2015 was a very difficult year for most world markets, especially in U.S. Dollar terms (that is, when accounting for declines in the markets as well as in the currencies in which they are denominated).
Emerging Markets Were Punished… But Some More Than Others
The worst performers were generally those emerging markets which are dominated by commodity exports.
For example, Brazil, down approximately 43 percent in U.S. Dollar terms as of this writing…
Chile, down approximately 18 percent in U.S. Dollar terms as of this writing…
And South Africa, down approximately 24 percent in U.S. Dollar terms as of this writing.
Performance was slightly better for those emerging markets which are manufacturing rather than commodity exporters. Korea, down about 4 percent in U.S. Dollar terms as of this writing…
And the Philippines, down about 10 percent in U.S. Dollar terms as of this writing.
Those emerging economies with rapidly growing service sectors, both for export and for domestic consumption, also had markets which escaped the worst of the destruction visited on commodity exporters.
For example, India, down about 10 percent in U.S. Dollar terms as of this writing…
And China, whose domestic stock market should end the year up approximately 10 percent in U.S. Dollar terms, after a severely volatile year.
India and China both have services sectors that are growing rapidly in their contribution to total GDP, and accelerating in that growth. Note thatIndia and China are the only economies in the following graph that show significant services growth acceleration over the past 30 years.(When and if Prime Minister Narendra Modi’s reforms gain traction in India, we look forward to seeing its line steepen.)
Developed Markets Did Better Than Emerging MarketsSo among the emerging markets, manufacturing exporters and economies with rapidly growing service sectors performed the best on a relative basis in 2015. However, overall, developed markets have done better, as of this writing -- up in U.S. Dollar terms for Japan’s Nikkei, slightly down for Germany’s DAX, and close to flat for the United States S&P 500. One disappointing event in the U.S. has been the absence of the traditional
seasonal year-end rally that we had expected. To stock market technical analysts, seasonality matters in the U.S. market, and the failure of the seasonal rally will be viewed by some stock market technicians as a negative for stocks in early 2016.
If we break down that performance, however, a similar pattern emerges in developed markets to the one we observed in emerging markets: the relative outperformance of developed-market indices was driven primarily by service providers -- especially software.
Manufacturing export sectors of the economies did more poorly:
U.S. companies with significant commodity exposure did the worst, with coal leading the race to the bottom:
In 2015, then, the best of the best were service providers in developed markets.
1. General trends do not favor investing in a country, sector or industry as much as they favor investing in specific companies with strong fundamentals and strong tailwinds from social, political, economic and/or
2. The key variable is the U.S. Dollar, and if it continues to be strong, we expect a continuation of the trends that we saw in 2015. We do not anticipate a strong economic performance from the U.S. or Europe if the Dollar remains strong. Asia, and especially India and China, may grow faster.
3. Economic growth. For 2016, we expect real U.S. growth of 2.5 to 3 percent, and inflation of 2.5 percent for the year. This will produce total GDP growth of about 5 percent. Real global growth in 2016 (before
inflation) is expected to be at a rate of 3.4 percent, slightly faster than 2015. The fastest-growing countries next year will be India and China. We expect 4 percent real growth in India (we know that the data show faster growth, but a recent change in the data makes it untrustworthy in our opinion). We expect 5 percent real growth from China -- the best in the world again in 2016. When inflation is added to all of these numbers, global economic growth will be fine at about 6 percent.
4. Corporate profit growth. 2016 will not be as strong as growth usual. Early in an economic cycle corporate profit growth can exceed GDP growth substantially as costs are cut during recessions and revenues
begin to grow more rapidly once the recovery commences. At this juncture we expect US corporate profits to grow at about 5% in 2016 due to the drag of energy and commodity prices and the costs to corporations of higher interest rates on their debt. The expected 5 % growth rate of profits further argues for focusing on those companies that can grow in spite of the economic backdrop because of their unique products, services, capabilities and the fast growing industries that they serve.
