An unsettling year for the markets

The outlook is exceptionally cloudy


Investors face every new year with uncertainty. But the outlook for 2016 is especially hard to fathom because of two key questions: will the slowdown in the Chinese and other emerging economies continue? And how far will the Federal Reserve (and perhaps the Bank of England) move to tighten monetary policy?

The pattern in recent years has been for investors to start the year in optimistic mode about the outlook for economic growth and corporate profits, only to temper their enthusiasm over the summer. But this time is different. Moody’s, a ratings agency, has reduced its GDP-growth estimate for G20 economies in 2016 from 3.1% to 2.8%. Global trade has been disappointing: volumes fell in the first half of 2015 for the first time since 2009.

Since the financial crisis, investors have seen weak economic data as providing a good excuse for central banks to ease policy. That might be a bit much to expect from the Fed in 2016, but investors will be happy if any interest-rate increases are few and far between. The European Central Bank and the Bank of Japan still seem committed to monetary expansion. But the big hope is that China will respond to its slowdown with some policy stimulus, a move that would give a big fillip to other emerging markets, particularly commodity producers.

Equity markets in the developed world have benefited from low interest rates (which have steered investors out of cash and into risky assets) and from healthy profit margins, thanks to subdued wage pressure. But with American unemployment having fallen significantly, real wages are rising because of subdued inflation. And slowing emerging markets mean that companies cannot count on a bounce in global demand to keep profits motoring.

The waiting game

Bond investors must feel as though they are in a state of suspended animation. Every year, most commentators predict that the era of low yields is bound to end, because of a pick-up in growth and inflation, or a change in monetary policy. But the big sell-off has never really occurred; in 2015 quite a few European government-bond markets even had negative yields for a while. The default rate on corporate bonds remains low by historical standards and companies have managed to lock in low rates, easing the strain on their finances. Until inflation surges again, it is hard to see why bonds should sell off, and falling commodity prices and weak growth mean global inflation is likely to stay subdued. (Poorly run countries like Russia and Venezuela are exceptions.)

For commodities, the news has been so bad that the mood must change at some point. Investors have become convinced that the “supercycle” is in the down phase; abundant supply is overwhelming stagnant demand. Oil is the obvious example: Saudi Arabia’s attempt to put American frackers out of business in 2015 didn’t seem to work, and in 2016 production from post-sanctions Iran will be hitting the market. However, a lot of bad news may now be priced in.

Economic and profit fundamentals are not, of course, the only factors that could affect investment decisions in 2016; politics may come into play. The Greek crisis rattled markets for months in 2015. The big political event of 2016 will be the American presidential election. Investors will be sanguine about the outcome of a Bush-Clinton contest but will get nervous if the alternatives are Bernie Sanders and Donald Trump. British investors will get twitchy in anticipation of the country’s referendum on EU membership

The final cause of uncertainty may be market liquidity. For regulatory reasons, banks are no longer playing as big a role in market-making as they used to. The sell-off in August 2015 indicated that prices can crater for a while, with investors unwilling to hunt for bargains. The occasional “flash crash” is one thing; if they happen every month, investors might start to find zero returns on cash more attractive than before.

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