While we write in a predictive spirit, our views are necessarily malleable and we look forward to revisiting them with you throughout the year. Events will inevitably challenge us and influence the investment strategies that are in place for our clients as we start the New Year.
Since 1998, we have entered each year with a "base case" forecast outlining our views on the coming year. Yet, we are experienced enough to know that things do not always turn out the way we expect.
We are foremost in the wealth preservation business. Our theorizing and scenario planning is aimed first at inoculating our investment strategies against losses and providing stability for our clients regardless of whether our "base case" is correct.
Our second goal is to focus on trends we think will prevail during the next 12-24 months in order to profit from them.
Our "base case" is that 2016 is likely to be marked by a higher level of volatility and overall lower average market returns than we have seen in recent years. We also feel the probabilities of currently unknown events shaping market behavior are higher than it has been in the past. Our underlying rationale for our "base case" has to do with two major themes: divergent monetary policy and the China wildcard. We started drafting regarding these themes before the January 4 China-sparked draw down in markets around the world.
Divergent monetary policy relates to the reality that even as the US begins to tighten its money supply, the European Union (EU), United Kingdom (UK), Japan and China remain intent on looser monetary policy and more easing. Until December, US rates still hovered around 0% and the U.S. remained aligned with the rest of the developed world in a united front, flooding the globe with cash and nursing the global economy toward health. Now with the rate raise on December 15 - the first rate change since 2008 - U.S. policy is clearly diverging.
Bluntly put, there are good reasons other major central banks continue to be in an easing mode - they really need it! Japan is still facing recession. The EU is struggling with deflation and seems to flirt with recession on a near quarterly basis. China continues to fall short of its - ambitious - growth targets. Emerging markets are likely in a secular decline.
Prudent investors must consider the possibility that monetary policy could converge again later in 2016 or 2017. If the global economy falters in 2016, as some fear, the U.S. Federal Reserve Bank may have to alter its course and go back to a more dovish policy.
However, our "base case" is that the opposite is more likely. Most global economists are currently forecasting a moderate increase in global GDP growth rates. We believe that is a reasonable assumption. Consensus from the most recent Bloomberg economic survey is 3.6% global GDP growth in 2016.
Another major theme we foresee is China as the pivotal player for emerging markets and perhaps for all markets in 2016. Our "base case" is that China continues with a moderate level of growth in the 5-6% range. This is lower than their reported historical average, but still remarkable considering China is the world's second largest economy.
We do not believe there will be a "Chinese meltdown." As we have recently covered in Ellumination, given their foreign currency reserves and near 5% interest rates, China has leeway to pursue a range of monetary and fiscal policies to keep its growth rate at or near target. In 2009, China's credit expansion significantly helped the global economy as well as the Chinese. However, going forward, how China props up its own growth could well have destabilizing effects on other economies, especially emerging markets.
For example, in its effort to remain competitive, China may well continue to devalue the Yuan. Such devaluation could lead to contagion, further weakening already fragile emerging market economies and quickly spreading to developed markets. Lest we forget, in 1997, devaluation sparked the Asian financial crisis.
THOUGHTS ON THE RECENT RATE HIKE BY THE U.S. FED AND INTEREST RATE CHANGES IN 2016
With the rate-hike announced on December 15, the Fed embarked on what many - ourselves included - believe to be a poorly timed decision. The recent headline reduction to the US unemployment rate masks a number of delicate data points that hardly point to robust recovery. Our hope - although at this time not necessarily our conviction - is that it will be a "one and done" and we won't see more rate raises in the US in 2016; or at least not in the first half of the year.
According to a broad survey of economists by Bloomberg most seem to be expecting at least two more increases in 2016. A few are expecting a total of four.
THOUGHTS ON U.S. AND GLOBAL EQUITY MARKETS FOR 2016
Looking forward, we are likely to take an even more cautious stance than we did last year.That is particularly true as we move into Q1 of 2016. U.S. stocks, in particular, were priced for perfection as of December 31, 2015. We would be a lot more comfortable being an aggressive buyer of stocks if major U.S. averages were at least 10-15% below those levels.
In our 2015 Investment Outlook, our foremost predictions were that equity markets would prove more volatile than they did in the prior year and that we'd see only modest gains in US equity returns. Indeed, while the VIX (US market's implied volatility) averaged just 14 in 2014 it jumped up to 17 in 2015. The higher number represents a higher level of market volatility. There are a number of reasons we foresee further increased volatility and only continued modest growth in US markets during 2016.
