Has anyone seen the reset button? December has been quite iconic, considering the enormous market activity around central bank policy changes, a continued oil collapse, heightened equity turbulence and credit market turmoil…quite unlike the reduced trading and holiday season behavior one would expect. That being said, the S&P 500 finished up 1.5% last week, and ending 2015 in positive territory is no longer far-fetched.
The new year always brings new opportunities, and with 2016 forecasts rolling out across Wall Street, our take on what to expect next year begins with a macro outlook, and concludes with key trends to watch. Changing monetary policies have triggered a new financial era, and alongside, massive disruption amid consumer and enterprise behavior is under way. Opportunities are all over the place, and Wall Street remains as fascinating and as critical a destination as ever for connecting capital with ideas. Here’s our take for 2016.
The Macro Outlook
The Global Take: Yes, growth is slow. In fact, lower for longer, sub-par output, secular stagnation, lukewarm – call it whatever you wish, but the global economy is certainly not growing as rapidly as it used to pre-recession. However, the argument of ‘things aren’t the way they used to be’ could have been made in 2009, and even in 2002, when the Fed Funds rate was brought to near-zero and the 10-year yield fell to around 3%. Consider this – since the March’09 recession bottom, US growth stocks have outperformed their value equivalents by nearly 30 percentage points, hedge fund AUM have doubled to $2.7T even amid significant market underperformance, and the dollar denominated emerging market debt, high yield, and local emerging market debt asset sub-classes have delivered the highest 15-year annualized returns in fixed income. The private space, meanwhile, has thrived, with over 120 $1B+ companies worldwide as of October, per CB Insights. Our point? Low Fed Funds rates and treasury yields since 2002 have pushed investors out on the risk spectrum in search for yield; barring the 2004 tightening cycle, the December rate hike is likely to welcome investors back to the real world with a bang. Or, in more technical terms, greater volatility.
This tightening cycle is unique. In the previous US rate hike span, domestic inflation was above 2%, monetary policies were converging, commodities were in bull markets, and emerging market capital investment was surging; alongside, global growth was accelerating to 4%. Today, each of those characteristics are noticeably absent. As a result, past precedents may not provide significant insights into investor reactions now that the tightening cycle has begun, so be prepared for greater volatility. More on this below, but with that backdrop, we think the key themes to watch for in 2016 are potential geopolitical implications (in Europe, Russia and the Middle East) and their impact on the markets, the economic landing and reorientation in China, the search for commodity price floors, and importantly, the influence of diverging monetary policies on asset prices, including currencies. Wall Street’s consensus is calling for a modest increase in global growth next year, from 3.1% in 2015 to the mid-3%s in 2016. Here’s a further breakdown of some regions to watch:
Europe & Japan: With the noted success of QE in propelling equities upward in the US, the $1.1T program initiated by the ECB last year has had a similar effect on European indexes in local currency terms, with an outperformance by the STOXX 600 (7% YTD) over the S&P 500. Seeing a continued accommodative stance, the equity boost is unlikely to disappear in 2016. Alongside, as a net importer of oil, the benefits of an oversupplied market should also remain a tailwind for the region’s growth. The Eurozone grew by ~0.9% in 2015, and Wall Street is expecting an increase to ~1.5% in 2016. A key highlight is that household spending contributed nearly 75% of the total GDP increase in the region over the past year (BofA Capital Markets Outlook data). This is an incredibly positive sign – because alongside showing domestic strength, it makes the region less reliant on exports, especially amid continuing emerging market demand weakness. As a result, equities are relatively well placed to benefit in 2016.
We find risks for the European markets to be heavily stemming from the geopolitical front. Amid the migrant crisis, the growing popularity of extreme-end parties and consequent fiscal uncertainty may prove a major headwind, with Spain, Poland, Hungary, and other regions all displaying some divergence from northern European nations. Alongside, we see that Wall Street’s banks – for several weeks – have continued to beat the drum for an overweight position in Eurozone equities, therefore risking a crowded trade; the same goes for the euro’s weakness against the dollar. Feel free to invest, but note the caution on the political front. Germany remains our relative favorite in the area.
Japan is expected to grow at 1% in 2016, compared to 0.6% in 2015, per consensus estimates; similar views on the yen, meanwhile, expect it to weaken further, potentially reaching 130 against the dollar. We feel that Abenomics, while seemingly working, is yet to prove sufficient amid demographic headwinds alongside continued low inflation. In our opinion, private sector investment remains the key to sustained economic growth; the quality of earnings and capex, as a result, should be evaluated while considering investing…being selective may be preferred over just buying the NIKKEI and hoping that QE delivers.
