The year of diminishing returns

The year of diminishing returns

17-11-2015 | Previsioni annuali

The year of increasing volatility: that was the key takeaway in the Outlook 2015 we presented last year. Volatility we forecasted and volatility we got. Volatility is likely to stay with us a little longer. 

  • Lukas Daalder
    Chief Investment Officer
  • Léon  Cornelissen
    Chief Economist
  • Peter van der Welle
    van der Welle

Much like 2014, 2015 has turned out to be a disappointment from an economic perspective, with growth once again muted. Although the year is not over yet, it is clear that the world economy will expand at a slower pace than it did in 2014. This is not only the result of weaker Chinese growth, but also due to the fact that the US economy is having to absorb the shock of much lower oil prices and a higher dollar. For 2016 we expect the world economy to strengthen, but only to a limited extent.

As one of the risks for the year(s) to come, we flag the diminishing returns of QE, as buying even more bonds will start to have less of an impact in financial markets and the economy. Diminishing returns also applies to the financial markets in general. Seven years after the financial crisis, we are now in the mature phase of a bull market. Valuations have increased, lowering the prospect of above-average returns. This holds true for risky assets in particular, but sovereign bonds will also be expensive in the scenario of subdued but expanding growth we expect in 2016. This does not mean that we expect negative returns in 2016. We are generally positive on risky assets such as equities and high yield, but far less so on government bonds.

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Macro-economic prospects

For 2016 we expect the world economy to strengthen, but only to a limited extent. We do not expect a general crisis in emerging markets, nor do we see a recession in China, though risks have clearly risen recently. The stabilization of the oil price within a broad trading range will remove a major disinflationary factor, pushing up global inflation by about one percentage point from current levels.

US – The current slowdown in the US economy and increasing worries over China and other emerging markets are reasons to expect a cautious approach by the Fed. It remains to be seen whether we will see a meaningful acceleration in US growth in 2016. We predict a GDP growth rate of 2.5%, in line with 2015, and only two modest rate hikes in the course of the year.

China – The Chinese economy is struggling to reach its growth target of 7.0% this year. The Chinese government’s tolerance for weak growth is limited, due to the need for social stability. The Chinese government is unlikely to significantly lower its growth target for 2016. Instead, it will probably choose a target of 6.5% in line with the new five year plan. A competitive devaluation may appear to offer an easy way out. However, for the coming months, such a move is highly unlikely.

Europe – Recently, the German economy seems to have run into trouble as, for example, Eurozone industrial orders have fallen sharply. Growth in 2015 will as a consequence amount to about 1.5%. The period of deflation at the end of 2014 and the beginning of 2015 initially turned out to be short-lived (four months), but recently headline inflation has again turned slightly negative. We therefore expect the ECB to step up its current QE program, maybe even pushing lower the current negative deposit rate of -0.2%.

Japan - The Japanese government has now introduced Abenomics 2.0 and its three new arrows. The credibility of this program is limited, as the first arrow for instance aims for a hefty 22% increase in nominal GDP, without suggesting a timetable or giving any detail on how this target is to be achieved. The other two arrows consist of structural reforms, which were part of the third arrow of Abenomics 1.0 and have hardly been implemented.

Financial market prospects

Our theme of last year will remain very much with us in 2016. Realized asset-specific volatility is no longer subdued, but economic – and monetary – divergence will likely continue to drive volatility in financial markets.

Clearly, current equity valuations no longer support strong (i.e. above historical averages) stock returns. But some nuances have to be made. First, valuation metrics, although possessing quite impressive predictive power for medium to long-term equity returns, are far less effective for one-year forecasts. Second, the August sell-off made stocks less expensive. So although current valuation levels are no longer supportive, they do not infer an imminent stock market crash. Third, what are the risks of this event occurring? A global recession is not our base case. Geopolitical risk is a serious factor, but that is nothing new. A constructive view on stock valuations can be further justified from a cross-asset perspective. Ex ante equity risk premiums are still above the historical average compensation for taking equity risk. In the current setting this is more a sign that bonds are very expensive rather than that stocks are cheap.

With emerging market equities trading at a 31% discount to developed market equities on a 12-month forward looking PE, valuations look attractive at first glance. However, historically the discount should be in excess of 40% if we are to expect outperformance on a one-year horizon. So although we are not there yet, prospects of a Fed rate hike and a pick-up in already very depressed earnings might take us to the sweet spot in the coming year. This will provide opportunities to purchase emerging market equities with high odds for outperformance on a one-year horizon.

The sovereign bond market was more of a challenge for investors in 2015. First, the correction in Europe in April caught many investors by surprise, as joining the QE trade with the ECB buying bonds at a pace of EUR 60 bln seemed obvious. Second, later in the year, the sovereign bond market couldn’t live up to its status as a safe haven, as it failed to offer protection against the erupting volatility in risky assets in August. To us, this is an indication that investors are increasingly aware that the sovereign bond market is very expensive and no longer the obvious place to seek shelter when weak spots in the recovery appear. This awareness is heightened by expectations that the Fed will hike rates at some point, exerting upside pressure on global yields.

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