In 2016, for the first time since equity markets bottomed in March 2009, the outperformance of equities relative to bonds is far from assured. A combination of faltering earnings growth and above-average valuations in many key markets means equities may struggle to post gains over the course of 2016. The prospect of rising interest rates in the US, albeit at a modest pace, only increases the challenges faced by US equity markets, while also pressuring fixed-income portfolios globally. Offsetting the negative factors will be continued loose monetary policy in the eurozone and Japan, but as extraordinary monetary policy enters its eighth year, its effectiveness is waning. Volatility spikes will remain a constant companion thanks to regulation and the growing share of electronic trading.
Equities: the air is getting thinner
The ecstatic response of equity markets to each new round of monetary easing, be it from the European Central Bank (ECB), Bank of Japan (BoJ) or People’s Bank of China (PBoC), illustrates how dependent they have become on central bank stimulus. The support of central banks was welcome and needed in the immediate aftermath of the global financial crisis, but in our view it has now become an addiction. The angst experienced in US markets last year as investors contemplated a hike in interest rates by the US Federal Reserve (the Fed) is a preview of what Europe and Japan will experience in turn when their monetary policies finally normalise.
The reason that a move in the US from negative real interest rates towards the long-run average of 2% is so unsettling is that doubts persist about the strength and durability of the economic recovery, and with it the potential for stronger revenue and earnings growth. The rise in the dollar has implicitly tightened financial conditions. The Fed's new hiking cycle began with annual GDP growth at around 2.5%, a slower pace than for any previous cycle. Corporate margins in the US have been at historical highs for over a year as companies have already taken the easy measures to cut costs and any incremental improvement is ever more difficult to achieve. To continue posting earnings gains they have turned to share buybacks, dividends and mergers and acquisitions (M&A), instead of investing in their own businesses. The efficacy of these measures is weakening and with valuations above the long-term averages, there is limited prospect for price appreciation.
Certain sectors are nonetheless likely to outperform the broader index, namely consumer (both discretionary and staples) and information technology. Falling unemployment and rising wages should encourage further consumer spending, though not in lockstep as the savings rate is also likely to rise. The pressure on companies to reduce costs wherever possible will benefit IT businesses providing solutions such as cloud technology. The strength of the tech sector should also boost the performance of growth indices relative to value indices. The strong US dollar will continue to weigh on large capitalisation multinationals, particularly those with a high exposure to commodity-intensive emerging markets, but those with a household-demand focus should benefit from the transition in those countries towards consumer-driven growth, particularly in China. Despite the stronger dollar, a more defensive market should favour large caps compared to small caps. Declining bond yields have helped boost the performance of REITs relative to the broad market. We anticipate this relationship will reverse as US rates move up. Outside the US we prefer Asia and Europe as spreads are still attractive and central bank policy should keep base rates supressed.
The eurozone is experiencing a mild cyclical recovery but the economic reforms necessary to create sufficient labour and capital market flexibility for companies to increase profits in a low nominal growth environment are largely lacking (as is also true for Japan). While margins are low for many eurozone corporations and there is consequently scope for earnings growth, forward multiples already reflect the market’s expectation that this will occur. The weak euro and ECB support should nonetheless allow the region’s equity markets to continue advancing through 2016. As in the US, we expect commodity/emerging market- exposed companies to lag while those leveraged to domestic demand should outperform. The correlation between the yen-dollar exchange rate and the Nikkei index remains high and we anticipate that it is likely to remain so. The sluggish growth of the Japanese economy, exposure to a slowdown in China, and inflation expectations below the BoJ’s desired target all mean that the central bank is highly likely to maintain its quantitative easing policies throughout next year. Although, as in Europe, reform efforts have been disappointing, there has been enough effort, particularly concerning corporate governance, to boost corporate margins above their historically low levels. The most important distinction to note between Japan’s market and other developed equity indices is that forward multiples remain below average, making it one of the few countries where equities can be considered cheap. While this certainly reflects the longer-term challenges the country faces (particularly demographics and rigid labour markets), there is still scope for a further revaluation of the market.
Export-focused emerging market (EM) corporates will benefit from weaker domestic currencies, but the drag on EM index returns from the stronger dollar will likely dominate returns for hard-currency investors. More important, however, are the macro- and microeconomic factors dragging down corporate profitability. Some countries are facing budget challenges (such as Brazil) or excessive current account deficits (Turkey). China’s slow pivot from an commodity-hungry, investment-led economy to one driven by services and consumer spending has weakened the position of raw materials exporters. At a microeconomic level, EM companies have not taken the measures adopted by many of their peers in developed countries, particularly the US, to cut costs and improve efficiency. They have consequently seen significant underperformance in return-on-equity (ROE) terms. The deterioration began in 2008, when the ROE for the MSCI Emerging Markets Index was 18.4% and for the MSCI World Index 15.8%. Since then, ROE has fallen by around 700bp for emerging markets, but just 300bp for developed, explaining much of the underperformance in EM equities (see Exhibit 1).
