Asset class implications
We start 2016 very much as we left 2015, cautiously positive on risk with a modest preference for stocks over bonds, a preference for developed markets over emerging markets, an overweight to credit diversified across US and European high yield, and a neutral outlook for duration. In our view, the most crucial allocation question for 2016 will be how and when to cover our longstanding structural underweight in EM. The path of the US dollar and, by extension, commodities will be key factors in making this call.
We lean against consensus for the US dollar, seeing the currency’s strength reaching a maximum in the first quarter before stabilising and potentially easing later in the year. We expect interest rate differentials to be fully priced by the end of the first quarter, at which point growth and trade differentials should cap further USD appreciation. An easing of US dollar strength would simultaneously take a boot off the throat of EM economies and remove a key earnings headwind for US corporates. It is too soon to talk of covering EM underweights, but if our US dollar outlook proves correct, then mid-2016 could present an important turning point for EM assets.
Among developed market assets we spread our risk across overweights in US and European stocks, as well as high yield credit. The positive credit impulse and money supply growth in Europe in 2015 should translate to positive momentum in European stocks in 2016 and we see further support from both margins and operating leverage. The overweight to US equity leans against consensus, but we see the two principal headwinds from 2015—strong dollar and weak oil—stabilising in 2016.
High yield continues to divide market participants. We take the view that diversification (US and European exposure) and avoidance of resources-linked sectors mitigate the risks in the asset class to a significant degree. Ultimately this is an economic call—if the US economy expands in 2016, then high yields spreads should begin to contract. Finally, for duration we continue to take a neutral view.
While we do expect yields to grind higher in 2016, with US 10-year rates reaching 2.75%, we see little risk of a sharp spike in riskless rates. There is ample demand for duration from liability managers, risk managers and central banks globally to offset the upward pressure of gradually rising US policy rates. At the same time, inflation risks remain muted given recent price action in commodities. So even with yields drifting up, the combination of coupon carry and roll gives expected total returns of around zero for US 10 -year notes in 2016.
On balance we maintain a “mid-cycle” portfolio, set up for a world with low but positive returns, but are conscious that our active asset allocation decisions over 2016 will in large part be a function of the path of the US dollar.
John Bilton is global head of Multi Asset Strategy at JP Morgan Asset Management