Biggest uncertainty for 2016 the direction of the US dollar

Michel Perera

One of the market’s foibles is the tendency to find similarities with previous periods.

This year has often been compared to 2011, with its August-September correction triggered by fuzzy macro fears relating to China, the United States and Europe, followed by the sharp October recovery.

The script played out well this year until the end of last month. Then other factors crept into the picture this month to drive markets lower again in defiance of the traditional rally at the end of the year.

The main concern centres round energy prices and their effect on markets. Whereas low energy and commodity prices are good for the US economy (and other developed economies) as consumers have more money to spend, the stock market has a larger share of producers and industrials. Hence, it is concerned about energy producers going bankrupt.

The mechanism is as follows: the energy price fall causes stress in the energy sector of the high-yield market, which in turn spreads to other high-yield sectors, creating a negative feedback loop for risk assets and confidence in general.

Uncertainty about credit markets is damaging sentiment just when black-and-white answers are eagerly sought. Despite a positive reaction to the US Federal Reserve’s new interest rates, market participants have been dusting off comparisons with previous rate-raising cycles to gauge the effect of Fed increases on different assets, at a time of little certainty in other factors driving markets.

It does not seem to matter that low oil prices have never caused a US downturn, that very few leading indicators of a recession are visible and that the Fed is highly unlikely to cause sharper inflationary pressures in the absence of a recession.

The market is not convinced and wants continuing clarity on future central bank policy, on global growth, on fourth quarter and next year’s earnings.

For our money, we foresee next year’s earnings recovering as energy prices stop falling at a rate that chips away at S&P 500 overall earnings.

The IMF forecasts the US growing at 2.8 per cent and Europe at 1.6 per cent. It also foresees China growing at 6.3 per cent, which would be positive for global growth as opposed to the frequently-quoted scenario of a hard landing.

We prefer equities and alternatives to fixed income, as bond returns may be challenged by Fed increases. Within equities, we prefer developed over emerging markets, as developed markets are finally recovering from a multiyear deleveraging cycle that had depressed growth, whereas emerging markets are now moving from a credit boom to their own deleveraging cycle.

We expect mid-single-digit earnings growth for the year, which should translate into a similar return for the US stock market.

Europe could do better based on the improvement in the credit impulse and the soaring money supply, but it could also be held back as the largest sector, financials, suffers from negative deposit rates.

Japan is, as ever, an interesting case, where strong earnings keep differing widely from uninspiring economic data owing to the new governance rules and shareholder focus by corporates.

Many emerging markets would require faster growth to perform well. Within emerging markets we are more concerned about Latin America than Asia because of its commodity reliance.

The risks to our view next year are multiple. The tight jobs market in the US may fan inflation expectations, while continuing geopolitical risks may weigh further on sentiment and credit defaults may exceed estimates.

More importantly, though, can markets go from being central bank-driven to focusing on fundamentals without a hitch? Higher volatility, greater sector and security dispersion will make the environment less clear but will offer pockets of opportunity to active managers.

The main uncertainty, however, revolves round the direction of the US dollar. If history is any guide, its strength should fade into the Fed’s cycle of rate increases. This is, however, subject to the Fed not surprising on policy moves next year.

Michel Perera is the chief investment strategist for Emea at JP Morgan Private Bank


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