2016 could be good for the dollar but only average for equity, bonds

Investment strategists expressed wide-ranging outlooks in their forecasts for the markets for 2016.

A. Gary Shilling, president and economist, A. Gary Shilling & Co., Springfield, N.J., economic consultant and investment advisory firm, was the most contrarian.

For his best U.S. asset classes for 2016, Mr. Shilling said he is long on 30-year Treasury bonds, both coupon and zero coupon.

“I've been a bull on Treasuries since 1981 when the yield on a 30-year bond was 15.21%, Now it's 3% and it's going to 2%” in 2016. That (drop) would amount to more than a 20% appreciation on coupon bonds and 35% appreciation of zero-coupon bonds, Mr. Shilling said.

“Why? Two factors,” he said. “Deflation is really looming, which tends to reduce interest rates because real rates go up in deflation. So it offsets the decline in yield. The other reason is the safe haven” of Treasuries.

Mr. Shilling's second pick as best asset class is long on the dollar. “Everyone in the world is devaluing against the dollar,” Mr. Shilling said. He said several countries “don't have domestic economic growth” so to get it they increase exports and curb imports by “trashing” their currencies, including in the yen and euro, as well as in Canada, Australia, New Zealand, Indonesia and South Korea.

Mr. Shilling also is shorting commodities. “Because there is just a huge excess of supply and more of it coming,” whether it is copper, crude oil or agriculture commodities, Mr. Shilling said. Overall, he would overweight high-quality bonds and underweight equities.

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, has a different outlook.

“We expect short-term interest rates to rise primarily because the Fed” will increase the federal funds rate, Mr. Memani said. “The impact of that on the long-term maturities, for example 10-year and 30-year, is going to be very modest if at all. So we expect shortened rates to rise (and) long rates to remain relatively stable.” As a result, the Treasury yield curve will flatten.

James W. Paulsen, executive vice president and chief investment strategist, Wells Capital Management Inc., Minneapolis, takes yet another view.

Mr. Paulsen considers a diversified exposure to real assets, including commodities, as the best asset bet for 2016. All real assets are a challenge for asset owners to implement, Mr. Paulsen said. “You have to be mindful of illiquidity. One way to deal with that is to diversify it out. Don't just bet real estate, don't just bet commodities.” As global growth heats up, commodities, for one, could bounce up, he said.

Messrs. Memani and Paulsen both believe fixed income will be the worst asset class for 2016.

“For U.S. investors, the appreciation in the dollar will take away any potential benefit we may get” out of fixed-income assets globally, Mr. Memani said.

Mr. Paulsen said: “Bonds are going to have a bad year,” because the Fed began in December the process of resetting rates,

But he also added that “everyone should own bonds. I own bonds. I hate them but I own them because I know that I'm wrong.”

Mr. Paulsen also recommended asset owners underweight fixed income “pretty close to minimum long-term parameters.”

Tim Hopper, managing director and chief economist, TIAA-CREF, New York, agreed that fixed income will challenge institutional investors. “You are going to get some downdraft in bond prices as interest rates go up,” Mr. Hopper said, So in 2016 “you want to (be) more nimble. That's where active management can truly shine.”

Mr. Memani believes domestic and international equities will be the best asset class. With equities generally seen as the key risk-seeking asset in diverse portfolios, asset owners will face challenges reaching their return assumptions with equity market predictions modest at best.

“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 increase 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.”

For the equity market, Mr. Memani forecast mid- to high single-digits for the Standard & Poor's 500 and the MSCI Europe Australasia Far East indexes. Mr. Memani likes U.S. equities, especially large-cap growth, because of “very modest” fixed-income and economic growth expectations. He also likes non-U.S. developed market equities because of attractive valuations as well as a potential for accelerated economic growth and the European Central Bank's continuing monetary easing policy.

Mr. Paulsen sees a wider possible range from down 5% to up 5% for the S&P 500 and up 5% to 10% for EAFE. “I would overweight the rest of the world,” Mr. Paulsen said, while underweighting U.S. equities.

Since international stocks “have underperformed for so many years, nobody likes them,” Mr. Paulsen said.

“They are all kind of underweighted in most portfolios, which means if they start to outperform, more and more (investors) will start of come back. ... I like the under-ownership ... because they have underperformed there are relatively better values,” he added.

Mr. Hopper said U.S. equity returns “will be a little low from a historical perspective” with the S&P 500 rising between 4% and 7%. “There is still some doubt you will see earnings growth,” he added. “That could lead to continued choppy markets as we've seen this year. Positive but nevertheless a little bit more choppy.”

Mr. Hopper said he would overweight non-U.S. equities. “From an asset allocation perspective, you might take money off the table in the emerging markets space ... to buy developed market equities in Europe and leave the allocation untouched in the U.S.,” Mr. Hopper said.

Messrs. Shilling and Paulsen also see recession as a big investment risk.

It would take a shock to get there,” Mr. Shilling said, putting the odds of recession at below 50/50. “The biggest investment risk is that slow growth topples over into recession. That's very positive for Treasuries but negative for stocks. I don't see imbalance right now that's going to make that happen but when you have growth as slow as it is, it doesn't take much to tip it over.“

Recession “is not an overwhelming concern,” Mr. Paulsen said.

Indicators — like the yield curve, interest rates, fiscal policy growth, rate of growth in the money supply — have “gone haywire” in their correlation to future economic growth, Mr. Paulsen said. “What the heck are any of us watching to determine if there is recession risk when all the old indicators no longer work?” he asked.

Mr. Memani said the biggest investment risk for 2016 will be intensifying “deflationary pressures from emerging markets, including China. “That will depress prices and will create intense bouts of volatility in the markets,” he said.

On geopolitical risk, Mr. Shilling said: “If you want to prepare for any kind of global shock, there are only two things you buy — the dollar and Treasuries, end of story.”

But other strategists generally took the view expressed by Mr. Paulsen. “Risk is already accounted for by your diversification. ... Every portfolio should have long-term parameters that are diversified across ... different asset classes,” he said.

“You do that precisely for geopolitical and other unpredictable risks that you know for a fact will occur but there is no way to predict” them. Investors should not let such risk lead them “down a bad path and ... end up doing pretty dumb things like cash out or buying all defense stocks.” n