China: China would likely take the crown for causing the most lack of sleep on Wall Street. As an $11.4T economy, nothing here goes unnoticed, including the ~250% debt-to-GDP ratio – which will need help sooner than investors are factoring in, in our opinion. We remain skeptical of investing in equities here in 2016 until there is greater clarity around monetary policy. As the nation steers itself towards a domestically oriented, service-and-consumption-driven economy, watch for PBOC’s policy changes around the yuan in 2016; further weakness will help given the current overvaluation (in our view), but the consequent impact on other emerging markets’ competitiveness as well as the US 10-year yield may be significant. That being said, China is a solid structural long term investment play; by 2030, over 50% of the world’s middle class will be located in emerging markets, from approximately 20% today, and China’s potential for driving the 45% of spending coming from emerging markets – also double the percent of today – is tremendous. The country remains a major wild card for 2016, but don’t worry about missing anything, because every bit of data originating here is sure to be dissected at length by investors worldwide.
India: India’s growth since its market liberalization in 1991 has been fairly robust and structural in nature, albeit, slower than China’s. The young demographic age and room for growth provides significant potential for the long run. The pro-business Modi government, elected last year, has yet to deliver on some of the promised reforms, but overall signs remain encouraging. Importantly, the economy is relatively less dependent on foreign conditions, with less than 15% of its GDP derived from exports. The relative outperformance against peers in 2015 is noteworthy, with the rupee down only ~5%, and the Sensex off -7.4% YTD, compared to the EEM index, off -15%. As a net oil importer, it was handed a bonus with oil prices plunging in 2015; expect inflation to tick up next year as oil prices find a floor and businesses acclimatize. Amid the global monetary policy emphasis, the RBI’s policy will continue to be heavily scrutinized; interestingly, the RBI recently signaled that its policy will be dictated mainly by domestic growth inflation dynamics, rather than US Fed tightening, which is ‘materially different than other emerging market central banks’, as highlighted by JP Morgan’s Global Data Watch team. Furthermore, government spending grew from 1.2% YoY to 5.2% YoY from Q2 to Q3; this is likely to reduce in 2016, and private investment and consumption will need to take the reins quickly to deliver on the 7%+ growth expectations. While challenging, India remains a structural win for the long term, and investors can expect an outperformance against its peers in the coming year.
Emerging Markets: As noted in August, 44 nations consider China their largest export market, per Forbes data. Currency headwinds, foreign exchange reserves and debt-to-GDP concerns will catalyze divergence in performances in 2016 from the asset class. Nations with notable exchange rate links to the US dollar will likely see significant pressure, especially if they are commodity-driven economies; Chile, South Africa, Columbia, Peru and others have already initiated rate hikes to deter capital flight, which will likely dent economic growth. Nigeria, Russia, Venezuela, and several others, meanwhile, are suffering from fiscal constraints due to low oil revenues. Political reforms may cause surprise winners; watch Brazil. Overall, corporate debt stands at 75% of GDP for emerging markets – double the percent of 12 years ago, and dollar denominated debt has doubled from 5 years ago…not a strong balance sheet when US conditions are tightening, global growth is modest and commodities are weak. We expect a continued underperformance from the emerging markets in 2016.
The United States: And finally, we turn stateside, where over half of the world’s market capitalization resides. Domestic conditions are robust; labor markets find themselves at near-full unemployment rates of 5% (U3) and 9.6% (U6) as of November; core CPI, meanwhile, is at 1.9%, and core PCE at 1.3%. While still lower than the 2% inflation target, the trend is positive. Furthermore, the NFIB Small Business Survey found in November that the percent of small firms planning to raise compensation has jumped to the highest level since 2006; given its robustness as a leading indicator, the Bank of America is projecting wages to rise to 3% from the current 2.5% as the year proceeds; we concur. With favorable oil prices, an ongoing auto and housing boom, a deleveraged consumer base with a high savings rate and a modest ongoing recovery, a profit recession currently under way in 2015 is unlikely to cause an economic recession next year; ex-energy, in fact, S&P 500 profits are actually up 2% YTD (Yardeni Research data). Per FactSet, consensus estimates are calling for $128/share in S&P 500 earnings in the coming 12 months, which would imply a forward P/E of ~16x – hardly ‘stretched’ by any measure.