5. Inflation and interest rates will impact the Dollar: Dollar appreciation is the year’s dominant variable to monitor. On one hand, rising interest rates and higher inflation in the U.S. -- both of which are expected by U.S. market participants -- will tend to strengthen the Dollar. On the other hand, though, the U.S. Dollar has already appreciated substantially in the last four years versus all U.S. trading partners except China. While the Dollar may continue its rise in early 2016, we do not believe that it has major appreciation potential from its current level. Once the Dollar begins to reverse itself and to depreciate, this would be a major positive for U.S. stocks and for commodities. The question is when this will happen. All investors should watch the Dollar carefully -- it will set the tone for many markets in 2016.
Finally, there are risks not currently foreseen by the investing public at large. What would surprise investors the most?
• A war in the Middle East which limits oil production and increases oil prices.
• An unsettling Presidential election campaign. The Republican nomination battle is already producing a turbulent campaign season; establishment and anti-establishment Republican candidates may stake out
widely varying positions and create dissension ahead of the general election, with uncertainty about the direction the nation might take as a consequence. (Hillary Clinton looks likely to win the nomination for the Democratic Party.) Psychological damage to markets could ensue if major candidates back populist measures that would undermine economic confidence: for example, higher personal and/or corporate income taxes (including higher sales and excise taxes for business); policies that would sharply reduce profit margins in the health insurance, pharmaceutical products, hospital services, and/or outpatient services industries; proposals to exert government control by nationalizing any industry; or proposals to dramatically increase regulation of industry and business (or even of particular industries or sectors of the economy).
• Further disturbances in Europe: for example, further Russian aggression in Ukraine or the Baltic states, or further financial disruption in Greece, Portugal, or elsewhere.
On the other hand, the emergence of a major presidential candidate who espouses lower individual and corporate income taxes, and who appears to have a good chance of winning the election, would improve market
Our Game Plan For 2016
We plan to spend the next six months very cautiously investigating companies which can grow without a strong tailwind from economic growth, yet that have low valuations. We will stick mostly to the U.S., as long as the U.S. Dollar is rising. We also find China and India potentially attractive, but not at this time. We anticipate holding cash and investing in companies that have superior fundamentals, and for those clients so inclined, we may find profitable opportunities in short selling. Many avenues of investing will become attractive when the U.S. Dollar stops rising.
We will start the year with a very high cash position. Two big opportunities may arise:
1. A top in the U.S. Dollar may provide investment opportunities in foreign currencies and in U.S. exporters.
All investors should closely monitor the U.S. Dollar and the election process to see if the Dollar stops its upward movement. When this occurs, we will be buyers of non-U.S. currencies and short-term government bonds in non-U.S. manufacturing and service-based economies.
We will probably avoid the commodity-producing countries, because their economic suffering will continue until world economic growth picks up decisively, which may take some time.
Once the U.S. Dollar stops strengthening, it will provide higher growth and profitability for U.S. exporters. It will take the pressure off many commodities which are not falling in foreign currency terms; these may
begin to rise modestly in the U.S., and the U.S. may experience modest generalized inflation.
2. A decline in the U.S. market of 10 to 15 percent will create a significant opportunity in U.S. stocks.
We anticipate 3 or 4 more interest rate increases in the U.S. in the coming months because economic growth is moderate and steady at about 2.5 to 3 percent. If the U.S. economy grows faster, stocks will become more attractive. If it grows much more slowly, politicians and financial regulators will call for more quantitative easing; under those circumstances, after a period of market decline, QE would cause U.S. stocks to rise.
Investment implications: 2015 was a year of divergences. Developed markets outperformed developing markets, services outperformed manufacturing, and commodity-related companies and economies underperforming everything else. Broader indices often served to conceal these divergences, with some software-related names, for example, far outpacing the performance of the S&P 500. 2016 may prove to be a good time to exploit those divergences; we plan to hold significant cash balances while we study investment opportunities in reasonably valued companies which can grow against a tepid macroeconomic backdrop. Initially, we will concentrate on U.S. companies as long as the trend of U.S. Dollar strength continues. However, the Dollar’s substantial appreciation over the past four years against the currencies of the U.S.’ trading partners argues against the potential for major appreciation in 2016. We continue to view Dollar strength as the key, and will watch carefully to see how it unfolds during 2016; a top in the Dollar may present opportunities to buy quality U.S. exporters and the currencies of manufacturing and service-led economies outside the U.S. With the U.S. market fairly valued to slightly overvalued, we will also view a substantial correction in the U.S. market as an opportunity to buy companies we like at more reasonable prices.
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