Tim O’Neill and Eric Lane delve into some of the trends, themes and cycles that investment professionals at Goldman Sachs Asset Management believe will have important investment implications in 2016.
An environment of modest-but-positive global growth is likely to remain for some time. Growth in developed economies remains reasonably well supported by accommodative policy, improving labour markets and low energy prices. However, overall economic growth has slowed in emerging markets and some countries are experiencing significant challenges.
- In general, we believe that the positive factors in the world’s largest economies outweigh the challenges presented in emerging economies
- It is important to differentiate between emerging economies: many continue to grow rapidly
- Global growth appears modest, yet sturdy. The largest economies should benefit from low energy prices and easy policy.
Four key themes for the year ahead have emerged from our conversations with investment professionals across Goldman Sachs Asset Management. Two of these – ‘Stay tuned for a long expansion’ and ‘Fresh strategies for discerning returns’ are considered in more detail in this article.
This last theme encapsulates our view that, after a turbulent 2015, China looks set to continue to be a source of market volatility but policymakers there are likely to prioritise growth and stability. We also expect the impact of the country’s economic transition to become more nuanced across emerging economies.
“We are being conservative with the risk we take, diversifying to ensure no one position can lead to a significant erosion of capital.”
Watching for inflection points
Moderate global growth and highly accommodative central bank policy have provided a broadly supportive backdrop for investment returns across many asset classes for the last several years. Looking ahead, investors are understandably alert to potential catalysts that could bring an inflection point in the long cycle, but we see many reasons to remain optimistic.
- The economic cycle: We think the prolonged period of modest-but-positive global growth has a long way to go. In developed economies, growth remains reasonably well-supported by a combination of accommodative policy, improving labour markets and low energy prices.
Meanwhile, in emerging markets, overall economic growth has slowed and some countries are experiencing significant challenges. It is increasingly important, however, to differentiate among emerging economies – many continue to grow at a rapid rate, some potentially benefit from lower commodity prices and some are better positioned to navigate China’s transition.
Overall, we think the positives in the world’s largest economies outweigh the challenges in some emerging economies, pointing to another year of global growth that is moderate but generally supportive of many asset classes.
- The policy cycle: Historically, the initiation of a rate-hiking cycle by the Federal Reserve has not ended the expansion phase of the US economic cycle, and we do not expect that to happen this time around. With US monetary policy lagging far behind economic growth, the Fed’s first hike is far less important for financial markets than the pace of the tightening cycle and the eventual stopping point. The Fed has signalled both of those will be considerably more moderate than in the past.
In addition, we believe the Bank of Japan and the European Central Bank remain in maximum accommodation mode, while the Bank of England does not appear to be targeting aggressive rate hikes, suggesting the global policy backdrop is likely to remain highly accommodative. Policy divergence raises the risk of volatility spikes on unexpected developments but we believe central banks are acutely focused on these risks and would respond accordingly to threats to growth and stability in financial markets.
- The corporate cycle: While US monetary policy is lagging behind economic growth, the US corporate cycle appears to be somewhat advanced. US companies are finding it more challenging to generate earnings growth and have become more aggressive about issuing debt to fund transactions that can benefit stockholders, including share buybacks, mergers and acquisitions and dividends.
Each phase of the corporate cycle has been prolonged, however, with a slow recovery in credit after the 2008/09 financial crisis and a gradual expansion of corporate leverage. We expect the next phase – a transition to rising defaults – to be extended as well. Although we anticipate a significant rise in US energy sector defaults in 2016 because of the drop in oil prices, we expect the default rate in most other sectors to rise more gradually over the next few years.
From a global perspective, European corporations continue, in our view, to behave conservatively, with less M&A activity and fewer share buybacks. Although the ratio of corporate-debt–to-earnings has increased in Europe, that has primarily been due to weaker margins. In Asia, we view macro conditions, such as broadening growth and cheaper energy, as conducive to credit – particularly high yield.
- The commodity cycle: The recent downturn in commodity prices is another cyclical development with important implications for the 2016 outlook. In our view, the commodity cycle is in a phase of oversupply, which followed relatively high prices between 2006 and 2014 and has been exacerbated by slower growth in China. We expect the path to higher prices to be a long one. Crude oil faces both excess production and high inventories, which could drive prices lower in early 2016 before returning to equilibrium heading into 2017.
