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In this edition of the Quarterly Investment Review, I will focus on some of the key factors influencing the investment landscape in 2016 global growth outlook, drivers to equities and fixed income, as well as the importance of dynamic asset allocation. 2
2015 has been a challenging year for most asset classes. For those asset classes that have generated a positive return, such as Asian corporate debt or developed market (DM) equities, performance was only marginally better than cash equivalent. Meanwhile, Asian and emerging market (EM) equities, as well as global high yield corporate debt, have suffered losses in 2015 due to a combination of factors such as weak commodity prices, soft global growth and dollar appreciation. As a result, our hypothetical weighted asset allocation (diversified) has generated a negative return and underperformed cash for the third time in the past 10 years. 3
2016 is expected to be a year of respectable, but not spectacular, economic growth for the world economy as a whole. More importantly, we need to pay attention to the relative performance between DM and EM economies. We have experienced a convergence in economic growth between DM and EM economies since 2012. This is partly due to the ongoing recovery of the U.S. economy and the economic stabilization in Europe. Meanwhile, China s economic slowdown and hard times for commodity exporters have also put pressure on emerging countries. Even as the IMF is expecting this convergence to slow in 2016, the outperformance of emerging markets may not return to the best of times we experienced before the global financial crisis. 4
Near term cyclical indicators, such as manufacturing Purchasing Manager Indices, continue to show that DM economies are enjoying more solid growth momentum than emerging markets. This is particularly true in the U.S. and Europe. For emerging economies, the downturn of the global trade cycle and weak commodity prices are impacting production growth. One piece of good news is that the low inflation environment is likely to persist and this would allow Asian central banks to maintain a low interest rate policy even at a time when the U.S. Federal Reserve (Fed) is slowly normalizing its policy rates. 5
The three major developed economies central banks, namely the Fed, the European Central Bank (ECB) and the Bank of Japan (BoJ), have all adjusted their monetary policy in December 2015. The Fed has finally ended the near zero interest rate policy. The ECB has extended its quantitative easing (QE) program to March 2017 and the BoJ has also fine tuned its QE program in terms of asset purchase in equities. We expect limited action from the ECB and the BoJ in the first half of 2016 unless there is a substantial change in their economic and inflation outlook. For the Fed, the path of rate hike is expected to be gradual and cautious. Do not be surprised to see the Fed pause if there are any speed bumps on the road. 6
Growth in the U.S. is still well supported by consumption and corporate investment even if investment in the energy sector has been hit due to low oil prices. Inflationary pressure is also largely absent at this stage which means the Fed can remain gradual in its rate hike cycle. Unemployment rate is likely to fall further and this would eventually put some pressure on wage growth. 7
The recovery in the euro area is steady. Despite the Greek debt saga in 1H 2015, other peripheral European countries, such as Spain, Italy and Portugal, are posting firm growth numbers. Both businesses and consumers in Europe are also confident and these are reflected by improvement in retail sales and auto registration data. Headline inflation is still hovering around zero due to low energy cost but core inflation (excluding food and energy) is slowly rising. 8
For Asia, the tough times of weak exports and production is unlikely to ease any time soon. The global trade cycle is still in a downturn and demand from the U.S. and Europe are not sufficiently strong to offset the negative impact from China s slowdown and weak commodity prices. It is not just commodity exporters that are suffering, manufactured goods exporters, such as Taiwan and South Korea, are also facing weak demands. There are little immediate signs of rebound at this stage. This could limit the upside surprises for Asian corporate earnings in 2016. 9
Our view of DM equities outperforming EM and Asian equities in 2015 has been largely correct, although dollar returns from Japan and Europe were disappointing. In addition to weak earnings performance, Asian equities performance has also been weighed down by the strong dollar. The significant volatilities in August and September were also a big challenge for equities. Our preference for developed markets over emerging markets on a risk adjusted basis remains in place for 2016. 10
For developed economies, U.S. corporate earnings have suffered a double hit from cheap oil (on energy sector) and a strong dollar (hit on overseas earnings) in 2015 that should gradually dissipate and add to earnings growth. Still, U.S. companies need to find sources of earnings growth as profit margin peaks. There is more upside potential for European corporate earnings to improve given relatively low profit margin but improving economic fundamentals. Japanese companies can no longer rely on a weak yen to help boost earnings, but improvement in corporate governance and greater emphasis on return on equity should continue to appeal to investors. 11
For emerging markets, valuation is low relative to history, but this has been a less appealing attribute to investors in recent years due to weak earnings prospects. We believe investors should continue to differentiate amongst various markets within emerging markets. Moreover, we believe there are a number of catalysts that would help to support sentiment and encourage EM equities re rating. Stabilization in commodity prices and Chinese economic performance are critical to providing some stabilization to EM economic and earnings performance. The end of the dollar strength would help too. 12
Fixed income continues to be an important part of an investor s asset allocation since it provides much needed stability to the overall portfolio. But the challenge in 2016 is how to ensure the total return from fixed income is not inferior to cash. U.S. Treasury and DM government bonds are unlikely to generate sufficient return and they are potentially exposed to volatility as a result of the normalization in the U.S. monetary policy. Investors can consider selectively invest in corporate debt and EM debt. 13
Many investors are concerned about the outlook of the global high yield debt market, as low oil prices have increased the risk of default for high yield issuers in the energy sector. While this may be the case on an individual company basis, it is also important to recognize that the non energy issuers should remain well supported by the steady growth of the U.S. and European economies. Moreover, the repayment pressure is light for 2016 and 2017. Hence, the significant widening in spread is a potential opportunity for investors, especially given the ongoing hunt for yield in still a low rate environment. 14
Oil prices have continued to push lower on supply concerns, and this worry has been exacerbated by the Organization of the Petroleum Exporting Countries (OPEC) that is maintaining its output target and possibly increasing production from Iran. While some of the high cost producers, such as shale oil in the U.S., have cut back their production investment sharply that should be reflected through weaker supply growth, the risk to supply remains on the upside. Even as global consumption is likely to expand steadily, it would take time to absorb the new supply as well as run down the high level of inventory. 15
The divergence in central bank policy is still likely to be supportive of the dollar even though the extent of appreciation is likely to be much more limited than in 2014/15. Moreover, we continue to stress the importance of differentiation amongst currencies when it comes to considering the performance. Countries with strong current account surplus and less dependenc on commodity exports are likely to enjoy more currency stability. 16
As we noted at the start, 2015 has been a tough year for investors and this chart has shown the weighted contribution from various asset classes to our hypothetical diversified portfolio. 2015 was difficult as asset classes that generated positive returns have been outweighed by negative performance in other asset classes, especially EM and Asian equities even though these two asset classes only have a combined weight of 30%. This implies that it is becoming more important to adjust the weight of various asset classes in active asset allocation in order to enhance the impact of preferred asset classes and limit the drag from asset classes that investors believe could underperform. Also, a long only strategy may no longer be sufficient and selective use of relative value strategies may be needed to improve the overall return of the portfolio. 17
We believe that volatility in both fixed income and equities could remain high in 2016. Uncertainties from the Fed, possible speed bumps on global growth and nervous market sentiment could all raise volatility. Investors should also be aware that the traditional negative correlation between equities and fixed income could temporarily break down during periods of heightened volatility. This would reduce the effectiveness of diversification, but we continue to believe that a well diversified portfolio is still investors best option. They just need to be mentally prepared for these occasions. 18
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