2016 Investment Outlook
The Federal Reserve increased short-term interest rates Dec. 16 for the first time in nearly a decade. The action capped a year of uncertainty about global asset markets. The possibility of a Fed rate hike had been a key contributor to market volatility throughout 2015.
For all of the hoopla regarding the first rate hike, it's more symbolic than anything else. We're talking about a 0.25% increase in short-term rates from essentially zero — not a huge move by any measure. The more important focus should be on how quickly the Fed moves to lift rates to more normal levels. A number of factors will likely be considered in setting that cadence, with the state of the U.S. economy topping the list.
Economic data for 2015 was a mixed bag. On the plus side, unemployment fell from 5.7% in January to 5% in October and November, its lowest point since early 2008. A record number of job openings helped pull up wages, and labor productivity also increased. Housing values are up (dramatically in some parts of the country), and construction looks to be on an upswing.
On the less rosy side, economic growth in 2015 was slow and bumpy. Falling oil prices continued to be a net negative for the economy, as those effects spilled over into manufacturing and other sectors. The strong U.S. dollar made imports cheaper and exports more expensive, giving U.S. companies a disadvantage next to their overseas rivals. The dollar's might also weighed heavily on commodity demand and prices, which presented gale-force headwinds for emerging markets dependent on resource exports.
The U.S. economy was the standout global performer in 2015, but then again, there wasn't much competition for the title. China, long the world's growth engine, saw its pace of economic expansion drop to its lowest level in years as it seeks to transform itself from a mass producer of cheap export goods to an economy led by domestic consumption. Europe and Japan both sought to add pep to their sputtering economies via massive monetary stimulus programs.
The volatility still wasn't enough to end the current bull market, now approaching its seventh birthday as one of the longest and strongest in more than a century. In August, the U.S. stock market saw its first correction — a drop of 10% or more — since late 2011, but the downturn was short-lived. U.S. stocks were up slightly through November (Figure 1), as were those of other developed markets. Emerging markets and gold, however, were both down by double digits.
On the fixed income side, Treasuries (up nearly 2% for the year through November) benefited from a reach for yield from abroad as well as from periodic safety trades. Credit, including high yield, was hurt by widening spreads caused by diminishing earnings growth paired with escalating corporate debt burdens. High-yield also felt the impact of rising default rates, particularly with the energy and materials sectors.
Looking Ahead to 2016
The Fed has long been itching to raise short-term rates off zero, where they have been since late 2008, and to move toward a more normalized policy structure. It also has been adamant in its communications that it intends to follow a slow and gradual path on later rate increases to avoid jeopardizing the fragile U.S. economic recovery.
For us, the main concern about a rate hike is a lack of persuasive proof that the economy has achieved or can soon achieve escape velocity, a breaking loose from the strong downward pull of sluggish growth and very low inflation. We see the U.S. economy staying below 3% growth in 2016, which would justify the Fed's "lower-for-longer" approach on rates.
Rising U.S. rates could further strengthen the dollar, which would likely amplify the negative impact on U.S. multinationals, emerging markets and commodity prices. We think, however, the dollar's climb may be overdone even taking into account rising domestic rates and the looser monetary policy in key overseas economies.
The stronger dollar provides more purchasing power for U.S. consumers, whose spending accounts for 65 to 70% of gross domestic product. Americans, however, remain cautious going into 2016 and thus have not cranked up their spending. We're not sure why. One theory is that debt-burdened consumers are still keeping a tight grip on their wallets. Another is that rising health care and housing costs are grabbing the bulk of the cash freed up by lower energy prices.
How U.S. equities might behave as short-term rates go up will largely depend on how longer-term rates are affected. The Fed only has control over the short end of the yield curve. Interest rates for longer maturities are determined by the market based on expectations regarding growth, inflation and other macroeconomic factors.
Figure 2: U.S. inflation has trended toward zero in recent years.
If rates at the long end of the yield curve flatten or fall while short-term rates are rising, it's an indication that investors believe the economy is heading for a slowdown and possibly even a recession. In that case, the long bull market could be nearing its end. We have, however, seen few serious signs of a recession looming. The U.S. economy is continuing to expand, albeit at a modest pace, and the stronger dollar is keeping a lid on inflation (Figure 2).
If, on the other hand, economic growth picks up as the Fed raises rates, the yield curve would likely steepen as investors allocate more to equities to share in the economic good times. In this scenario, the bull market would have a good chance of heading into an eighth year. In any case, we expect volatility to remain at heightened levels next year.
The pace of Fed rate hikes in 2016 will be an important determinant of how bonds are affected. Assuming that the Fed embraces "lower for longer," the tightening process may not have much effect. Gradually rising rates would reflect a growing economy with little risk of overheating, which tends to benefit diversified portfolios. Credit, including high-yield, could fare well if rate hikes are consistent with an improving economy.
In our view, those investing for the long term should keep their perspective regarding current market conditions, as the impact of shorter-term events tends to be smoothed out over time. This may be an opportune time to review your portfolio allocations to make sure they are still appropriate to meet your goals. We caution, however, against making any hasty or fearful decisions that could jeopardize your well-thought-out investment plan.
