As we come to the end of 2015, it may feel as if it were a year of turmoil, with volatility increasing, worries about the end of the liquidity cycle surfacing and the (surprisingly) sudden realisation by investors that Chinese growth cannot continue on a trajectory of 7% forever creating much soul searching. However, in terms of stock market moves, the year looks to be ending on a marginally negative note, with a muted decline from the peak of the Shanghai index in June.
This makes predictions for 2016 all the more difficult. Nevertheless, there are some key factors a long-term investor can rely on:
- Interest rates will rise from current levels, with the tightening starting in the US and followed in a staggered fashion by the UK and eventually Europe. This combined with reasonable economic growth in the US (the largest global economy) and in China (4-5% growth is still substantial for the second biggest global economy) should make
for a constructive case for equities;
- The world’s temperature has passed through the +1 degree level and looks set to go through the +2 degree level. Whatever decisions come out of the Climate Summit in Paris, future valuations of all assets have to adjust for a carbon discount;
- The barbarity of the atrocity in Paris, which brought the kind of murder ISIL has been inflicting on Muslims in the Middle East for two years to developed economies, along with Russia’s adventurism in the Ukraine, underlines that political risk is likely to play a much larger role in investment thinking over the next decade than it did in the preceding decade.
Hermes Investment Management
2016 Outlooks by team
RISK | MACROECONOMIC | STEWARDSHIP | EQUITIES | GLOBAL EMERGING MARKETS | ASIA EX JAPAN | GLOBAL EQUITY | EUROPEAN EQUITIES | SMALL AND MID CAP | MULTI ASSET | REAL ESTATE | INFRASTRUCTURE | FIXED INCOME | CREDIT
As the tide recedes on market risk, sharp rocks are slowly being revealed. It will be possible to navigate around them, but only with careful portfolio management. Risk manifests itself in several different forms – no single metric will give a complete picture – but we can highlight a handful of areas of potential vulnerability:
- Volatility has been on the rise and markets are likely to see further and more severe spikes in volatility in 2016;
- Some decoupling between credit markets and equities has taken place and we expect that to continue, but the risk that correlations all rise together across asset classes is very real;
- Liquidity risks remain most prevalent in the credit market, but there are genuine dangers of spillover to other markets in the event of financial stress; and lastly, We expect markets to remain fragile and vulnerable to shocks.
Risk of contagion is on the rise and portfolios may appear more diversified than they actually are. Financial markets are inherently unstable and represent a challenge for even the fittest-for-purpose risk models – we must be aware of their limitations and the potential pitfalls into which our portfolios might be led.
We are still expecting baby steps toward policy exits, as central banks with ‘skin in the game’ avoid taking the market off-guard. My outlook revolves around four beliefs.
First, US and UK real policy rates will stay negative into 2017 and ‘peak’ rates will be much lower than we are used to. Eight years after the first traces of crisis, we have moved to a two-speed recovery. In the lead are the US, Canada, Australia, New Zealand and, for the first time, the UK. But in the slow lane are Japan, the eurozone and some emerging markets. The eurozone will continue to lack fiscal union. Greece may restructure, but this will likely be felt more by official institutions than private markets. And, like Japan, the European Central Bank (ECB) may have to extend its liquidity.
Second, lower peak rates could be delivered by the Federal Reserve and Bank of England selling some of the government bonds bought under quantitative easing (QE). A risk to the pound, though, is the ‘known unknown’ of the UK’s EU referendum.
Third, China is slowing, but has the ability to soften the landing. The effects on leverage and deflation need to be watched, but the Fed may not be knocked off course.
Fourth, despite pockets of vulnerability, a blanket emerging market crisis seems unlikely. Few have fixed currency pegs to protect, so foreign exchange reserves need not be exhausted. Ultimately, they too may try QE.
This all suggests that 2016 will be more like 2015 than 1994, when US rate hikes hit most assets hard. But, the policy ball is in China’s court.