The "cheap money" resulting from post-crisis easing policies helped stoke developed world stock prices. It is for this reason that since 2012 equity returns can be explained mostly by multiple expansion and not earnings growth. That is to say it is the prices of shares that have risen (the numerator of the P/E ratio) and not earnings (that equation's denominator). Even a whiff of possible tightening - as we've seen in the back half of 2015 - sends a shiver of sobriety. Shareholders ask "Are these prices worth it? Will we see these companies we have been investing in actually grow?" Without clarity as to the answer, many choose to press the "sell" button now and ask questions later.
The graph that follows portrays the ups and downs of the S&P 500 throughout 2015. There was a lot of volatility in the second half of the year. This index opened 2015 at 2056 and closed the year at 2044. In August it got as low as 1861. The difference between the high and the low during the year was 12.84%. In the end there was no return for the year.
We think that 2016 could be just as volatile, if not more so.
SEE CHART BELOW
The coming year is only likely to bring more uncertainty. Firstly, rising rates in the US will begin to reign in how much US investors' have available to shovel into stocks. Higher rates will also curb companies' ability to grow earnings. With the US unilaterally starting to pursue more hawkish monetary policies, the dollar will continue to strengthen. One of our highest conviction trades for Q1 and Q2 of 2016 is a rising U.S. Dollar.
Such dollar strength can be devastating to American firms. Imports become more attractive to consumers (as they become relatively cheaper) and at the same time US goods and services sold abroad become less competitive (as they become relatively more expensive). Besides the impact of a strengthening dollar, companies' costs to borrow increases, so investments in plants and production become less viable, further dampening earnings (albeit more in the long run than immediately).
Considering the gloomy scenarios we've presented, why are we not even more pessimistic? Why are we not predicting that US stock prices will drop in 2016? As we've mentioned, the rest of the developed world continues with unprecedented monetary easing. For many international investors, the US may continue to be "the cleanest dirty shirt" (as Bill Gross famously said in 2012 referring to the US bond market). Compared with what is going on in the rest of the world, there is a modicum of confidence the US is on a slightly upward trajectory.
Bloomberg surveys show earnings forecasts for the S&P 500 to range between $120 and $130 for 2016. Consensus seems to be closer to $125. The mean Shiller P/E for the entire history of the index is 16.7. If the S&P 500 were to end 2016 at the mean (16.7 x $125) it would end the year at 2087. It closed on December 31, 2015 at 2044. If the S&P 500 closed 2016 at its average "forward annual P/E" of 14.3 it would close at 1787.
In other words, for the S&P 500 to close significantly higher at the end of 2016 one of a couple of things has to happen. Either earnings have to increase much faster than currently expected. Or, investors must be willing to pay even higher premiums to own stocks than is currently the case. We are not expecting either to happen.
One of the reasons we see limited upside for equities all-around is that valuation levels are elevated everywhere, not just in the US. In the US current forward PEs are about 16.5 (compared with 14.3 ten-year average). However, in Europe forward PEs average 15.5 (compared with a 12.2 ten-year average). Japan is the only developed country where the forward PE is lower than the 10-year average. Forward PEs in Japan average 14.6, compared with a 16.2 ten-year average.
Emerging market forward PEs are low, just 11.1 (compared with 11.9 ten-year historical average). However, we feel these low valuations are justified. China has shown its willingness to de-peg from the US dollar and pursue additional currency devaluation. Further Yuan devaluation could send other less robust emerging economies into a tailspin. Most emerging economies businesses have US Dollar and Euro-denominated debts.
More than anything this hodgepodge of good news - continued dovish monetary policy in Europe, Japan and China - and bad news - US rate hike and Emerging Market secular slump - sprinkled liberally with uncertainty presages volatility.
Charlie Tian of Gurufocus.com, one of our favorite value investors, is predicting a 0.5% increase in the US stock market over the next one year. This prediction sits well with us, yet, rest assured, we will work hard to take advantage of volatility and thereby do our best to earn higher returns for our investors.
MORE THOUGHTS ON FIXED INCOME MARKETS
It is easy to forget that the global bond market is about twice the size of the global equity market. US Treasury debt alone comprises about 30% of this $100+ trillion market. So, even as we remain less than sanguine on the prospects for a traditional buy-and-hold fixed income portfolio, we feel there are certainly pockets within the enormous fixed income market that will present opportunities.
