Flexibility is important. Don't get tied down. Keep searching for attractive yields, be selective and make sure you are rewarded for the risk you take. That is the mantra for bond investors in 2016.
“The interest-rate hike in the US and the transition of the export-oriented Chinese economy to one more focused on consumption and services will be the most important factors for equity investors in 2016,” says Mark Glazener, head of Robeco’s Global Equity Team and manager of the Robeco fund.
These factors are playing out against a backdrop of slowing global economic growth. That growth is neither buoyant nor evenly distributed. “The US has already had several years of economic expansion and the Eurozone is showing convincing signs of recovery. In Japan, growth is still a challenge, partly because China won't play ball. Emerging markets are still grappling with an economic slowdown and China is in the driver's seat," according to Glazener. “Monetary policy will remain relaxed, but things will start to change. The United States will be the first country to raise interest rates.”
A hike in short-term rates by the US central bank, the Federal Reserve, has been on the cards for a year now. However, the majority of market pundits no longer expect the Fed to raise rates before the year is out. But, according to Glazener, it will definitely happen in the first half of 2016. “We think a series of 25 basis point increases in short-term interest rates will be initiated next year. When the Fed raises rates, it always means a series of hikes. I expect this to take place in the first half of the year, because the Fed won't undertake any further major monetary measures in the run up to the US presidential elections in November 2016, to avoid impacting the outcome.
In a rising rate scenario, interest-rate-sensitive sectors such as real estate and utilities tend to fall out of favor with investors, while financials such as banks and insurers become popular. “Companies that are up to their ears in debt run into difficulties when interest rates rise, because refinancing becomes more expensive. This is company specific and so can affect companies in every sector,” says Glazener.
The danger is more acute for US companies than European ones, thinks the fund manager. “In the US, corporate debt levels have already risen again. Balance sheet debt has picked up as a result of takeovers and share buybacks. The animal spirits are back with a vengeance. In Europe, corporate debt levels are stable and companies are not yet following their instincts.”
The result of the US presidential election may be important for certain sectors. Glazener: “In the United States, drug companies are free to set their own prices. The Republicans want to maintain this, but the Democrats want to bring prices under government control. If the Democrats win, earnings and stock prices in the pharmaceuticals sector could come under pressure.
Oil is another sector that could be affected by the election results. Traditionally, the US has always banned oil exports. But the shale-oil revolution is putting pressure on this ban. The Democrats don't want anything to change – they want to keep US oil in the US. The Republicans however want to open the door to US oil exports.
China's economic transition is a theme that has been around for a while and one that will continue in the coming year. However, it is still difficult for investors to see what is really going on in the Chinese economy. Glazener prefers to look at the Li Keqiang Index rather than government figures. This index, named after Chinese Premier Li Keqiang, combines rail transport volume, electricity consumption and bank-loan indicators. It should give a more accurate picture of the Chinese economy than the official Chinese government figures. Glazener: “The LKQ has fallen more sharply that the official figures. But I don't think China will abandon its transition policy and re-embrace its export-led model.”
When it comes to the other large emerging countries, Glazener expects Russia and Brazil to remain in recession. India is a bright spot.” It is the most dynamic emerging country. “India is benefiting from the low oil price because it has to import all its oil. The country is also attracting foreign investors. But the reforms necessary to tackle bureaucracy and improve infrastructure are happening very slowly. And Indian stocks are expensive,” according to Glazener.
As a global investor, Glazener favors Europe and Japan. He thinks the corporate earnings in these regions will catch up. “In Europe and Japan, stock valuations based on price/earnings ratios are comparable with those in the United States. But corporate earnings are not yet back at 2007 levels and that is in marked contrast to the US. Expected higher earnings from companies in Europe and Japan mean these regions offer attractive investment potential.”
There is less merger and takeover activity in Europe than in the United States. “The focus is more on earnings per share and companies are not yet at the stage of large-scale mergers and takeovers.” In the United States, Glazener prefers companies with a large exposure to the domestic market rather than firms that are heavily dependent on exports.
Equity markets will continue to experience high volatility. Glazener: “Next year equity markets will go up and down, but not really book gains overall. The period of easy pickings is now behind us. With hindsight we can conclude that equities were dirt cheap in 2009. The global economic recovery and the constant flow of money from central banks formed the basis for fantastic returns. Now that these last two factors are losing their impact, stock selection will become more important than ever again. The focus will be on companies that generate high cash flow and invest it to create a higher return on invested capital.
Last year growth stocks were the favorite, but their valuations have risen considerably making them less attractive.”
Another trend that will continue in 2016 is the growing number of passively managed investment funds, such as ETFs and index funds. “The differences between an actively managed fund and a passively managed one will only become more important,” acknowledges active fund manager Glazener. This is why he wants to increase his Robeco fund's active share, but also keep the tracking error low. “As far as difficult-to-predict factors such as exchange rates, interest rates and inflation are concerned, I don't want to deviate too far from the index. In financial jargon this is known as keeping the factor risk down and ensuring a low tracking error. So the deviation from the index is primarily the result of stock selection, where the focus lies more on corporate performance on ESG (environmental, social and governance) issues.”
Glazener is also following the current trend of having a more concentrated portfolio and will reduce the number of positions he holds from 100 to around 80 or 85 next year. “Companies that score less well on ESG factors will be sold.” The way a company deals with ESG forms an integral part of the Robeco analysis and valuation model. “ESG data improves our understanding of a company's risk/return profile,” says Glazener. “ESG factors have a positive or negative effect on its competitive position. In other words: they create value for the company. Or not, as the case may be.”
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