Volatility and absence of momentum in 2016 mean a tactical approach is needed

The coming year can just about be described as a ‘Goldilocks’ environment (not too hot, not too cold), but not a very appealing one. It is likely to see an absence of momentum in economic growth and in corporate earnings, concerns about the effectiveness of monetary policy, and periods of elevated volatility in financial markets. In this environment, an active tactical asset allocation and stock-picking will have a key role, as valuations are stretched and expected returns are low with a buy-and-hold approach.

Decent growth, but no momentum

We expect global economic growth of 3.3% in 2016, slightly better than in 2015, but with an absence of momentum. US real GDP growth is forecast at 2.4%, above potential. Growth should also be healthy in the euro area, at 1.8% – with potential for an upside surprise if stronger bank credit and fiscal expansion boost investment spending. In Japan, we expect inflation and real economic growth to remain subdued: Abenomics is having only mixed success.

We think the Chinese authorities will succeed in supporting economic growth at around 6.7%. Emerging economies also lack growth momentum, and will be a source of risks for the global economy and financial markets in 2016.

Monetary policies

We expect the Fed to raise interest rates by 25 basis points in December 2015, and then probably twice more (a further 50bp) in 2016. The ECB is likely to extend its QE programme by six months and take interest rates further into negative territory. The desynchronisation of the monetary policies of the main central banks will continue to create uncertainty for markets.

Exchange-rates will remain very volatile, with potential for major disruptions – which argues for minimising currency exposure. The USD bull trend is likely to continue for now, although the bulk is played out; the EUR should weaken towards parity with the USD.

A tactical approach is required

Returns potential for DM equity markets in 2016 appears limited to around 7-10% (including dividends), supporting a neutral weighting. Further expansion of valuations multiples will be difficult in the absence of a turnaround in earnings expectations. Quality stocks, with above-average sales and profit growth linked to innovation, are likely candidates for market outperformance.

From a strategic perspective, the risk-reward balance for EM equities still seems unfavourable. However, with valuations low, if pressures in certain countries temporarily abate, there could be tactical opportunities to play the rebound. EM bonds will likely offer attractive yields, but downside risks to EM currencies suggests caution, favouring EM debt in hard currency rather than local currencies.

Widening spreads on US high-yield corporate bonds may present an opportunity over the course of 2016. However, default rates have risen recently, and are now normalising, which could make this asset class less attractive at present. Returns on investment-grade corporate bonds are not exciting but, unlike cash in EUR and CHF, are at least not negative. Investment-grade could therefore offer a tactical play to help reduce DM equities exposure.

Yields on core long-term sovereign bonds will rise slightly as US monetary policy tightens, probably to around 0.8% for German Bunds and 2.7% for 10-year US Treasuries by end-2016. Nevertheless, 10-year US Treasuries will remain attractive in order to diversify portfolios against shocks to equity markets.

Expected returns for 2016 are roughly in line with our forecasts for the long-term, or a nominal total of around 4% for a balanced portfolio.