2016: growth, but no momentum
A case of lacklustre Goldilocks
The coming year can just about be described as a ‘Goldilocks’ environment (not too hot, not too cold), but not a very appealing one. It is likely to be characterised by weak inflation, an absence of momentum in economic growth, concerns about the effectiveness of monetary policy, ongoing weakness in emerging markets, and periods of elevated volatility in financial markets. This scenario for 2016, as outlined in this edition of Perspectives, reflects a number of key convictions about the secular outlook.
In the inflation/deflation debate, we are in the deflationist camp. Admittedly, headline rates of inflation are likely to rebound in the coming year as the impact of the sharp fall in oil prices since 2014 drops out of calculations. However, we think that the upturn in inflation will probably be limited, because deflationary pressures arising from overcapacity in the global economy remain strong. Notably, China has barely begun to tackle the huge overhang of excess supply in its manufacturing sector. The risk of deflation will therefore persist, and DM central banks will struggle to hit their 2% inflation targets. For example, even with QE, the ECB expects inflation to be only 1.0% in 2016 and 1.6% in 2017.
In the secular stagnation/growth debate, we are in the growth camp. According to proponents of secular stagnation, structural headwinds to growth, most notably adverse demographics, could result in permanently lower rates of economic growth in developed economies. However, we are more optimistic. In our view, growth is gradually normalising as cyclical weaknesses abate, and we expect fairly healthy rates of economic growth in developed economies in 2016 (2.3% in the US and 1.8% in the euro area). Moreover, we believe that an innovation shock could boost growth in the coming years — and indeed that a technological innovation shock has already begun, although its effects are still concentrated on certain sectors for now. Seven sectors are playing a leading role: the internet, IT/information and data processing, automation, transport, energy, life sciences and smart materials. Our US quality equity allocation represents a play on this emerging innovation shock.
We expect central banks to remain broadly supportive of financial markets in order to preserve the wealth effect generated by QE and bolster economic growth. However, they are running out of steam. Their monetary policies will remain desynchronised, non-homogeneous and non-cooperative. For instance, in 2016 we expect the Fed to pursue a gradual tightening path, following a likely first rate rise in December 2015, while the ECB took interest rates further into negative territory and expanded its QE programme in December, and may yet loosen policy further. The uncertainty and imbalances arising from these divergences are weakening central banks’ ability to repress financial volatility. We accordingly think that volatility will increase in 2016, with a standard volatility regime punctuated by spikes.
We believe that emerging economies will be a source of risks for the global economy and for financial markets as they transition over several years from an export-based model to one with a greater role for domestic demand. The gap in economic growth with developed markets has narrowed sharply and will remain compressed in 2016. Moreover, the micro environment is lacklustre, with EM earnings growth in single digits, and there are still considerable downside risks to many EM currencies. The large expansion in corporate debt in recent years is a concern, and developments in certain large emerging economies, notably Brazil, pose the risk of a shock. We therefore retain a cautious stance towards emerging assets in 2016, although there may be tactical opportunities.
Bearing in mind these underlying trends, expected returns for 2016 are for a nominal total of around 4% for a balanced portfolio — roughly in line with our forecasts for the long-term. Valuations are stretched, and further valuation expansions will be difficult in the absence of an improvement in earnings growth, which we expect at only around 5% for US and European companies in 2016. In this environment, an active tactical asset allocation and stock-picking will have a key role, as expected returns are low with a buy-and-hold approach.
With December already halfway through, all of my colleagues in the Investment Platform at Pictet Wealth Management join me in expressing our very best wishes for the end-of-year festive season. We would like to thank all our partners and readers for your loyalty, and we look forward to sharing with you in 2016 a New Year full of economic and financial developments.