Our 6 ½- year old economic recovery appears to have more life ahead in 2016. Expansions, like bull markets, do not die of old age. Rather, they end due to demand or supply side shocks. We believe that the economic drivers are in place to extend this expansion cycle. Consumer spending, by far the largest component of the U.S. economy, has been growing at just under 4%, outpacing business investment, government spending, and net exports, the other contributors to GDP. Granted, our economy has had difficulty hitting on all cylinders. Even though consumer spending has been on a healthy track, capital expenditures by businesses have suffered from the severe cutback in spending by the energy sector, a trend we expect will continue in 2016. Thus, a pick-up in real GDP growth beyond a muted 2.5% pace is unlikely. We’ll probably experience growth a bit above the approximately 2% rate we’ve been experiencing since this recovery was born in the summer of 2009.
We indicated above that we feel positive about the American consumer’s propensity for continued spending next year. With unemployment poised to drop below 5% and wages showing early signs of a pick-up in their growth rate, we believe there’s good reason to be optimistic about the pace of consumer spending in 2016. This is further supported by our view that oil prices will remain meaningfully below $60 throughout 2016, giving consumers some added confidence that they’ll continue to save at the pump. In 2015, consumers chose to save and de-lever their balance sheets with some of the gains from lower gas prices. We may see this again in 2016 but as oil prices stay lower for longer, consumers will view gas savings as more permanent and will feel a bit freer in spending those dollars.
We view the Federal Reserve’s unanimous decision, earlier this month, to end its historic seven-year-long zero interest rate policy as a vote of confidence in the economy’s ability to absorb slightly higher rates and still show moderate growth. The economy has long since moved beyond the crisis environment that originally necessitated a 0.0%-0.25% Fed Funds range. The dovish language in Fed Chairwoman Janet Yellen’s statement regarding future interest rate increases leads us to expect the Fed to lift rates very gradually, maybe only three times in 2016. The Fed will continue to assess economic developments and data and act based on that data rather than having a calendar-driven rate-rise schedule. Our 1% year-end 2016 Fed Funds target indicates a continuing accommodative stance by the Fed. If we, indeed, see three 0.25% rate increases from the Fed in a 2.5% GDP growth environment, we would expect the 10-year Treasury yield to end 2016 slightly below 3%, up from its current 2.24%.
A question we have been asked frequently of late is, “How do stocks perform in a rising rate environment?” History shows that stocks often experience positive returns for the 12 months following the launch of a rate increase. Fidelity Investment (AART)’s research department studied stock market levels one year after the start of rate tightening cycles from 1950-2010 and showed the average one-year return at greater than 10%. The positive results stem from the correlation between a lift-off in rates and steady economic growth. In our current low growth scenario, we don’t expect 12-month returns to reach 10%. But we do expect some market upside. Investors should not fear the market in the face of the Fed’s rate hike but, rather, see it as a vote of confidence in our economy and corporate profits. Clearly, Yellen and her committee believe there is little danger that economic growth will reverse course. We concur and, in fact, believe growth could pick up a little in 2016.
Global economies, and China in particular, remain a wildcard in our 2016 outlook. Although we do not expect much change in the recent global growth of 3.5%, the texture will be different. In general, developed economies are showing improvement while emerging economies are facing headwinds, particularly those countries with significant trading ties to China.
China’s true growth rate remains an enigma as the government works to transition to a more consumer-driven economy. Recent official GDP growth numbers have run at 6.9%; however, most analysts feel that they’re overstated. We agree that growth may well have slowed more than official numbers indicate, but we believe that the pace of slowing is fairly well controlled. Healthy consumer spending is, to some degree, offsetting China’s slump in manufacturing and exports. We expect China to combine central bank rate cuts with targeted, sector-specific stimulation to manage the economy’s slowdown. We remain in the camp that China’s slowing growth will not lead to a hard landing. Our base case is for the Chinese government to successfully steer GDP growth to a gradual decline over the next two years toward a more sustainable 5% level.
The Eurozone continues to push forward and, we believe, shows greater prospects for growth, at the margin, than the U.S. in 2016. European GDP growth is forecasted at just under 2%. The improvement is being led by recovering domestic demand supported by a highly accommodative European Central Bank (ECB) whose quantitative easing has successfully loosened credit availability for both households and corporate borrowers.
Emerging Markets (EMs) still face the headwinds of a Fed rate liftoff which could lead to further dollar strength, additional slowing in China, and low commodity prices. It’s difficult to paint all Emerging Market economies with one brush, given the wide dichotomy in their economies depending on how tied they are to China and commodities. However, many are facing a forced unwinding of leverage as they confront slowing economic growth. Although the debt loads on sovereign balance sheets in the EMs are substantially lower than we saw back in the Emerging Market crisis of the late 1990s, the needed adjustments could create some pain and are likely to continue to weigh on the group in 2016.
Based on our 2016 outlook, we believe that it is prudent to undertake a small amount of de-risking in portfolios. Although we expect stocks to outperform bonds, we view the S&P 500 valuation as fair, not cheap. We believe that corporate profits will show recovery from the energy- and materials-sector-induced contraction of 2015. But with profit margins near peak levels, revenues showing anemic growth, and wages potentially poised to expand, we question how robust earnings growth will be. We couple that with the potential for P/E multiple contraction in a rising interest rate environment and believe that the price appreciation in stocks will be limited to low-single digits with total returns, including dividends at the mid-single digits. Thus, we feel that the opportunity cost of paring equities back slightly is quite low.
Our de-risking would include a slight underweight to small and mid-caps, which tend to be more volatile than large-caps. An underweight to Emerging Markets is warranted until we see more stability in many countries’ economic models. We believe a small increase in Developed International markets makes sense, not because it is less volatile than domestic large-cap stocks, but because of improving country fundamentals and continuing ECB stimulus, coupled with more compelling valuations. Within bonds, we continue to advocate a defensive allocation of short-duration bonds alongside core intermediate holdings. We are maintaining our overweight to corporate bonds and mortgages versus treasuries until rates move somewhat higher. We believe an actively managed bond portfolio has the potential to offer modest positive returns in the rate environment we anticipate.
The summer of 2015 brought the first market correction in over four years. We briefly moved into undervalued territory in stocks but the recovery was swift. The higher volatility that we’ve experienced in the second half of 2015 may well continue into 2016. If we were to see another correction bring valuations meaningfully below historic averages, we would view it as an opportunity to reallocate more aggressively into stocks again. Our stance on the markets should not be misconstrued as negative. We believe the economy is healthy and that stocks will offer muted positive returns in the coming year. Rather, we feel it’s prudent to take a little risk out of portfolios based on current fair valuations and the advent of the first rate increase by the Fed in almost a decade. It may prove to be an overly cautious stance. However, we believe some downside protection at a low opportunity cost is a sound tradeoff.
Debbie Silversmith, CFA
Chief Investment Officer
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