It’s been a volatile year for markets, and uncertainty seems set to dominate the next year as well. These market conditions, however, also create opportunities.
The year started with angst over higher US interest rates, lower commodity prices and emerging markets. But concerns had mostly settled, with markets recovering by the time the Brexit debacle hit in the final week of the financial year.
As the year progresses, solid fundamentals, strength in China and supportive policy are expected to drive moderate returns for markets.
At BT Investment Solutions, our baseline is that the global economy will have a reasonably solid year. Our forecasts are broadly similar to the outcomes of the past year, based on our assumption for continued accommodative policy to offset the European uncertainty. We continue to prefer risk assets over fixed interest in our asset allocation, but are less aggressive with shares due to more stretched valuations and global event risks ahead.
Our forecasts for the various asset classes are set out in Chart 1 below.
1. Elevated uncertainty
We expect that the enduring impact of Brexit will be small. Responses by central banks will mitigate the broader economic impact. However, the impact on markets could be exaggerated and volatile in the short term as investors attempt to assess the economic and political implications. Volatility seems set to be higher throughout the year ahead and there is the prospect of more event risk episodes that will see sharp moves in markets.
The US election will also be a critical event during the second half of this year. The table below shows the critical events on the horizon. There are likely to be a number of other Brexit-related events but their timing is unclear.
2. China stimulating again
The Chinese government has changed its priorities to soften the hardline reform agenda and refocus on solving problems in the property sector, along with lifting economic growth. The impact has been immediate, starting a pipeline of activity that should continue well into 2017.
- The People’s Bank of China (PBoC) has lowered reserve requirements for Chinese banks, allowing them to lend more. Indeed, credit growth has picked up sharply. There has also been a substantial increase in local government bond issuance due to an easing in rules late last year.
- A range of measures has been introduced to assist the property market directly. Mortgage rates have been lowered, residency rules have been changed and down-payment rules have been relaxed in most markets.
- Fiscal spending is set to ramp up. The Government has stated its intentions to fast track a number of large-scale infrastructure projects in 2016.
These policies are starting to have an impact. House prices have been rising across the country (as shown in Chart 2) and developers have begun planning new projects. This will have a positive impact on a number of assets including Australian resource companies, commodity prices and emerging market assets.
3. Old world slowly rehabilitating
Trend global growth has been lower since the financial crisis. Global growth has averaged around 3.5% since 2012, compared with closer to 5% in the five years to 2008. A large number of issues have contributed to this, including adverse demographics, Chinese reform, previous overinvestment, deleveraging and the constraints of tightening bank regulation.
However, the better news is some of these pressures are starting to ease allowing for more solid outlooks in the US and Europe over the next few years even with heightened political risk. The health of the European banking sector has improved, which has allowed the banks to start lending again. US household debt has also fallen, suggesting the process of deleveraging is well advanced.
4. Policies still continue to be a major support for economies
Aggressive central bank action, particularly in Japan and Europe, was an important circuit breaker to weak markets earlier in the year. We expect central banks will now step in again in the wake of the economic and political uncertainty created by the Brexit vote.
At the same time, governments are becoming more comfortable in expanding fiscal policy. European spending has lifted significantly in response to the refugee crisis and as Eurozone rules have been eased. There is also the prospect that government spending will rise in the US next year after the new president is elected.
Policy makers have been able to provide more policy support because inflation remains well below target.
Our forecasts now incorporate a further cut in the European deposit rate, accelerated asset purchases in the UK, Europe and Japan and a further delay in the Fed tightening cycle. We now only anticipate one Fed rate hike in the pipeline but do not expect this until 2017. There is also the prospect of even more aggressive action from the Bank of Japan (BoJ), including outright central bank financing of infrastructure projects.
A noticeable acceleration in inflation could change this policy outlook. Central banks would no longer be able to provide more stimulus as required and instead may be forced into an aggressive reversal. We expect this would have a material effect on share valuations. As a result we continue to monitor inflation trends closely.
Preference for shares
We are forecasting global share markets to generate high single digit total returns over the next year, comfortably outperforming global bonds.
As valuations have rerated back to normal levels, further upside to shares will require a pickup in earnings growth. There has been a continuation of downgrades, with Earnings Per Share (EPS) growth revised down from 7% at the start of the year to 1%. This was particularly acute in January and February. But since then, the pace of downgrades has eased. Our macro forecasts are consistent with a return to positive EPS growth over the next year, especially in Japan and Europe. Meanwhile, valuations should also remain well supported given low global bond yields.
Our forecasts for regional markets are below.
- Europe is our most preferred region. European shares have been particularly hard hit following the Brexit referendum, especially financials. Markets are ratcheting up the probability that another vote on EU membership will be held. We think this is an overreaction. More broadly, the ECB has been supporting the outlook for corporates through cutting rates and purchasing corporate bonds, which will put downward pressure on the cost of capital. European firms have substantial earnings upside given the economic recovery in Europe has also lagged other regions.
- US shares have continued to outperform in recent months, supported by the recent fall in the US dollar. Any increase in market stress as the year progresses will ensure US shares will remain well bid. But we fail to get too excited in an environment of peak US profit margins and stretched valuations.
- We have downgraded Australian shares to neutral on the back of less supportive valuations. The outperformance of the ASX200 in recent months has meant valuations are now stretched, particularly in the core market. Whenever the market PE has moved above 16x, this has usually not been a good signal for forward returns.
- We have moved Japan to neutral given its underperformance since the start of 2016. There are still some negatives for Japanese shares, including the appreciation of the yen, and questions around the effectiveness of BoJ policy and Abenomics. But the risk of a large fiscal expansion by the government in the second half of 2016 and relatively attractive valuations make us more comfortable on the outlook.
- Emerging markets are our least preferred region given the persistence of macro headwinds. We expect commodity prices to remain broadly stable and the US dollar to move higher. Deleveraging in many emerging market economies is also yet to occur. But longer-term, emerging markets represent an attractive buying opportunity as GDP growth strengthens relative to developed economies.
- Meanwhile, global property is expected to deliver strong returns over the next year and perform in line with broader equity markets as income growth and yields remain healthy. REITs continue to enjoy a favourable landscape as the global economy is growing, albeit at a lacklustre pace, while easy monetary policy boosts the demand for defensive income streams. A number of positive occupier market trends – including low supply, falling vacancy rates and upward pressure on rents – point towards improved prospects for real estate income growth.
Tim Rocks is head of strategy and research at BT Investment Solutions
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