At the same time, credit spreads in the high yield segment have rapidly widened, and amid higher costs of capital, record shareholder-friendly dividends and buybacks (estimated at $1 trillion in 2015, per Barron’s) should reduce substantially in 2016. The 2-year yield has nearly doubled to 1% in 2015 amid the rising rate environment, while the 10-year has essentially remained stagnant, at 2.20% – against Wall Street’s estimates calling for a much higher year-end yield back in January. A continuing flattening of the yield curve could cause concern. It is also important to note that shareholder returns and M&A activity, meanwhile, last peaked in 2007 – and you may recall what happened in the following year; the previous M&A record was in 1999, and the year after also had a similar story. Therefore, the post-zero-interest-rate era will likely require a significant recalibration of shareholder expectations.
Historical forward P/E data shows that multiple contractions have occurred over the past 2 tightening cycles. This time, the situation may be dicier. Experts continue to argue on whether tightening is necessary, and we find essentially no developed world tightening success post-2008, with reversals in Sweden, Israel, the ECB and Canada. Previous tightening conditions, as noted above, are noticeably absent. As a result, volatility is likely to be higher in 2016, and we believe a forward multiple contraction from today’s 16 to 15.3 may occur. We estimate negative single-digit S&P 500 returns in 2016, with a projected year-end value of 1960.
However, amid potential market weakness, individual stocks should show significant divergence amid structural market trends; there is plenty of outperformance potential from certain sectors, similar to this year. In a contrarian play, we prefer growth stocks over value stocks given the lack of growth worldwide may continue to crowd investors into rewarding stocks that do show growth. Alongside, we prefer less leveraged over more leveraged firms, domestic US over international assets, and TIPS over HY debt and short-term treasuries. All of this, of course, amid greater volatility.
Trends To Watch
Away from macro, the perspective changes dramatically when you consider how a firm with a ~$300B market cap firm and 1.5 billion users can have a 30% sales CAGR (Facebook), a $30B consumer-oriented firm founded in 1964 can continue to display an 8% 10-year CAGR (Nike), or how a streaming network which began as a DVD-service 18 years ago is upending decades-old media firms today with a 24% quarterly YoY sales growth (Netflix). Did someone say we’re in a slow growth environment? Think again.
2015 delivered massive disruptions in entrenched sectors, with the advent of AirBnB, Uber and others on the private side, and exceptional performances by Facebook, Netflix, Amazon and Google on the public front, to name a few. We felt the winning characteristics in 2015 could be distilled down to data analysis, information transfer, and asset utilization; firms which effectively delivered at least 2 out of the 3 themes gained serious value…of course, the product had to be good to begin with. A significant number of these companies were in the consumer discretionary and technology sector; consequently, both were among the top three performers in the S&P 500, up 8.8% and 5.6% YTD respectively. Here are some trends to watch in particular in 2016.
Demographics will greater influence business models. Millennials just outnumbered baby boomers in the US; in the coming 5 years, the world will have over 2 billion people in this group, commanding over $2 trillion in spending power and consisting over 70% of the total labor force. The generation is characterized by the highest debt level of any US generation, shows a weariness of stock markets after seeing 2 brutal crashes while growing up, and is hell-bent on staying healthy and making the world a better place (less carbon footprint, more kale salad, etc.). Furthermore, millennials prefer experiences to assets, desire customized products, and need instant gratification, per research from Cassandra Reports.
With such characteristics, firms and brands that prefer localization over globalization (for speed to market and relatability), those that identify themselves as promoting sustainability or being environment-driven, and those that can create tailor-made products have competitive advantages over those that don’t. We’ll expand more on particular firms to watch in the coming weeks.
E-commerce will keep booming. Brick and mortar sales were negative, while e-commerce grew at approximately 15% in 2015, per ComScore. Even better, e-commerce constitutes just 8% of US retail sales so far, per the US Census Bureau. A WSJ interview with a shopper last week summed it up, stating ‘pile the whole family in the car, fight the crowds with the stroller, and what if they don’t have what you [want]?’. There’s no going back…welcome to the Amazon world. Be careful regarding upstarts in the space, however…Amazon’s really, really good at its game.
Supply chains will transform quicker. Additive manufacturing (3D printing) will continue to move into the limelight. With the global working age population set to slow in the coming years, amid wage pressures and logistical complexities underlying global supply chains, companies investing in capital equipment will continue shifting towards robotics, faster speed to market and new technology; look for 3D printing to deliver for more firms in the way it has for Boeing and Alcoa so far.
