State of affairs
Having crossed the mid-way point of a “lacklustre” 2016, what else lies ahead? Neo Teng Hwee discusses the global outlook
Having crossed the mid-way point of a “lacklustre” 2016, what else lies ahead?
The year started with cautious optimism that the global economy would recover from a slowdown since the second half of last year. China, the epicentre of financial volatility, began currency reforms, cleaning up corruption and dealing with excess capacity in the state-owned enterprises. However, the economic fallout stoked market fears that a perfect storm was in the making. At the same time, the free fall in oil prices sent shock waves through the emerging world, as well as through the energy industry and banks that have related exposures.
Thankfully, volatility subsided as the Fed slowed the pace of policy normalisation, keeping interest rates unchanged in the first four policy meetings this year. Although the Chinese currency and economy have stabilised, oil prices have recovered and the US economy appears to be recovering from the first quarter weakness, the global outlook remains challenging and a cautious risk-taking approach is warranted.
We have maintained our outlook since the start of the year, which is that 2016 will be a year of lacklustre, single-digit returns for risk assets as they trade within broad ranges with higher volatility. This outlook was based on the view that while key economies (particularly the US economy) were not likely to tip into recession, growth expectations were subdued. Additionally, we held the view that aggregate global monetary policy would tighten as the Fed embarked on its rate hike cycle, but would see bouts of reprieve in the event of economic or market shocks.
These perspectives have held up reasonably well. The rally since mid-february appears to be more of a relief rally than the next leg-up to new highs in the current cycle. We see few fundamental upside catalysts for growth and earnings, as the outlook remains muted. Indeed, the consensus forecast of global GDP growth for 2016 has steadily been revised down in recent months and currently stands at three percent — not disastrous, but fairly lower than the average 3.5 to 3.8 percent. As an example of the weak growth, US non-residential fixed investment (a leading indicator of broader economic activity) contracted 5.9 percent year-on-year in the first quarter.
Where equities are concerned, there are other headwinds and hence our underweight call. The first is seasonality. Whether the Wall Street adage of “Sell in May and go away” encapsulates deeper wisdom or is simply a self-fulfilling prophecy, the fact is that since 2000, the May to September period has seen global equities post an average return of -3.2 percent. Further headwinds include already high valuations and peaking corporate profit margins at a time when wages are beginning to rise. These conditions make it difficult to expect sustained capital gains on equities. Equity investors may consider rotating into defensive sectors with a focus on delivering returns through income distribution.
Corporate bonds should remain a sound investment. While growth prospects look weak, they are unlikely to precipitate recessionary conditions that would threaten general corporate creditworthiness. Fixed income investors may wish to be selective and avoid segments where spreads have already tightened substantially and valuations are high. In particular, we would be selective with US energy-related issuers, as well as Chinese high-yield property names. Sovereign bonds present little value at either low or negative yields and may encounter mark-to-market losses as the global economy recovers.
The US dollar rally since mid-2014 took a pause following downward revisions to US rate hike expectations and subsequent dovish communication by the Fed. That said, the substantial rally in various emerging market assets, including local currency bonds, is likely to consolidate after strong gains. However, emerging market assets are likely to have bottomed out this year as valuation has become more attractive after years of poor performance. Investors could also add gold to their portfolio as real interest rates are likely to stay low and gold can act as an insurance in times of uncertainties.
As a general guide, given the largely range bound market conditions, investors should avoid buying into rallies and selling into panic. For more sophisticated investors, active participation through derivatives could also capture opportunities as volatility periodically spikes.