Five themes that could set the tone in 2016

After last week’s attempts to learn key lessons from 2015, this column will now turn its attention to the year ahead. In the (unfortunate) absence of a crystal ball, no promises or guarantees can be offered, but below are five themes which investors need to think about when it comes to portfolio strategy in 2016 and beyond.

They are

1. Oil will continue to have a major say – and weak oil prices have historically been good for growth and consumer stocks in particular
2. The dollar and how it could pile further woe on Emerging Markets
3. Deflation, rather than inflation, proving to the biggest near-term threat to investors’ portfolios
4. November’s Presidential election could keep a lid on US equities
5. Volatility may start to rise, placing greater emphasis on the need for a properly balanced portfolio

Each one is outlined in further detail below.

Five themes for 2016

1. Oil will continue to have a major say in the markets. This much may seem obvious when the Oil & Gas Producers sector represents 24%, 12% and 19% of the FTSE 100’s forecast sales, profits and dividends according to the analyst consensus, but oil’s influence is deeper than that. 

The chart below shows year-on-year change in oil prices against global GDP growth back to 1970. On the five prior occasions oil fell 50% year-on-year, just as it has now, global growth accelerated, so it is to be hoped that 2016 sees a repeat.

Weak oil prices have tended to give the global economy a welcome lift

Source: Thomson Reuters Datastream

Weak oil prices have historically given a boost to the global economy and it may be no coincidence that Consumer Discretionary was the best performing sector in America’s S&P 500 last year and ranked second of 10 in the global S&P 1200 (behind only healthcare). The UK’s General Retailers and Travel & Leisure sector did less well, ranking 25th and 11th out of 39, possibly hampered by a warm winter and the price pressure created by the internet, so it will be interesting to see if they perform better this year if oil stays below $40 a barrel (and it is labouring at $32 at the time of writing).. 

2. Watch the dollar (and therefore Emerging Markets). The US Federal Reserve’s December statement suggested the central bank expects to push through four more, one-quarter point interest rate rises in 2016, to take the headline figure to 1.5%. 
The markets seem sceptical as the US two-year Treasury yield, generally a fair proxy for monetary policy, stands at just 0.95% at the time of writing, but any further increases at a time when Japan and Europe are loosening and the UK doing nothing could give the dollar a boost.

The greenback rose around 10% against a trade-weighted basket in 2015 and ended the year around 106 on the Bank of England’s index. However, this index peaked at around 120 in 2000 and 160 in 1985 so it could well go further.

Dollar gains have tended to mean Emerging Market losses

Source: Thomson Reuters Datastream

Dollar strength needs to be watched by investors in Emerging Markets (EM) in particular. There is a clear historic inverse relationship between the buck and EM assets so dollar gains could again be a problem for these markets, even though they have already done badly for four years. Note that the Mexican peso and South African rand have already hit new all-time lows against the dollar in 2016.

3. Deflation remains a big threat. While inflation is the logical conclusion of central bank monetary-printing and zero-interest-rate policies there is little sign of it, even after seven years of waiting and the near term deflation remains every bit as big a risk. Rising global indebtedness, ageing populations in the West, China’s sliding currency, the rising dollar and the price-discovery powers of the internet are all strongly deflationary trends. 

China’s currency continues to slide.

Source: Thomson Reuters Datastream

Of these, China may be the sleeper, since the renmimbi is now lower than it was after the summer’s sharp slide and Beijing could be about to export deflation across a wave of products and industries, such as steel and cement. It may not do much for commodity demand either, while it also means any companies which can provide sustainable, organic profit and dividend growth in this tricky environment are likely to be highly prized. Expensive these stocks may be, but they could become more pricey still unless global economic growth picks up. It also means bonds could surprise yet again, just as they did in 2015.
 
4. This is an election year in America. Geopolitics could affect markets in so many ways in 2016, given the ongoing European migration crisis, unrest in the Middle East, spiky relations with Russia, the possible end to Iranian sanctions and ongoing tensions between multiple nations in the South China Sea but one of the few events guaranteed to happen this year is the US Presidential Election in November.

US stock market tends to do least well in a Presidential election year

The Democrat and Republican candidates are still jockeying for position and it does appear that markets can turn cautious during a Presidential election year. The table above shows that the S&P 500 since 1948 has, on average, done worst in election years (the final one of a Presidency), although that average gain of 4.8% does include a wide range of individual outcomes.

5. Volatility may finally start to rise again. As some central banks increase interest rates and tighten monetary policy (the US and a host of emerging markets) and others continue to loosen (notably Japan and Europe), markets will have less of a comfort blanket in the form of cheap cash. This could provoke an increase in volatility, which has generally been notable by only its absence for the past few years, barring the odd panicky month such as August 2015.

Defence stocks are one potential hedge against any geopolitical upset

Source: Thomson Reuters Datastream

More volatility would reaffirm the need for a properly balanced and diversified portfolio and investors can choose between a wide range of asset classes, such as equities, bonds, commodities, property and cash. Central banks are trying to create inflation although they are currently failing as deflationary forces prove too strong a while the authorities will never rest until they succeed (the world’s massive debts mean they must prevail) the timing of their breakthrough remains uncertain, especially as more Quantitative Easing remains the most likely end-game.

A good multi-asset fund or investment trust (as defined by the Association of Investment Companies’ new “Flexible Investment” category) could help here. Anyone wishing to go down the DIY route might look for a good balance between bonds and stocks with decent yields (for deflation) and stocks and commodity-exposed securities (for inflation) to cover all the bases. 

In addition, defence companies offer a hedge against any military upset in the Middle East (as may downtrodden oil shares) while some investors will have noticed that gold is also creeping higher after a torrid five years. This column will return its attentions to the precious metal once more in the coming weeks.

Russ Mould

AJ Bell Investment Director