TORONTO, ONTARIO -- (Marketwired) -- 12/09/15 -- The business cycle will be crucial for further gains in risk assets next year, now that the global tide of "easy money" that inflated valuations in recent years has crested, according to the BlackRock (NYSE: BLK) Investment Institute's 2016 Investment Outlook.
The Outlook, "Cycles Out of Sync," details the Institute's global economic and market views for 2016, and offers insights on the likely implications for investment returns and asset allocation decisions. Overall, the BlackRock Investment Institute (BII) counsels investors to pay much more attention in 2016 to the business, credit and valuation cycles, as the impact of the monetary policy cycle fades.
With valuations no longer cheap and corporate profit margins under pressure in many markets, economic growth is needed to boost revenues. "We expect little or no price appreciation in fixed income and only muted gains for most equity markets in 2016," the BII notes.
"Careful navigating" will be critical in 2016 because key cycles now appear to be "out of sync," according to the BII. In particular, valuations appear to have leapt ahead of the business cycle in many markets, especially in the U.S. "We have essentially been borrowing returns from the future," the BII says.
"The outlook is made even more challenging because long-term trends such as aging populations, high debt loads and technological change are intersecting with short-term cycles, meaning that the high growth rates of the past may not return," said Ewen Cameron Watt, Global Chief Investment Strategist with the BlackRock Investment Institute. "But the good news is that we see a modest pick-up in global growth and a renewed investor focus on fundamentals."
Equity Markets Running on Empty
Most equity markets have been running on empty in 2015, the BII notes, with multiple expansion (a rising price-to-earnings ratio) and dividends hiding "sins" such as flat or falling earnings. "The question for 2016 is whether, with global financial conditions slightly tightening, the markets can stand on their own legs," said Russ Koesterich, Global Chief Investment Strategist with the BlackRock Investment Institute. "If companies are to grow earnings, a return to top-line growth is essential - especially for markets where valuations are high."
The effects of movements in the U.S. dollar and oil prices will be critical next year, the BII believes. Further gains in the dollar would intensify pressure on commodity prices, emerging markets (EM) currencies and U.S. profits by making its exports less competitive. Falling oil prices have dragged down long-term inflation expectations and could encourage some central banks to step harder on the monetary accelerator.
Watching Out for Volatility, Momentum Shifts
Volatility has died down from highs seen during the summer's global equity sell-off and most asset classes are now around their 20-year volatility medians. Yet, volatility could rise again, the BII believes.
"On the positive side, we see few pockets of true exuberance," Koesterich said. "However, even without any shocks, volatility is likely to rise."
Koesterich believes that investors also need to be wary of momentum shifts - periods when market leadership reverses abruptly. "Exposure to quality companies such as established tech and healthcare has proved an effective counterweight to momentum in periods of rising vulnerability," he said.
Intensifying regional conflicts and geopolitical tensions also could finally start to affect markets, the BII notes, with refugees and the "Brexit" referendum stress-testing the European Union in particular.
The U.S.: Growth Cycle Has "Room to Run"
A lot is riding on the U.S. economy in 2016 as many other parts of the world show declining or sluggish growth, the BII suggests. "Though consensus expectations for 2016 U.S. growth have been gradually ratcheted down, we believe that the growth cycle still has some room to run," Koesterich said.
With the U.S. economy in relatively good shape, the U.S. Federal Reserve appears ready to finally end the era of zero rates. The central bank seems to be looking beyond the near-term drag of lower energy prices on inflation. Rising rents in the housing market will also help inflation edge higher in 2016, the BII says.
What will happen when yields rise? "Banks and insurers have been positively correlated with rising yields, and our other preferences include technology, builders and prime U.S. commercial real estate," Koesterich said. In investment grade fixed income, sectors such as financials and cable are favored over materials, manufacturing and consumer products.
Europe: Austerity Eases
The eurozone business cycle is in the early stages of a slow-motion recovery, but core inflation remains stubbornly low (although it has been ticking higher) and Europe's export revival is under threat from the slowdown in the emerging markets, the BII says.
"We expect reform momentum to take a backseat to border controls and security issues in 2016," Cameron Watt said. "We see a modest growth boost in 2016 as governments loosen their austerity belts and spend more, and not just on security."
The BII notes that European equity valuations look attractive. The weak euro, subdued wage growth and expanding domestic credit should support European corporate earnings in 2016, whereas the strong dollar is pressuring U.S. profits. At the same time, the BII cautions that overweighting European equities has become a consensus view - and "markets have a way of going against the grain."
Japan: Focus on Shareholder Rights
The BII believes that the Bank of Japan could boost quantitative easing and the government increase spending as the Japanese economy once again flirts with deflation, with both moves boding well for corporate earnings.
"Importantly, Japan Inc. is showing a newfound appreciation for shareholder rights, with dividend payouts and share buybacks on the rise," said Cameron Watt. "Since 2008, return on equity has been steadily rising; we also like Japanese equities because they are cheap and enthusiasm for the 'Japan trade' has cooled."
The near-term risk is China's slowdown, as that nation is Japan's second-largest trading partner (after the U.S.). At the same time, Japan's economy is domestically focused, with less than 5% of corporate Japan's overall revenues coming from China.
A Soft Landing for China, Perhaps a Cyclical Swing for EMs
The BII's base case for China is a soft economic landing. China is likely to undershoot its current five-year annual real growth target of 6.5%, the BII says, but that is not the end of the world. Even real gross domestic product (GDP) growth of 5% would be healthy for a roughly US $20 trillion economy. The BII sees many reforms in motion stimulating China's GDP in the near term, including a move toward market pricing and cutting manufacturing overcapacity.
"Nowhere do China's economic shifts reverberate more than in the emerging world, as the EM and trade booms have relied heavily on Chinese demand," said Cameron Watt. "EM countries reliant on Chinese demand and commodity exporters such as Australia now face a double whammy, in that China's growth has fallen further and faster than expected and the composition of the growth is changing fast, from demand for natural resources to an appetite for consumer goods, services and dairy products."
Yet, the BII believes investors would be prudent to recognize cyclical swings that could help propel the EM equity markets higher, at least temporarily. Such forces include global growth edging higher; significant depreciation in many EM currencies; easing inflation next year in some countries, and the oil price collapse, a boon for oil-importing nations.
Investment Ideas for '16
Here is a summary of the BII's investment recommendations for 2016:
-- We prefer equities over bonds, particularly European and Japanese stocks. Many U.S. equities look fully valued. Overall, we expect lower returns than in the early post-crisis years. -- We see little or no price appreciation in fixed income. Selected high yield, investment grade and hard-currency EM debt look attractive relative to government bonds. -- We prefer hard assets and market-neutral strategies within alternatives. Examples are core U.S. commercial real estate in prime cities, infrastructure projects in power or transport, and equity and credit long/short.
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About the BlackRock Investment Institute
The BlackRock Investment Institute leverages the firm's expertise across asset classes, client groups and regions. The Institute's goal is to produce information that makes BlackRock's portfolio managers better investors and helps deliver positive investment results for clients.
Executive Director Lee Kempler Executive Editor Jack Reerink Global Chief Investment Strategist Ewen Cameron Watt Global Chief Investment Strategist Russ Koesterich