Asset Class Outlook
We think the better opportunities are to be found overseas, and our portfolios are positioned to take advantage of the shift.
Looking forward, we see a continued rotation away from U.S. equities and toward other international developed markets, most notably Europe. The eurozone's long-stagnant economy appears to be picking up momentum (Figure 3), and additional lift is being provided via monetary stimulus from the European Central Bank (ECB).
Figure 3: Eurozone's economic growth is still low, but has been on the upswing.
Figure 4 shows current allocations by asset class, and below we offer some insight into the rationale for our positioning.
Figure 4: Asset allocation favors developed markets and high-yield bonds.
U.S. Equities
Heading into 2016, we are neutral on U.S. large cap stocks and maintain an unfavorable view of U.S. small caps. Both of these positions derive from our opinion on their respective fundamental valuations — we consider large caps to be close to fair value and small caps to be significantly overvalued.
A key question going forward is how U.S. companies will be able to grow their earnings, which will be necessary to justify their current valuations. Year-on-year earnings declined in the second and third quarters of 2015 (the first consecutive quarterly drop in six years), and the fourth quarter could see a decline as well.
During the slow economic recovery, companies have managed to generate per-share earnings growth without much help from revenue growth, which has been paltry. They have relied on other methods, notably cost-cutting and stock buybacks, to enhance profitability and support their share prices.
Growth-oriented stocks have consistently outperformed value stocks during the current bull market. Even within growth, most of the gains have been dominated by a relatively few big-name stocks in the technology and health care sectors. Further economic improvements could bring fundamental investing back into vogue.
U.S. Bonds
We have an unfavorable outlook for core fixed income. Low absolute yields are suppressing the income component of bonds, which leads us to believe there are better relative opportunities in other asset classes.
Our view on noncore fixed income, however, is favorable despite some widening of credit spreads in 2015. Our focus on fundamental credit research continues to turn up selective opportunities, notably in asset-backed securities and high-yield.
In rising-rate environments over the past quarter-century, high-yield bonds have outperformed Treasuries and investment-grade corporate bonds. Of course, there's no assurance that this past relationship will hold true in the future. High-yield default rates have risen in 2015, but they remain very low by historical standards.
Municipal bond issuance increased in 2015, with the additional supply contributing to higher prices. We expect issuance to remain solid in 2016. Higher interest rates stand to reduce muni bond prices over the short term, but coupon payments would offset part of that decline, and the principal from maturing bonds could be reinvested at higher interest rates.
International Equities
We hold a favorable outlook on international developed markets. Our highest conviction area is developed Europe, a view based more on relative stock valuations than on top-down macroeconomic factors.
Fundamental measures, such as price-to-earnings and price-to-book-value ratios, show European equities to be significantly cheaper than U.S. stocks (Figure 6). Compared to the U.S., European earnings growth is forecast to be higher in 2016, and lower profit margins in Europe potentially give them more room to grow.
On the macro side in Europe, economic growth continues to be very low on an absolute basis, but it is increasing. Credit is expanding, wages are climbing, and rising prices are beating back a deflationary threat that was significant less than a year ago.
The ECB's monetary easing policy adds to the appeal of European equities by helping to depreciate the euro, which provides an advantage to Europe's exporters over their U.S. competitors. This advantage may be more important going forward as China and other emerging markets contend with slowing growth. Falling commodity prices also benefit European manufacturers on the cost side.
Figure 6: Fundamental valuations are more attractive in emerging markets and Europe.
Emerging Markets
We like emerging markets (EM) in the long run because of cheap valuations (Figure 6) and their higher economic growth potential. In the shorter term, however, a number of powerful headwinds faced by EMs have persuaded us to maintain a neutral weight.
How China fares in 2016 stands to have a major influence, as China has long been the marginal consumer of energy and other commodity exports that form the economic foundation of many EM economies. If China's efforts at monetary stimulus fail to put a floor under the declining GDP growth trend, EM equities could feel the impact.
The strong U.S. dollar tends to work against EMs. This is particularly true for those commodity exporters, given that the global natural resources trade tends to be priced in dollars. Brazil and Russia have been hit hard by this relationship. Rising interest rates in the U.S. also could work against many EMs if the rates drive the dollar higher. Manufacturing-focused countries in East Asia, however, would likely benefit from cheaper commodity inputs.
But if the dollar's gains fall short of expectations and the Fed doesn't rush to normalize rates, EMs could move upward as investors return to the market to take advantage of actual conditions that weren't as bad as anticipated.
Investing in securities products involves risk, including possible loss of principal.
This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisers. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy, or investment product. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.
The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.
Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.
Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers, and affiliates.
Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # 0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer
On Thursday, December 17, 2015 12:52 PM, "sarah_oz@yahoo.com [TSP_Strategy]" <TSP_Strategy@yahoogroups.com> wrote:
In January, we'll update the performance of the various services. For 2016, we're scheduled to add TSP Radar and TSP Smart.
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Posted by: Erick Estela <erick.estela@yahoo.com>
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Neither the TSP Strategy group, nor individual members, are licensed or authorized to provide investment advice. Any statements made herein merely reflect the personal opinions of the individual group member. Please make your own investment decisions based upon your personal circumstances.
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