Group Chief Economist
From an environmental perspective, the outcome of the 2015 UN Climate Change Conference in Paris will have a significant impact on the efforts of companies, politicians and investors to mitigate carbon emissions and global warming. In 2015, we saw a record number of shareholder proposals regarding environmental issues and this is likely to continue in 2016, particularly in the US.
Businesses are also facing further pressure to address social issues. In particular, human and labour rights will be in the spotlight after the introduction of acts on modern slavery in the US and UK in 2015.
Enshrining social issues in law means that companies can no longer afford to ignore what is going on in their supply chains. However, we are confident that the laws will not be troubling for businesses, due to existing commitments to responsible corporate practice.
Similarly, diversity has climbed up shareholders’ priority list. Often considered a gender concern, in reality diversity in business goes far beyond this. In addition, it is essential to address diversity beyond board at lower levels of management. We are currently developing a new methodology for dealing with diversity issues.
Awareness of the materiality of governance issues among shareholders will continue to grow. We anticipate proxy access – the right of shareholders to nominate candidates for the board at AGMs – to dominate discussions between shareholders and boards in the US. Engagement with US directors has been on the rise, something we expect to continue.
Dialogue between companies and shareholders will also improve globally, even in traditionally difficult markets.
More countries are expected to launch their own stewardship codes.
CEO of Hermes EOS
Seven years on from the onset of the global financial crisis, and our introduction to “unconventional monetary policy”, investors and savers alike are still waiting to return to business as usual. By now, it had been hoped that central bankers would have receded back into the shadows, rather than remaining centre stage. Market behaviour is still worryingly dependent on the latest utterance from the Fed, Bank of England or Bank of Japan (BoJ), something that appears unlikely to cease anytime soon.
In 2014, the last round of QE came to an end in the US. An initial bout of “taper tantrums” was quickly reversed and global equity markets moved to fresh highs in the spring of this year, aided by the ECB and BoJ taking up the monetary easing baton. On the surface, all appeared calm. Yet, the end of QE in the US ushered in troubling times for other markets. Commodity prices tumbled, emerging market currencies cracked, credit spreads started to widen and global trade sagged. Even the mighty Chinese economy succumbed to the pressure, triggering a savage domestic bear market.
While the ECB and BoJ were pumping fresh liquidity into their economies, neither the Japanese yen or the euro were reserve currencies, and it was the effective withdrawal of US dollar liquidity that hit credit growth in many parts of the developing world. With the Fed still agonising over the first rate rise, despite an apparently healthy economy, volatility will remain an uncomfortable companion into 2016. While the markets are focused on the normalisation of interest rates, next year could well see the Fed return to the unconventional, with uncertain consequences for asset prices.
Head of Equities
The 2016 outlook is positive for the emerging market manufacturers, such as China, India, Taiwan, Korea, Poland, Hungary and Mexico, which make up over two-thirds of the MSCI Emerging Markets Index. Conversely, the outlook is neutral for the commodity producers, Russia, Indonesia, Brazil and South Africa, which contribute around 20% to the same benchmark.
With Chinese growth continuing to moderate, commodity demand will remain modest. However, as the People’s Bank of China is in an easing cycle, economic activity relating to housing in top-tier cities, services and e-commerce will remain healthy. Meanwhile, Indian growth should improve over the course of 2016 as public sector bank balance sheets are recapitalised, amid wider positive sentiment.
Taiwan and Korea should see muted economic growth but their healthy reserve levels and current account surpluses should support current valuations, while earnings growth in both countries, and dividend yields in Taiwan, should support equity prices. Eastern Europe and Mexico are making slow but steady progress in terms of both their
economies and earnings.
Commodity-based economies are facing headwinds which could continue should the Fed raise rates. Although commodity currencies have already caused pain for investors, there could be more to come, depending on
policy responses. Russian, Indonesian, Brazilian and South African leaders have left investors uninspired, focusing on populist declarations rather than long-term structural reform. If this is not corrected, Fed rate hikes could spell more weakness for their currencies and economies.
Overall, after four years of underperformance, it is likely that emerging markets will start to see stabilisation of their relative performance. Given that emerging market currencies could trough as well, an interesting longterm entry point for the asset class could arise this year.