Artificial intelligence, block chain technology and digitization will gain focus. The potential for the trio is tremendous; AI could rapidly change machine interaction, block chain technology could remove intermediaries from all sorts of electronic transactions (think credit transactions), and digital analytics could seriously enhance productivity. According to McKinsey, online talent platforms, big data analysis and the Internet of Things stands to add up to $2.2T to US GDP by 2025. Furthermore, healthcare, construction and the hospitality sectors are among the least digitized, while utilities, mining and manufacturing are in their early stages; overall, McKinsey states that US economy is only realizing 18% of its digital potential; firms have realized this, and the number of connected devices in the world are expected to triple to nearly 40 billion by 2020, per Juniper Research. The potential extends to the public sector, including initiatives for smart cities. Watch for firms including Palantir, Google, as well as the older guard of Microsoft, IBM, and others to move such ideas ahead. We’ll elaborate more on this subject in January.
Alongside, expect decentralized currency talk (regarding bitcoin, etc.) to make a resurgence amid central bank fatigue as 2016 progresses. We’re also keeping an eye on Facebook, given its track record of being ahead of trends…the timely purchase of Oculus gave it a headstart in the virtual reality space, and after Whatsapp and Snapchat, Facebook Messenger’s incorporation of Uber is also a potential game-changer. If the app-in-app trend takes off, similar to Tencent’s WeChat model, Apple’s App Store may stand to be impacted big time.
The real-time sourcing of data will start realizing its potential. Keep an eye on firms including PlanetLabs, Orbital Insight and Descartes. If hundreds of tiny satellites – the size of shoeboxes – take images of Earth each minute to watch shopping mall cars, construction site shadows, crop yields and oil tanker locations, information knows no boundaries. Speaking of which, the private sector is making major advances in space overall, including SpaceX and Amazon. The opportunities are just endless in this field, and the exploration is just beginning.
Alternative energy technology development will progress. Fusion energy development from firms such as Tri Alpha and Helion Energy has tremendous unrealized potential, while hydrogen cell technology, displayed by the Toyota Mirai launched in California this year, may begin to make inroads alongside the Tesla-led electric vehicle space. In general, renewable and clean energy should create significant news, especially with COP 21, originating from the Paris Climate Change Conference. According to the Blackrock Investment Institute, Norway’s $873B sovereign wealth fund will no longer invest in fossil fuels. The money has to go somewhere, right? Political incentives for renewable energy technology development and implementation should help move the field ahead.
Assisted driving will drive attention. And finally, we touch upon our favorite subject – assisted driving. Why? Because human error causes over 95% of auto accidents – and last year, killed over 33,000 people in the US alone. Apart from saving lives, over 6% of US GDP could be freed up for better use, according to the Boston Consulting Group. The stunning numbers, along with a greater emphasis on safety by the US NHTSA, will drive automakers to move into the later stages of Levels 1, 2, 3 and 4 ADAS technology. Expect greater collaboration between tech and auto carmakers; firms such as Mobileye, Tesla, and Google will remain in the limelight, alongside the usual manufacturers including Ford, BMW, and GM.
Financial technology will find its footing. Before we conclude, a quick thought on financial technology – a hot topic on Wall Street. Seeing Silicon Valley’s collaboration with the big banks, the potential for mainstream adoption is enormous regarding online lending, crowdsourcing, etc. However, in a higher interest rate world, lenders and borrowers will need to adapt to capital that is more expensive. The business models are yet to be tested in such an environment, and as outlined in the WSJ last week, firms such as Lending Club, etc. will face challenges…we stay incredibly optimistic on the potential, but would exercise caution while investing; the details are important and being selective will count. Digital wallets and mobile payments, meanwhile, are a more obvious bet; per predictions from Forrester, money spent in stores by these methods will grow from $4B in 2014 to $34B in 2019, and transaction volume growth is projected to be far over 20% annually in the coming years. The players include Apple, Samsung, Google, and others. More to come on this in January.
What it means for you: Wall Street links capital to the ideas that deserve it – and over the years, it has done a pretty phenomenal job. For 2016, we may see short-term ups and downs due to monetary policy changes, commodity price fluctuations and irrational investor behavior, but don’t forget that patient investors have been handsomely rewarded; long-term data shows annual returns averaging ~10% from the S&P 500 during the post-war era. Firms with visionary management teams and great products shape markets, and when they do well, so do their investors. Next year might be volatile, but the highway to prosperity wouldn’t be nearly as rewarding if there weren’t some challenges. Investors should gear up…Wall Street promises to be an incredibly fascinating destination in 2016.