Economic outlook at a glance
Our macroeconomic outlook for 2016 is broadly favourable – a continuation of low but positive global growth, led by the developed economies, and a moderate pick-up in inflation.
- US: The economy looks strong enough to warrant a gradual increase in interest rates in 2016, but the combination of tighter financial conditions and weak global demand will probably keep growth in the low 2% area.
- UK: We expect growth to remain in the low 2% range in 2016, with contributions from consumption and business investment. We think the Bank of England may raise interest rates in the first half of the year.
- Eurozone: We believe growth will stay around 1.4% and inflation will probably struggle to top 1% as the euro reaches the limits of its potential downside despite continued heavy policy stimulus.
- China: Growth looks likely to slow to somewhere north of 6% in 2016, as the economy transitions to a more consumption-driven model. We expect further targeted stimulus by the People’s Bank of China as financial conditions remain tight.
- Japan: Strengthening domestic demand should help growth recover modestly in 2016. With inflation still well below target, the Bank of Japan may ease policy further in the first half of the year.
Working harder for returns
While we see a broadly supportive backdrop for returns across many asset classes, we anticipate modest returns from major equity and fixed income markets. This has macro drivers, including moderate global growth, the emerging markets slowdown and the lateness of the credit cycle in select regions. Valuations also matter in a world of ultra-low interest rates and fair – in some cases full – equity valuations. We believe maintaining investment returns requires a renewed focus on the efficiency of portfolios. By ‘efficiency’ we mean making use of additional sources of return that do not necessarily contribute greatly to a portfolio’s risk. In our view, this means allocating away from a reliance on market returns – traditional ‘beta’ – and using a diversified set of exposures, dynamic asset allocation and selectivity within asset classes.
The moderate returns we expect in 2016 generally trace their roots to the moderate pace of global economic growth, the slowdown in emerging economies and the lateness of the credit cycle in select regions, each of which presents challenges for risk-aware investors.
Our global outlook is still broadly positive, as we feel global growth can improve. We are positive on equities and the outlook for Europe and Japan in particular. As was the case in 2015, however, we see mean reversion playing a potentially important role in the evolution of investment returns, and we foresee the possibility of market volatility on account of China’s transition and the contrasts in global monetary policy. After years of strong post-financial crisis returns in equities and fixed income, particularly in the US, we expect a wider range of asset classes to compete.
We expect portfolios with varied exposures to adapt more readily to a period of low investment returns. Incorporating asset classes with imperfect correlations to each other can potentially be a useful starting point for investors who seek to improve returns without adding too much risk to a portfolio. This approach can also help reduce overreliance on core asset classes.
Diversifying assets range from ‘satellite’ asset classes within equities and fixed income to hedge funds and liquid alternative investments. Moreover, a range of asset classes from commodities to global real estate have historically offered what we view as notable diversification potential.
In addition to a broader range of asset classes, novel exposures within existing asset classes can help diversify a portfolio. As an example, value or carry-based relative value strategies in equity, rates or equity markets may offer what we consider to be attractive returns that have historically shown reduced correlation to their wider asset classes.
We think active investment approaches may be well positioned in a low-return environment – whether through dynamic asset allocation or active security selection. The slowdown in economic growth in some regions versus others, or the contrasts in monetary policy across the developed world, has not affected all markets in the same way.
In equity markets, for example, where we see little potential for higher valuations, we think stock prices are likely to be driven by diverging company fundamentals, such as those that are capable of growing revenues. A higher dispersion of equity returns should benefit active managers who focus on individual stock selection to generate alpha.
Tim O’Neill and Eric Lane are global co-heads of the investment management division at Goldman Sachs Asset Management (GSAM). This article is an edited version of the 2016 GSAM Outlook, which may be read in full here
Fresh strategies for discerning returns
- We favour equities over credit and credit over rates. We expect single-digit global equity returns, with more upside potential for European and Japanese markets than the US.
- Investors face fair – in some cases full – equity valuations and ultra-low interest rates, which we view as a potential recipe for modest subsequent equity and fixed income investment returns.
- With only small positive returns expected in ‘core’ equity and fixed income assets, we see potential roles for other asset classes and alternative strategies.
- Well-diversified, dynamic and selective investment approaches can be important tools in today’s environment.