In the near-term, we are likely to see defaults on the bonds of companies that can't survive prolonged low energy prices and/or a continued strong dollar. That said, in the longer term, with the prospect of clarity about the trajectory of US Fed rate hikes, we could see US fixed income, especially US sovereign debt, as the "cleanest dirty shirt" for US institutional investors who are still required to hold a certain amount of fixed income as a percentage of their overall portfolio. Indeed, the certainty of bonds' increasing fixed cash-flow may become increasingly attractive for those who rely on yield for income.
Yields on US securities, including treasuries and corporates, will rise along with the Fed's hikes (even as the prices of such bonds trade down, as a bond's price and yield always move in opposite directions). Already, the prospect of hikes is factored into the yield on the 10-year treasury, currently hovering around 2%. For comparison, the yield on the equivalent German government bond is a mere 0.50%.
Ultimately, not unlike our outlook for equities, although the overall picture is uncertain and to some extent bleak, we do foresee volatility as an opportunity, and the main reason an active approach to investing will make the difference between flat and up-trending returns.
WHAT ABOUT COMMODITIES AS AN INVESTMENT IN 2016?
Commodities were slammed 2015. The CRB Commodity Index is currently near its 43-year low.
Despite these low valuations, we do not currently see commodities as a buying opportunity and fear commodities (and many of the emerging market economies that rely on them for export) may have entered a prolonged bearish cycle.
While prices may come up somewhat from these all-time lows, we currently do not see a rationale for the increased demand that would drive price appreciation. Global growth remains sluggish. According to the IMF, 2015 had the slowest level of growth since 2009. Going forward as well, the IMF has warned of continued slow growth.
Moreover, China's deliberate move away from a manufacturing to a services-driven economy will continue to take a toll on commodity demand. As one economist said, "trees don't grow to the sky." For many commodities, prices had been based on assumptions that Chinese manufacturing growth would continue at unusually high rates. Simply put, supply will likely to continue to outpace demand, resulting in little upward price pressure.
SEE CHART BELOW
From the technical perspective as well, commodities do not present a buying opportunity, despite low valuations. As this chart shows, commodity prices only continue to collapse and there is no sign (yet) of stability. This index is comprised of 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.
What does this all mean for our clients? Firstly, back to basics.... Our top priority is your ongoing financial well-being. In Q1 of 2016 we will be contacting you to talk about how volatility and this market environment may affect you and your family's portfolio in the coming year and what we are doing in terms of portfolio inoculation. It is also an opportunity to review and perhaps update your financial plan as well as your estate plan. We are here to help you develop and sustain your long-term financial goals.
As we look forward to 2016, volatility and unpredictability underscore our "base cases" for all major market classes, both domestically and internationally. The markets are an amazingly dynamic organism and so too is your 5T investment team. We are consistently incorporating new information and challenging our views.
As we have discussed, with the US rate hike on December 15, we officially entered the uncharted territory of global divergent monetary policy. Concurrently, more than ever, how China decides to foster its economic growth will have repercussions both for developing and developed markets. We will almost certainly acclimate to a "new normal" in terms of the levels of uncertainty and volatility we'll see in the markets.
In such an environment, more than ever, active management should be the key to out performance. Your long-term prosperity and happiness is what has always been most important to us and we are thrilled an honored to be working with you again this year.
Our entire team wishes you a happy and prosperous 2016.
All the best,
GOVINDA, PAUL, MARIAH, JEFF, & PHILLIP
THE INVESTMENT POLICY COMMITTEE
5T Wealth Management, LLC
(707) 603-2672 Office
(707) 486-7333 Cell
Disclosure and Disclaimer - Updated last on JANUARY 6, 2016 by Paul Krsek:
ELLUMINATION is the proprietary newsletter written for clients, friends, and affiliates of 5T WEALTH MANAGEMENT .
SINCE 1998 Paul Krsek HAS BEEN the sole author of ELLUMINATION. While the views and representations found in the newsletter generally reflect the attitudes and opinions of the 5T WEALTH MANAGEMENT members and staff, Krsek wrote without editing was therefore is solely responsible for the content and opinions contained in ELLUMINATION.
AS OF JANUARY 2016 ELLUMINATION IS NOW A COLLABORATIVE EFFORT OF THE INVESTMENT POLICY COMMITTEE OF 5T WEALTH MANAGEMENT, LLC. THAT COMMITTEE IS CURRENTLY COMPRISED OF GOVINDA QUISH, PAUL KRSEK, MARIAH QUISH, JEFFREY ROUSH AND PHILLIP LAMPE.
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