Head of Hermes Emerging Markets
Hermes Asia ex Japan
Last year we predicted that after several years of defensive, high quality growth stocks outperforming, 2015 would be the year of the cyclicals. We were wrong and throughout 2015 cyclicals continued to de-rate relative to the defensives. However, in our view this has only increased the likelihood that 2016 will be the year that the reversal occurs. We do not think that the time is yet right to buy the deeply cyclical companies, meaning those in industries that have massive overcapacity and are likely to incur many years of declining earnings or losses such as steel, iron ore or shipbuilding. Instead, we continue to think that the market’s sweet spot, from a valuation perspective, is quality cyclical stocks. We define these as stocks that maintain a good return on equity over the cycle, have a short down cycle, remain profitable in the down cycle and run with little debt. Quality cyclical stocks include companies in sectors such as retail, manufacturing, petrochemicals, ports and technology. The picture is further improved when these stocks can be found in cheap markets that have underperformed over many years; hence our preference for Korea and Hong Kong listed Chinese shares relative to those listed on other Asian and the developed markets.
Portfolio Manager, Hermes Asia ex Japan
Hermes Global Equities
2015 has been a year marked by volatility, as global growth failed to live up to expectations. The lack of robustness in the global economy has come as a surprise to us and to many other investors given the high levels of capital expenditure in recent years, leading to heightened levels of risk and nervousness.
Despite these concerns, we do not see the slowdown in growth as the start of another recession; we see this as a mid-cycle correction. Given the high levels of corporate investment still coming through, we believe the economy and the markets will continue their upward trajectory in 2016.
However, the markets’ nervousness has extended to the Fed, with interest rate rises delayed and now running significantly behind where we would have expected them to be. In the search for yield, investors have favoured dividend-paying stocks despite their lofty valuations and we anticipate this trend continuing until we see central banks more willing to tighten monetary policy.
We continue to seek opportunities in under-valued companies Demonstrating a blend of strong growth and quality. From a regional perspective, Japanese equities are attractive. Japan looks cheap compared to both the US and Europe, as well as to its own history.
Furthermore, the introduction of the country’s Code of Corporate Governance this year has placed shareholder and executive focus firmly on governance standards; this has the potential to unlock significant value.
Head of Hermes Global Equities
As we enter the first earnings season of 2016, the headline growth rates in Europe will face tough comparisons from the recent stabilisation in the euro after its sharp decline against most major currencies during the second half of 2014. The currency-induced rally in early 2015, fuelled by the perception of these translation benefits, was stopped in its tracks as the stark reality of slowing global growth, especially in China and Brazil, became apparent. As that currency benefit washes through, the global backdrop of weak emerging markets and slowing Chinese growth will become increasingly clear. We enter the new year with expectations for more monetary stimulus remaining high, although the tools available to policy makers have been significantly depleted. Against this backdrop the Fed is hesitating on rate hikes and stands in the unenvious position of being damned if they do, damned if they don’t. We believe that cycles will continue to remain short and shallow and will be overlayed with periods of hope and fear leading to significant volatility. The market has taken years to understand the real life impact of QE and low interest rates. We believe that the biggest risk lies in global liquidity and the ability to fund growth through credit, which poses many risks to markets.
As we have seen for many years, European corporate fundamentals remain polarised, with companies whose fortunes are tied to economies and currencies seeing growth rates fluctuate as the waves of QE ripple through those countries and companies that are exposed to commodities and oil. This has led to deflationary pressures which have benefitted consumers to the detriment of the countries that produce them.
Technological changes are forcing companies to adapt to a new world, pressuring businesses to reinvent themselves to avoid the destruction of their business models. Anchoring to the past has never been so dangerous for investors and companies alike. By taking a market view investors are often led by the macro, leaving them exposed to the subsequent indiscriminate flows. However focusing on fundamentals is key and European opportunities abound. Structural growth is ever present and change is ever more exploitable. Investors need to embrace this change at all levels and to look forward not back.
