The investment landscape of 2015 was filled with a number of unforseen shocks which resulted in a somewhat unrewarding experience for most fixed income investors. As we welcome a new year, unfortunately many of the factors contributing to the low growth, low inflation environment remain firmly in place. In this paper, we will take a look at following topics:
- What major themes we expect to see in the first quarter;
- Will global forces continue to present a headwind to the US economy;
- Will divergence between regions grow; and
- A description of the challenges still in place for already cheapened asset classes.
Our base scenario assumes that many of the challenges that markets had to contend with will remain in place with little to no catalyst for a sea change in global growth. We do, however, believe that in real terms, certain market leaders, the US and the UK in particular, will rise toward trend as 2016 unfolds. As a result, the policy divergence story of 2015 will continue to be in tact as greater differences in economic health will result in greater divergence in central bank policy. These differences will necessitate a change in focus away from the purely “risk-on/risk-off” strategies that proved successful over the last eight years, toward a more targeted approach that will differentiate between regions, countries, asset classes, and even issuers in 2016. We believe that in the US, the greater risk is that growth will be higher than estimated and that base effects will cause a welcome rise in inflation. As the effects of the earlier rise in the dollar and the decline in commodity prices gradually fade, growth should return to trend in the US. This could cause Federal Reserve (Fed) policy to be more aggressive than current forward prices suggest. The Fed did not move in December because growth and inflation needed to be managed down. Instead, the Fed merely started on a course to normalize rates and signal to the market that conditions that once required profound accommodation were behind us. This suggests that, in the absence of a flight-to-quality event, rates risk is to the upside. We believe that the divergence between regions could also grow larger due to European Central Bank (ECB) policy that will be forced to deliver further accommodation in 2016. Under this backdrop, we differ from some who forecast global recession, continued global disinflation and a meaningful sell-off in risk assets. We caution however, that while many asset classes look fairly valued or even cheap, the challenges that have led to these cheapened levels are still in place. Therefore, we expect to be somewhat targeted, and far more tactical in how we take risk in the coming year. Of greatest interest are sectors that benefit from healthy consumer spending, financials and the somewhat oversold conditions in certain high yield sectors, the latter of which now offers close to double digit carry given the severity of recent declines.
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