OVER EMERGING MARKETS Developed markets the U.S., Europe and Japan have outperformed emerging markets in the past three years. This trend is unlikely to change in the near term, since low commodity prices, a strong U.S. dollar and below-average global growth hamper EM earnings. In Europe and Japan, QE is encouraging flows into equities. Improving corporate governance can enhance Japan s appeal to international investors. VALUATION: BUILDING A CASE FOR EMERGING MARKETS EM equity valuations suggest the market has already factored in some of the earnings challenges and macroeconomic headwinds. The key to EM equity re-rating will be stabilization in both the Chinese manufacturing sector and broad commodity prices. A clearer picture of the outlook for U.S. monetary policy normalization, and the subsequent reduced threat of capital outflow from emerging markets, could also bolster confidence in the asset class. The timing for these catalysts is difficult to predict. Nonetheless, current valuations are attractive for investors with long-term investment horizons and the ability to endure volatility. FIXED INCOME: AMPLE LIQUIDITY TO KEEP YIELDS LOW Even after the Fed normalizes monetary policy, QE by the ECB and BoJ and low interest rates elsewhere are likely to sustain fixed income demand and prevent government bond yields from surging. At the same time, government bonds face reduced return potential in an environment of depressed yields and high prices. Investors will need to look for income by taking on more risk in the corporate debt market and select emerging markets. The Chinese bond market, now undergoing significant structural development, is one area where correlation with U.S. monetary policy is low. 8 YEAR AHEAD 2016
MULTI-ASSET AND FLEXIBLE APPROACH A multi-asset approach can lead to a more balanced risk-return profile by taking into account the correlations among asset classes. Alternative asset classes, such as hedge funds, private equities and real assets, can also enhance returns for those investors able to access them. Short positions can also help investors take advantage of market trends, such as currencies vulnerable to a strong U.S. dollar or assets that are considered overvalued. Not only can they bolster returns, but also such short positions can hedge against market corrections. Conclusion: Flexibility in the face of volatility Diversification and active management are likely to become more important in the challenging global investment landscape we envision for 2016. Facing the prospect of lower returns and higher volatility, and cash returns stuck at zero, investors will need to take a more flexible approach to asset allocation. This will require support from active managers to extract value from various asset classes, as well as access to a broader range of financial instruments. In this way, investors can hope to realize their targeted returns at appropriate levels of risk. J.P. MORGAN ASSET MANAGEMENT 9
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