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Skerritts View - January 2016
Will 2016 Be The Year Of Enlightenment?:
At the time of writing this, we’re less than a week into the New Year yet it feels that the mood has been set for the rest of it. Before most of us had even got out of bed on the first working Monday after Christmas, the Chinese stock market had suspended trading as their index plummeted 7%, triggering the worst opening sessions for Western markets for more than two decades. The Saudi embassy was aflame in Tehran and North Korea had set off a hydrogen bomb registering over 5 on the Richter Scale. Happy New Year.
We wonder whether this will be the Year of Enlightenment; the year in which people come to realise that things are not going to go back to being “normal”. Normality for most of us was the period between 1980 and 2008, when a once in a lifetime credit boom led to everything going up – wages, prices, markets, house prices – virtually everything. In the Credit Crunch of 2008 it all stopped. Those who have not come to terms with the “new normal” will have a very long wait for their old normal to return.
But We’ve Had Nothing But A Bull Market Since 2009:
When we put forward our less-than-optimistic view we are challenged by those who point to the fact that we’ve had nothing but a bull market since 2009, so why are we so downbeat? Our answer is that we’re only relatively downbeat (we prefer the term realistic) and we are not saying that there will be no way of making money from here. It will just be a lot harder; investors will need to be more active; and expectations of double digit returns can be well and truly consigned to the memory box. Since 2009 we have seen central bankers add the QE fuel to a supremely undervalued market which reacted to the travails of 2008 by expecting things to be 9 times worse than the Great Depression of 1929. That was clearly too pessimistic. But now we have reached the following scenario: for the first time
in modern history, debt levels are extremely high almost everywhere, the pace of technological change keeps accelerating, there is a geopolitical shift under way of the withdrawal of the US from the Middle East, the rise of China and the re-emergence of Russia, and interest rates are remaining lower for longer (despite an upward twitch from the Fed in December). The world is working out how to deal with the changing backdrop.
The problem we face now is that the central bankers are out of ammunition but we are entering a phase of slowing growth virtually anywhere that you look in the world. In 2009 the Fed, Bank of England and Bank of Japan bailed us out initially. This was closely followed by China and its remarkable expansion programme hoovering [can we say hoovering rather than vacuuming or dysoning?: Ed] up any commodity that came out of the ground, thus boosting the emerging market economies as never before. The US then picked up the baton as the emerging market miracle faltered, followed by Mario Draghi at the ECB, but as the US now suffers from fatigue together with China, who is going to step forward next? The answer is not exactly obvious. This is why we suspect that Janet Yellen at the Federal Reserve raised rates in December – so that she’s at least got something to lower when the economy is crying for help next. This is not a rosy scenario.
On top of this, there is no financial asset that looks cheap at the moment. In our opinion, a market correction is a near certainty in 2016. It’s just a question of when, and by how much. And will a correction turn into a full blown bear market? We’re certainly due one.
It’s Not All Doom And Gloom:
We said earlier that debt levels had rarely been so high, but combined with interest rates at their extraordinarily low levels this is not necessarily a bad thing. Old school economists will be wringing their hands, but if debt is manageable and serviceable then it is probably one of the least of the world’s worries. It becomes a problem again if the debt becomes difficult to manage, and this is something that we are seeing, and will probably see more of, within the emerging markets as most of their debt is repayable in US Dollars, and the Dollar continues to rise against their currencies. For indebted countries, they are experiencing a rise in interest rates far beyond what we are expecting at home. This is why we will continue to avoid emerging markets and commodities until we see a significant change later in 2016 or beyond.
An expression that was popular at the start of the financial crisis was “inflating debt away”. That’s not going to happen any time soon. This has been one of the key areas that policymakers, politicians, bankers, economists and other theorists are having trouble coming to terms with. The notion of a lack of inflation is one that is alien to anyone that has lived since the 60s. We all learn that inflation is hiding just around the corner. Well, today, it isn’t. That other mischievous “flation” is here instead – deflation. Or at least, it’s hiding around the corner. But policymakers have not had to deal with deflation before, certainly not in their lifetime (except for Japan since 1989 and they’re still trying to deal with it today) and there seems to be a refusal to believe that it is a bigger threat than inflation even now. It won’t happen in 2016. It probably won’t happen in 2017, 18 or 19 either, but at some point we would wager that before we get another bout of inflation we will probably have to suffer a painful downturn to trigger a more orthodox approach than that shown recently in raising rates as the US economy is entering a slowdown.
Parking the Bus and Hitting On The Break:
It’s far from easy to create a strategy as we enter this year. It’s probably best to “park the bus” and try to “hit on the break” to use a football analogy. As previously mentioned, we will at least avoid, and short where possible, the emerging markets and commodities, whilst also reducing exposure to the US to one or two sectors. We will remove the currency hedge that we’ve had on our Japanese funds as any correction in the markets will probably see the Yen rise, and we will continue to concentrate upon the smaller company sectors in the UK and in Europe as these are more domestically focused and can benefit from those consumers who remain in employment, have little debt, and thus more disposable income in these low interest times. We will wait for a liquidity-driven crunch to occur in the high yield bond market and hit on the break by taking advantage of any sharp sell-offs that may trigger bouts of value as the year progresses.
They may be cheap, but we don’t see 2016 as being the year of the tracker fund. If we are right and we are stuck in a rut at best, and on the cusp of a bear market at worst, index funds will be a cheap way of not making any money (at best) or of losing you money (at worst). An actively managed strategy should hopefully still produce a return superior to simply sitting in cash, but it will be a bumpy ride and not particularly pretty.
Are we upbeat? Not really. But then, we’re not desperately downbeat either. It’s just that our expectations are tempered by the likelihood that volatility is going to probably be even higher than it was last year and for much of the year markets will trade within a range that will make avoiding losses difficult, and holding onto gains harder. But not impossible. We like a challenge and we think that 2016 will be exactly that. Bring it on.
Sources: BCA Research –December 2015