Exhibit 1: Profitability (ROE) and returns of emerging market equities relative to developed market equities
Source: FactSet, BNP Paribas Asset Management. Data as of 30 October 2015. Note: ROE based on next-twelve-month consensus estimates
Until there is more stabilisation in currencies, monetary and fiscal policy, and, crucially, a recovery in earnings, EM equities are unlikely to outpace those in developed markets. Sustained earnings growth will require significant structural reform and productivity gains and signs of this are lacking at the moment. Moreover, there is not even a valuation argument to support an overweight in EM equities. While the relative valuations of emerging equities compared to developed equities appear attractive, the discount is concentrated in Asia, and particularly in China and (China-linked) Taiwan. The discount in China reflects the overweight of the financial sector in the China index and underweight in technology and consumer discretionary relative to the MSCI EM Index. Most other emerging market countries are trading above their long-run average forward multiples.
Fixed income: the search for yield continues
Previously inaccurate forecasts over the last few years of a rise in 10-year US Treasury yields may finally turn out to be correct in 2016. The Fed's recent rate hike, their desire to move monetary policy towards historical norms and the modestly strong economic recovery in the US suggest that the Fed will raise rates by some 50-100 basis points (bp) in 2016. A rise in 10-year Treasury yields should follow, albeit not in lockstep.
Any increase, however, is likely to be less than would have been expected a year ago, due primarily to ongoing worries about the strength of the Chinese economy. Concerns that growth could fall far below the government’s target of 6%-7% has fed through to expectations for economic growth globally in both developed and emerging markets as well as to expectations for the rate of inflation. The depreciation of the yuan has added to these disinflationary pressures. An extended and expanded quantitative easing programme in the eurozone will put further pressure on US Treasury yields as eurozone investors are driven abroad in the universal hunt for yield. Consequently, US Treasuries are likely to post losses for the year, while eurozone debt returns should be modestly positive. Returns for the eurozone will be highly dependent on ECB policy decisions, however, and as the Bund selloff of April 2015 showed, swings in sentiment can be violent.
Even with central banks printing trillions of dollars, euros, pounds and yen, inflation expectations have remained supressed across most of the developed world. Short of an unexpected resurgence in growth, either in developed or emerging markets, expectations of future price appreciation will remain subdued. But the same distortions from QE that affect government bond yields also drive inflation-linked bond indices, meaning market measures of inflation do not necessarily reflect what economists and investors believe future inflation rates will be. Rising policy rates in the US and the UK should drive an underperformance of linkers relative to euro-denominated inflation-linked indices, with the eurozone again likely to see the most volatility given greater uncertainty around future ECB monetary policy measures.
An environment of steady economic growth and low inflation should generally be supportive of corporate bond returns relative to government bonds. Although spreads are at post-crisis lows, they are nonetheless above levels reached from 2005-2007. We do not expect the ECB to venture to purchase corporate bonds, but any expansion of the bank’s QE programme will have spill-over affects for all eurozone bonds, compressing yields across the board. The US is further along in the credit cycle than Europe so we would expect to see widening spreads relative to Europe.
High-yield spreads for US sectors outside energy were steady during the first drop in the price of oil in 2015, but the weakness subsequently spread to other industrial sectors. Although selectivity is always crucial, spreads on the Barclays US High Yield Index at around 6% seem adequate compensation given expected default rates of just 3% in 2016 (according to J.P. Morgan). While this is double the rate for the previous two years, it is far less than in previous periods of crisis in the high-yield market (see Exhibit 2). Our view on the attractiveness of the high-yield sector would change, however, if US GDP growth rates dropped towards 2%, a point where the ability of many more high-yield issuers to meet coupon payments would become questionable.
Exhibit 2: US high-yield default rates and spreads
Source: J.P. Morgan, Barclays, BNP Paribas Asset Management. Data as of 30 October 2015. Note: 2015 and 2016 default rates are forecasts
European high-yield bonds suffered less in the latter half of 2015 thanks to limited exposure to the US energy sector. They also seem to offer a fair risk-reward balance, certainly compared to compressed government and investment-grade corporate bond yields.
While rising US interest rates and weak commodity prices will pose challenges for many emerging market countries, depressed developed market bond yields will continue to drive investors towards USD-denominated emerging market debt. While the level of compensation for the risk is not what it was pre-crisis, it is still better than that offered in most other parts of the bond market. Local currency debt will at some point become attractive given that many currencies are undervalued and yields in some instances have reached levels not seen since 2009. We will be watching those countries with large budget and/or current account deficits to see that they are taking stronger measures to address the imbalances.
A more cautious outlook is warranted for investors at the start of 2016. Doubts about growth hang over both developed and emerging market economies, with catalysts for further GDP acceleration difficult to find. Equity market valuations are in some places high relative to likely earnings growth, making them vulnerable to unpleasant surprises or shocks. The hunt for fixed-income yield is unlikely to abate despite the start of the Fed's cycle of rate hikes, but investors should be considering what signals will trigger their exit strategies from the riskier parts of the market.