Stock market volatility continues to make headlines as uncertainty about the possibility of future interest rate increases puts monetary policy on center stage. Couple this new reality with modest U.S. and global economic growth, the start of slow emerging-market recovery, single-digit stock returns and further weakness in China — and the 2016 market assessment is fraught with credit, rates and currency risks, according to the Bank of America Merrill Lynch Global Research 2016 Year Ahead Outlook.
The question is, will these trends continue, or are signs of greater stability and balance on the horizon?
Global market conditions, and potential opportunities for investors to adjust to market ups and downs, will be addressed by Christopher J. Wolfe, managing director and head of the Merrill Lynch Chief Investment Office, at the SSU Economic Outlook on Feb. 24. Wolfe is also the chief investment officer for private banking and group and institutional investment within the Global Wealth & Investment Management Division of Bank of America.
He will discuss the “big picture” of potential events and policy decisions impacting the year ahead: modest global growth recovery is expected this year, helped by developed (not emerging) economies; moderate inflation keeps interest rates lower for a longer period; and dependency on monetary policy, a stronger dollar and lower commodity prices keeps market fluctuations high.
Globally, expectations are that developed economies will aid a global growth rebound with estimates that the U.S. economy’s GDP growth will be stable this year, with slow and steady growth of about 2.0 percent as of Feb. 11, according to Merrill Lynch, while the Eurozone’s growth forecast will be 1.5 percent, Japan’s 1.2 percent, and India’s 7.6 percent, according to the International Monetary Fund (IMF).
At the same time, China is forecast to see a decline in growth from 7.4 percent in 2014 to an estimated 6.6 percent in 2016, and that Brazil will go from a 2014 growth rate of 0.01 percent to -3.5 percent this year, based on IMF and BofAML Global Research data.
While developed markets (DM) continue to lead emerging markets (EM) in terms of GDP growth, by an aggregate 4.2 percent for DM to 2.1 percent for EM in the 2016 forecast, the gap between them has been narrowing since 2013.
Wolfe calls the current U.S. situation a “penny farthing economy” where the services sector is the strong, giant “wheel” pulling the manufacturing sector along. The U.S. manufacturing purchasing managers’ index, or PMI, has been contracting since fall 2014 from a high of 58, according to Bloomberg, Bureau of Labor Statistics and the Merrill Lynch Wealth Management Chief Investment Office (MLWMCIO).
The PMI measures the activity level of purchasing managers in the manufacturing sector. A reading above or below 50 indicates expansion or contraction, respectively, in the sector.
The final Institute for Supply Management PMI for the U.S. came in at 48.2 in January, down from a preliminary estimate of 53.7 and a final of 54.3 in the previous month. It is the lowest figure since October 2013, due to a slowdown in output and new business while employment was sustained, according to Markit Economics.
The services PMI index is based on data collected from a representative panel of over 400 private sector companies covering transport and communication, financial intermediaries, business and personal services, computing and IT, and hotels and restaurants. The index tracks variables such as sales, employment, inventories and prices.
The significance of this comparison is that the services sector is the primary driver of U.S. jobs, providing approximately 250,000 jobs, while the manufacturing sector provides less than 50,000 jobs, as reported at the conclusion of 2015.
Wolfe said consumer spending is pulling business investment along, buoyed by positive consumer sentiment and growing consumer confidence. He said this should persist and help propel spending. At the same time, he said business spending has recovered from precrisis lows (-20 percent in 2009), but has been trending down in recent years from a post-recession high of 10 percent in 2012 to under 5 percent in 2015.
The U.S. economy continues to bifurcate into a two-tiered economy, which he says has created a diverging profit story. When comparing the EBITDA growth of four key sectors — technology, health care, materials and energy — Wolfe says that while technology and health care industry profits grew by 1.9 percent and 1.5 percent, respectively, as of December, the materials sector grew by only 0.9 percent and energy by a mere 0.3 percent, according to Bloomberg and MLWMCIO. EBITDA equals revenue minus expenses, excluding tax, interest, depreciation and amortization.
Currently, inflation continues to remain stubbornly low, Wolfe observes, as the broad measures of inflation including both consumer price indices and personal consumption expenditure indices minus food and energy prices, show. The inflation percentage rate has remained below the Federal Reserve’s 2 percent inflation target since about 2012, based on Bloomberg data at year-end and Federal projections representing the mid-point of central tendencies. Progress toward achieving the Fed’s inflation target is expected to continue, rising closer toward the 2 percent level between 2017 and 2019.
Furthermore, he sees central bank monetary policy in the U.S. and Bank of England (BoE) diverging in 2016 as both institutions begin to normalize short-term interest rates. He predicts the U.S. Federal Reserve will move up gradually from the current 0.25 percent to 0.5 percent rate sometime in 2016 and possibly to 1 percent near the end of the year — and to 2 percent, or higher, by the close of 2017.
BoE, on the other hand, is already at the 0.5 percent level and may take longer to up its rate while lagging behind U.S. increases. Meanwhile, Japan, which adopted negative interest rates in late 2015, may begin to move into positive territory and join the Euro area with ultra low rates in the 1 percent range this year or in 2017, according to the MLWMCIO.
What does all of this to investors looking for guidance on positioning their portfolios during 2016?
“We expect volatility will remain elevated” and advises investors to keep portfolios diversified while executing on a disciplined rebalancing plan. He also believes global stocks should outperform bonds, and prefers municipal bonds and investment grade corporate bonds over high-yield securities.
“We favor a developed market investment strategy over emerging markets,” Wolfe said.
He is positive on U.S. equities, favoring large caps, higher quality and dividend growth strategies. His investment office team also favors Europe and Japan on a currency-hedged basis, and is negative on emerging markets based on “lower for longer” commodity prices and the slowdown in China.
Income remains essential to a multi-asset strategy, and investors should consider refining the core of their portfolios, he said. “Be flexible and manage duration and credit risk through unconstrained strategies,” Wolfe said. “Consider alternative investments, where suitable, for risk reduction and return enhancement to traditional stock/bond portfolios.”
Wolfe plans to present a graph revealing average annualized rate of return percentages associated with various investments. These results, based on Merrill Lynch Investment Management and Guidance data from January 1997 to June 2014, will show that traditional assets during this period had returns in the 6 percent (bonds) to 8 percent (stocks) range. With a mixed portfolio of 60 percent stocks and 40 percent bonds, the average return was about 7 percent.
Diversifying alternative investment strategies, including those made in long and short emerging markets, returned about 7 percent; event-driven equity and distressed investments (8 percent); long and short equity (8.5 percent), and broad private equity categories offered returns in the 14 percent range. Credit-oriented alternative investment strategies can include long/short credit investments with a 7 percent return, relative value investments (7.5 percent), and event-driven multi-investments (8 percent), according to data from 1997 to 2014.
In addition, diversifying alternative investment strategies including commodities during the study period had a return of 2 percent–3 percent, while managed futures averaged 5 percent, and core real estate and macro investments were both close to 10 percent. The percentage of volatility associated with each investment category ranges from about 3 percent for bonds and up to 18 percent for commodities and stocks. These are indices-based annualized rates of return.
While alternative investments provide an expanded universe of solutions beyond stocks and bonds, Wolfe cautioned that alternative investments are speculative and subject to a high degree of risk. Although risk management policies and procedures can be effective in reducing or mitigating the effects of certain risks, he said no risk management policy can completely eliminate the possibility of sudden and severe losses, illiquidity and the occurrence of other material adverse effects.