CIO of Hermes Sourcecap
Hermes Small and Mid Cap
While the market falls in August and September were sharp, they only took core indices (the S&P500 and MSCI World) back to the bottom of the upwards range in which they have been trading since they hit their lows in March 2009. As a result, we believe that the market environment is largely unchanged, despite pockets of volatility in economies such as China and despite a general waning of economic growth prospects.
On a 30-year view, these indices are still one standard deviation or so above their long-term trend, suggesting they are relatively expensive by historical standards. But this is only to be expected given that interest rates, and hence discount rates, are abnormally low. It does, however, necessitate a greater degree of selectivity amongst asset owners and managers to avoid over-valued areas of the market and to preserve capital if market fundamentals
After pausing for breath in 2014, small caps on a global basis are marginally ahead of large caps. We expect this to continue, especially as deteriorating economic growth enhances the attraction of stocks that can still produce growth. The low-growth environment will also likely lead to more M&A as growth-challenged larger cap stocks seek to revitalise their businesses by accessing newer products and markets.
Our approach, investing over extended periods in high-quality businesses, has historically enabled us to gain exposure at relatively low risk to these growth characteristics. Yet we still maintain a degree of downside protection, a combination which should prove to be fitting in the investment environment we anticipate.
Head Hermes of Small & Midcap
Rather than attempting to predict the future path of the economy, our asset allocation framework is systematically adjusted to changes in the environment. However, it is possible to define different economic environments in terms of growth and inflation levels.
We are currently in a period of moderate growth coupled with low inflation, both of which seem to be heading lower. At current levels, we see the potential upside for inflation to be greater than the downside, offering an attractive entry point to start accumulating inflation protection. As a result, our portfolio is positioned for a slowdown in growth, albeit with a long bias towards inflation surprises.
For 2016, we anticipate a number of potential differences.
Firstly, we are no longer confident that government bonds can deliver in a recessionary environment. As we strive to identify and maintain a diverse set of assets that can be reliably called upon to perform in different environments, we believe that cross-asset momentum can supplement our bond exposure.
If growth does pick up, the tide is unlikely to continue to lift all boats. We expect a much greater level of differentiation across assets and regions, which will require a flexible and opportunistic approach.
Although the system appears to be flush with liquidity, the central banks’ piping system has been slimmed down. While liquidity is plentiful in some areas, others may experience occasional and severe air pockets. We will remain focused on highly liquid assets whose volatility can provide a truer reflection of risk.
Investors have become so accustomed to forward guidance and unconventional policies that these factors are now relied upon when valuing assets. Inevitably such policies will either become even less effective or stop completely. This looming event risk calls for caution when setting risk appetite.
Head of Hermes Multi Asset
Hermes Real Estate
Global transaction volumes are at record levels and performance has been strong, but there have been recent signs of appetite abating. Real estate is likely to remain an asset class of choice delivering
income, a positive spread over bonds and real asset exposure in a world of uncertainty. That uncertainty includes a shaky recovery, unstable growth, persistent low interest rates, quantitative easing and increasingly weak inflation.
Yield compression has driven global real estate pricing back to precrisis levels, not always supported by the fundamentals, and many markets today are looking fully priced. Rental growth is expected to remain muted in a low-growth environment where occupiers face pricing pressures and tough trading conditions. Most markets are late cycle and value for investors will be difficult to find in 2016.
Our focus will remain on developed markets where powerful structural change factors (demography, technology, urbanisation and sustainability) provide momentum regardless of cyclicality through:
- Regeneration supported by new infrastructure;
- Alternative sectors including heathcare, student housing, and debt;
- New specifications for traditional spaces, including offices and retail, to meet evolving requirements.
Creating real estate assets to meet the occupational needs produced by these structural changes, and targeting real estate investments with the attributes to meet investor needs will be critical as the cycle unwinds.
We will look to capitalise on these in major US cities and across Europe’s key markets as we position our portfolio to reflect the late cycle moment in markets like the UK. We will also recycle capital to capture the benefits of diversification across the developed world’s real estate markets.
