Interest rates, GDP, China make 2016 uncertain year

In their predictions for 2016, investment strategists see single-digit returns, either negative or positive, in the equity market and fixed-income returns ranging from a bearish -3% to a bullish 20%.

They identify the most important triggers as:

• weak economic growth;


• the Federal Reserve stepping up interest rates, leading to better capital allocation;


• uncertainty in emerging markets recovery, especially China; and


• deflationary pressures conveyed in falling commodities prices, including oil.

As far as major unforeseen shocks such as a geopolitical risk like terrorism, the strategists recommend the best course is to maintain a diversified portfolio to spread exposure rather than to seek a safe harbor that concentrates assets.

None believes the presidential campaign and expectations about a new administration will affect the outlook for 2016.

Because of the generally modest outlook, asset owners will face a challenge meeting their assumed rates of return.

“The key drivers for the U.S. equity and fixed-income markets are going to be ... what is the (gross domestic product) growth rate, what the Fed does and what happens in emerging markets,” said Krishna Memani, chief investment officer and head of fixed income of both parent OppenheimerFunds Inc. and its institutional unit, OFI Global Asset Management Inc., New York.

James W. Paulsen, executive vice president and chief investment strategist, Wells Capital Management Inc., Minneapolis, said the outlook depends on “what happens to growth in the world. We are going to have a bounce in growth. I'm not talking about rapid growth, that's not going to happen. I"m talking about a synchronized global bounce in economic growth.”

A. Gary Shilling, president and economist at A. Gary Shilling & Co. Inc., Springfield, N.J., an economic consultant and investment advisory firm, said: “The economy continues to mosey along at about half of the rate of growth you would expect after the worst recession since the 1930s. I attribute it to the deleveraging that is taking place after the immense buildup of debt in the 1980s and 1990s. This process normally takes about 10 years. But we are eight years into it. At the rate we are going, it may take even longer. This deleveraging has been so robust that even with all the earlier fiscal and more recently monetary stimulus we are still (generating) so far in this recovery 2.1% compound rate of (real) GDP growth. Again about half what you'd expect.”

Tim Hopper, managing director and chief economist, TIAA-CREF, New York, said: “The U.S. economy is somewhat range-bound. It has been operating at the 2.25% to 2.5% range for a number of years. (All the GDP numbers are real, after inflation.) That's going to continue. There is no major (event) that is going to affect the economy either up or down (in 2016). The difference that we see (in 2016) is the normalization of (interest) rates. That is actually a positive for the economy. ... It will begin the process of reflating the economy. ... That will modestly boost (economic) activity. We've got a forecast for 2016 at 2.9% for GDP, following (2015's estimated) 2.5% average growth rate.”

“We're moderately upbeat in the sense that markets will turn on average another positive year, albeit a moderate one,” Mr. Hopper added. “It's not going to be a banner year for markets.”

Mr. Shilling said investors should approach 2016 “very cautiously. You now have a lot more volatility. ... That makes a tough investment environment. You have to pick your way through carefully.” For most institutional investors, cash is good, Mr. Shilling said. “It doesn't earn you anything, but by the same token you don't get whipsawed.”

A combination of global factors affecting the economy will confront institutional investors.

Predicting U.S. GDP growth somewhere between 2% and 2.5% for 2016, Mr. Memani said that will support the equity market. But growth also will bring the Fed into play, which “is going to create tremendous volatility in the equity markets, much the way it has.”

“China continues to slow down, and what happens episodically in the Chinese capital markets and from a (fiscal and monetary) policy standpoint will bring volatility into the U.S. equity market as well,” Mr. Memani said. “China is the bulk of emerging markets at the moment. What happens in China ends up being very important for emerging markets and how emerging markets asset perform.”

“If the Chinese growth rate decelerates at a more rapid pace than what we expect, it will have a meaningful impact on U.S. exports and ... on commodities prices and materials prices on a global basis,” Mr. Memani said.

Economic stimulation, despite a flawed track record, is reaching a new level worldwide.

“For the first time in this recovery we synchronized global economic stimulus,” Mr. Paulsen said. “We delivered it everywhere.” But the syncing hasn't come from policymakers.

“It was done by laissez-faire,” Mr. Paulsen said. “In the last year, we dished out to the entire world the massive equivalent of a global fiscal stimulus in the form of a 50% retrenchment in commodity prices. And then ... at the same time gave everyone a massive monetary stimulus in the form of a tremendous and significant drop in sovereign bond yields ... Then the U.S. added another stimulus to everyone else. We gave them a gift with a significant currency weakness.”

“So everyone is getting the equivalent of a pretty significant fiscal stimulus,” Mr. Paulsen said. “It's likely to work.”

Emerging markets remain a worry among investment strategists.

“A lot of people have trouble grasping (that) these economies are driven by exports,” Mr. Shilling said. “They are not domestically stimulated. Where do those exports go? To North America and Europe. If you have slow growth in North America and Europe, (it) limits export growth and subdues economies in these ... countries.

“China is not an independently growing economy,” nor are other emerging markets, Mr. Shilling said.

A rise in the federal funds rates could lead to better capital allocation and a boost for the economy. Mr. Hopper said the Fed's zero interest-rate policy “in essence is contributing to a misallocation of capital across the economy. As you begin to raise interest rates you remove the (false) support you have for non-economic projects and that capital is freed up to shift into economically viable projects. That process of allocating capital more efficiently and effectively actually will boost activity going forward.”

The strategists believe appearances can be deceiving in looking at the economic outlook, as well as seeing a dichotomy between the U.S. and non-U.S. markets.

Many investors “are overly pessimistic about the prospects of economic growth,” Mr. Paulsen said. For U.S. economic growth, “it's not going to bounce all that much because it's not really slowed down that much,” he said.

“There might be a bigger bounce abroad,” Mr. Paulsen said. “We are already growing at 2.5% to 2.75% and maybe we grow close to 3%” in 2016. The rest of the world, like Japan or Europe, might go from zero to 1.5%, which is a bigger change.”

“While everyone else is trying to put the recession behind them, the U.S. is at full employment and is going to have to tighten” by raising interest rates, Mr. Paulsen said. “The U.S. has crossed over (into) full employment, while no one else is even close to it.”

In the U.S., growth has come without any negative financial consequences such as price and wage pressures, Mr. Paulsen said. “But now that we have reached full employment, if we continue to grow it will have good and bad effects for the financial markets. It will increase sales, but it will also increase cost-push pressures, which will challenge profit margins. It will also necessitate the need to raise interest rates, which will challenge (market) valuation levels.”

“But that's not the case almost everywhere else (in the world),” Mr. Paulsen said. “If you get a bounce in Europe, there are no negative consequences for the financial markets ... same in Japan. If China bottoms out, their growth rate is not going to create a lot of negative consequences.” But it will create consequences in the U.S.

The strategists all see the Federal Reserve raising rates in 2016, forecasting a 2016 year-end federal funds rate of 50 to 150 basis points.

With equities generally seen as the key risk-seeking asset in diverse portfolios, assets owners will face challenges reaching their return assumptions with equity market predictions modest at best.

Mr. Hopper said the markets will challenge asset owners in reaching their assumed investment rate of return.

“We've had a few years of pretty good returns,” Mr. Hopper said. ”And sometimes you are not going to hit 10%; sometimes you are going to hit 5%. That's kind of where we are at in the cycle. The bull market has run for a while. It's brought us some pretty good returns in the past several years. So when it comes to a year when there is increased uncertainty and when the Fed is beginning a new (rate) cycle, it's not uncommon to see a weak year. ... But it is also just one year. And we are investing for the longer period.”