Portfolio Positioning for 2016

As seen in the January edition of Master Investor Magazine.

“My global outlook for 2016 is for broadly steady but slow growth – the new normal – but a nervous and skittish market over-reacting to news flow. My biggest threat for this year is a positive upside economic surprise – stronger than expected US growth! “

When Master Investor’s editor asked for comments on “Portfolio Positioning” for 2016, my immediate reaction was panic. Outlook articles are an opportunity for economic shysters to garner eternal market glory by guessing the big threats for the coming year. But, equally, such comments are hostages to fortune. Who knows what might really happen? In a world fixated by financial threats, it’s very difficult to find something new to pontificate about that hasn’t already been said!

New-year to year-end is an arbitrary period, but the associated festivities and the Mythic-Celtic-Psycho-babble that surrounds “new beginnings” mean we ascribe enormous importance to January 1st predictions. They rather set the tone for the coming year. My first comment would be forget New Year, and worry about the importance of positioning portfolios on a constant basis as the news occurs, rather than on any set timeframe.

Of course, the proper way to protect from market risks would be to constantly consider all the macro factors – such as the China economy, US growth and commodities, and then overlay the various micro themes. Let’s assume you are already doing that… The trick is not to simply follow the herd!

On a dynamic basis, the New Year has not started well. The first market day of 2016 opened with a 7% crash in China, pummelling global market sentiment. Over the first few days of the New Year, the financial media was full of doom and gloomsters predicting worse to come. How should serious investors position for such a nervous environment?

Relax – although the number of the year has changed, not much else has!

Stock ructions in China, ongoing tension twixt Iran and Saudi, North Korea exploding a hydrogen bomb, busted European bank bonds, EM crisis, oil prices in freefall, crashing commodities and missed inflation targets should simply remind us 2016 is likely be yet another “same as, same as” kind of year where nervous markets will continue to react badly to uncertainty and fear of unknowns.

Get over it. Strip out the daily noise and try to discern underlying themes that set markets.

I’d focus on “Normalisation” as my mantra for the coming year. Will the US Fed’s decision to gently raise interest rates support growth or kill it stone dead? I suspect the former. My global outlook for 2016 is for broadly steady but slow growth – the new normal – but a nervous and skittish market over-reacting to news flow. My biggest threat for this year is a positive upside economic surprise – stronger than expected US growth!

Although asset prices are inflated, that’s because of non-market factors. We are not in a period of irrational exuberance. Underlying sentiment will remain cautious – although we’re now into the rising US rate environment, there are, as yet, few discernible signs of real economic growth. The first week of the year saw the worst US manufacturing demand in six years. It will take time to convince markets things are getting better!

And while the US is normalising, the rest of the world remains addicted to intervention. The China slide in the opening days of 2016 was addressed in the “same old, same old” way – government institutions were instructed to start buying, and some $19.9 billion of short-term money was pumped into the market by the Bank of China to quell pressures. It’s hardly the stuff of an unfettered invisible hand.

I’ve heard some extraordinary expectations for stock markets this year. Some analysts are blithely predicting 10% plus returns. I can’t see it. Unless the current miserable economic data suddenly turns even more spectacularly positive than I expect, I can’t see any reason to justify much higher stock valuations. The truth is global stocks have still to correct the distorting effects of years of Quantitative Easing – which is what I mean by Normalisation. Government purchases of bonds pushed interest rates to zero, which had the effect of pushing stocks higher as yield tourists sought returns outside of fixed income.

Japan stocks did rather well in 2015 – but on the back of government directed pension fund buying and the devaluation effects of the lower yen. China stocks are maintained by government fiat. European stocks rose last year – and I’m not convinced I really understand why the prices anticipate growth.

US corporate results hardly seem to justify high expectations. What will happen to these markets if the support of governments was not there? In the case of China, freefall; in the case of the US, I’m beginning to see a stock market that reflects the underlying economy, and if that economy grows, then stocks will deservedly rally!

Bonds are going to be interesting. No less a global authority than Blackrock say it’s going to be a difficult year. But in what way? We’re expecting a modest bear flattening in the US – meaning 30-year bond rates will rise a little while the sell-off at the short-end will be more pronounced. That will cause modest losses, but not a bloodbath.

European bond markets are set for an interesting year. Despite continuing to miss ECB inflation targets, I suspect Draghi’s cupboard of QE surprises is pretty-much empty. By failing to deliver yet more QE stimulus by buying even more bonds and financial assets, he disappointed markets in December – promising much, but delivering little.

That’s been his modus operandi from the get-go, but now I get the sense that the ECB’s options are limited. Despite the economic pall that hangs over Europe, we may still see weaker European bonds (meaning higher yields) as Draghi’s repeated promises to “do whatever it takes” run into political roadblocks. He’s already done enough with near-zero rates, but to maintain these requires the maintenance of the polite fiction he can deliver on all these promises.

2016 will see Europe face many challenges: pressures from immigration, immediate political crises (such as Spain trying to construct a government), and the looming uncertainties of a BREXIT vote, to name but a few. As a result, I’m thinking European bonds look… problematic… And bear in mind, if the US fails to deliver real signals of burgeoning growth, then the dollar rally will stall, leaving Draghi’s hopes for European recovery on the back of a lower Euro in tatters.

The other major asset class to consider is the broad world of commodities. Just watching the TV over the holidays was enough to convince anyone the world’s weather has gone mad – with profound implications for agricultural commodities. We know the planet has just experienced the strongest El Nino event in the Eastern South Pacific – meaning a La Nina will follow. These both trigger predictable weather effects that can be hedged.

Meanwhile, while the market remains convinced raw material prices are wholly dependent on China, don’t forget other emerging economies have arisen that are cheaper producers and are set to replace the Middle Kingdom as the world’s factory floor. A weaker dollar – further reducing commodity prices – could well see stronger growth.

Oil is potentially a game changer – higher oil prices could prove the inflation spur so many central banks crave. They should be careful what they wish for – they might just get it. If the Middle East squares off between Saudi and Iran… watch prices. Even a modest oil spike to $70 dollars (where we see the true marginal cost of US production) could create an unexpected stagflationary cocktail.

Aside from the broad themes of how nervous markets settle and approach normalisation, what other trends can we expect in the coming year? What more can I add to the many articles already festooned across the market media speculating on all kinds of looming financial disaster, and dredging through the detritus of nonsense that passes as informed market opinion these days?

In terms of risks for 2016 I’ve read it all. From an eruption of Mount Vesuvius to a UK housing collapse, revolution in Saudi Arabia to a Unicorn meltdown in US markets. And why not, these are all possible market events in the coming year. My own threat board includes Flying Saucer Invasion (why not?) and China Part 2.

In terms of positioning my portfolio for both the known “unknowns” and the “no-see-em” threats of the coming year, I am reminded of two pieces of sage advice given to me by successful long-term investors: 1) if you don’t know, don’t go long or short, and 2) there is no point worrying today about something you might have to worry about tomorrow.

Good luck for 2016!