Head of Private Markets
Infrastructure remains an attractive asset class for many institutional investors, with the potential to generate long-term, stable and predictable inflation-linked cash flows, providing a good fit for pension fund liabilities. Responsible investing, and a focus on ESG, is also increasingly prevalent in infrastructure investments.
The UK continues to be one of the most attractive countries for Infrastructure investment, due to its reliance on Foreign Direct Investment, clear rule of law, and long-standing, transparent regulatory regimes. Lower interest rates for longer remains the macro theme and continues to feed through to asset prices, including certain parts of the infrastructure market. On the other hand, the market for core assets may be undergoing a secular change driven by reduced investment opportunities, which is caused by a significant increase in investment holding periods, due to direct investment by long-term institutional investors.
We remain cautious on valuations, but have focused on high-quality businesses that will respond positively to a changing macroeconomic environment. If there is a secular trend, returns will continue to reduce and valuations will continue to firm, possibly for a significant time to come.
We continue to look for infrastructure investments displaying lower potential dispersion of returns through utilising prudent or no third party debt for our Core strategy. Our Value Added strategy continues to incorporate a broader range of investment opportunities, in terms of both characteristics and geographical location.
The breadth and depth of prospective investment opportunities remains sound. Issues such as ongoing government fiscal pressures, decarbonisation policies and the security of the energy supply will continue to create interesting infrastructure investment opportunities in 2016 and beyond.
Head of Hermes Infrastructure
For credit investors, 2016 is likely to be characterised by the same challenge as 2015: how to identify asset classes which represent value in a low rate and low credit loss environment.
They must ask whether they are being paid sufficiently on an absolute basis for the risks they are assuming and, in some asset classes, the increased levels of illiquidity. 2016 could also see another year of spread decompression between low and high quality credit corporate names. Investors are becoming more discriminating about risk, after suffering a 1.7% contraction in earnings growth for the S&P 500 and a slowing upgrade to downgrade ratio.
The rating agencies are already voicing concerns that the high preponderance of covenant-lite loans in the US leveraged loan market may lead to higher losses. However, European leveraged loans, and particularly middle-market ones, are still some way off their historic tightest lending criteria levels: private equity houses’ equity contribution is above 40% versus 30% pre-2008, senior debt multiples are below 2007 levels and at 80bps, spreads per unit of leverage are twice what they were at the lowest point of the market in 2007.
These statistics mean that the European market feels less “frothy” than its US counterpart and is still likely to offer relative value through 2016. This comparatively better European value and diversity play helps explain the increased levels of investment from insurance companies and pension funds in this sector. Their involvement is likely to be an irreversible trend given the regulatory capital and liquidity pressures on bank balance sheets.
Head of Fixed Income
The poor sentiment clouding over credit markets as we go into 2016 is grounded in the uncertainty surrounding fundamentals, technicals and the future path of interest rates. However, in spite of these issues, market participants are most acutely focused on, and concerned by, market illiquidity. Illiquidity makes trading more laborious and creates volatility because it magnifies idiosyncratic risk. That said, we do not believe that the sum total of recent individual negative credit stories creates or indicates systemic risk.
We were reassured by the recent jumbo bond deals from the likes of Hewlett Packard Enterprises, Altice-Cablevision and Frontier Communications, as well as the reintroduction of hard-currency debt issuance from Russian companies Norilsk Nickel and Gazprom. These deals underscore the resilience of capital markets in this period of uncertainty.
As such, while we are constructive on credit, it does mean that credit fund mangers need to be extremely vigilant and disciplined in their security selection, their pricing of operational, financial and ESG risks, and their position sizes.
It also means that they need to look beyond the traditional risks that can influence performance, and consider more seriously how they can manage volatility, bond structure features, convexity, and duration, among others.
As we move into 2016, we believe that an unconstrained approach gives managers the best chance to capture value on a global basis and outperform in a market grappling with sustained volatility and an
uncertain macro outlook.
Co-Head of Hermes Credit
Co-Head of Hermes Credit
The views and opinions contained herein are those of the authors, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy.