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Prognosticators and Prophets Beware

The New Year ushers in a flood of investment predictions, including year-end index targets, key events, and my personal favorite, the inevitable “Top (pick a number like 10) surprises for 2016.” With the latter, prognosticators make outrageous and attention-grabbing predictions. If one or two even come close to being correct, the prognosticator becomes prophetic. If none prove right, it’s no big deal. They weren’t supposed to anyway.

To provide insight into what’s on our minds as we embark upon the new year, here are five themes we see as critical to outcomes in 2016 and beyond and their investment implications.

China

China’s recent emergence is perhaps best captured in the following statistic: China used more concrete between 2011 and 2013 than the U.S. did during the entire 20th century.[1] And the country’s economic significance continues to grow. The International Monetary Fund predicts that in the years ahead, China is likely to account for up to 50 percent of total growth in global income, trade, and commodity demand.[2],[3] However, following years of infrastructure building and urbanization, China is slowing. Leaders are now attempting to transition the centrally planned, communist country from a manufacturing and export-driven economy to one driven by consumer spending. Economist Larry Summers published an influential paper encouraging market participants to contemplate a wide range of potential outcomes in China and Asia writ large.[4]

Investment Implications: China is slowing faster than the market believes. While it will remain an important demand source, China is not likely to achieve its stated 6.5 percent growth goal. China could be more of a headache than a help to equity and commodity markets in 2016, leaving us less optimistic than we were at this point last year.

Divergent Central Bank Policies

In response to the 2008–09 financial crisis, major central banks cut interest rates and initiated asset purchase programs in an attempt to revive business and consumer spending. The U.S. Federal Reserve raised interest rates for the first time in nine years this past December, after terminating its latest asset purchase program at the end of 2014. The Fed concluded that the U.S. economy was strong enough to justify a more restrictive policy. Meanwhile, other central banks, including those in Japan, Europe, and China, are heading in the opposite direction. Their economies still need support and stimulus.

Investment Implications: The biggest impact is on currencies. All else being equal, if a stable country with strong military alliances raises interest rates, its currency should rise relative to the currency of a similar country that leaves interest rates alone. It was no secret that the Fed was going to increase rates before Europe or Japan, and the dollar has increased relative to the euro and yen. That makes dollar-hedged investments more attractive since we do not see other central banks moving faster than the Fed, but as we will discuss next, the Fed will not be in a hurry to raise rates.

Interest Rates

Bond yields and interest rates are the cornerstone of finance. From a borrower’s perspective, they represent the cost of money. From a lender’s perspective, they represent the potential reward for accepting the risk that a borrower may not pay him back. Interest rates tend to track economic growth and are positively related to inflation. If an economy is strong and price levels increase, central banks will increase their interest rate targets to stave off inflation. Because both existing and expected inflation remain low as shown in Figure One (the Fed would like to see both at around 2 percent), we expect interest rates to remain low for at least the next 12 to 18 months, and likely longer. Although the Fed increased its interest rate target in December, Fed officials are unlikely to increase interest rates further in the face of a fragile global economy. If they move too fast, the dollar will rally and hurt exporters.

Investment Implications: Given our view that interest rates will remain subdued in the U.S. and abroad, seeking ways to add value in bonds without taking excessive risk remains an important focus for our team. We have found opportunities in various parts of the fixed income market, including reinsurance bonds and structured credit (bonds tied to a pool of underlying loans, such as mortgages and auto loans). These securities are less sensitive to interest rate movements and have low correlations to other parts of a portfolio.

The Energy Market

A combination of a stronger dollar, increased U.S. supply (U.S. daily oil production has increased 86 percent in recent years, from 5 million barrels per day in November 2008 to 9.3 million barrels per day in October 2015), and softening global demand have hurt energy prices.5 While low gas prices provide a windfall to consumers, the data does not yet reveal that consumers are spending their gas savings. In fact, while still positive, consumer spending has been slowing despite an almost 65 percent drop in oil prices since June 2014. While consumers may eventually spend these savings, a more immediate issue is what happens to the cost of borrowing for smaller companies. The high yield bond market, which is roughly 18 percent energy companies, could see increased borrowing costs, a negative for lower-quality corporate bonds and small- and mid-sized companies that rely on debt markets.

Investment Implications: At some point, dislocations in the energy and commodity markets will provide attractive entry points for equity and debt opportunities. While we think energy prices may remain volatile in coming months, we are looking at opportunities in this space.

Demographics

Eighteenth century French sociologist Auguste Comte famously said, “Demography is destiny.” The world’s generational shifts and population trends can shape markets, determining both where growth is likely to occur and what sectors will perform well. From 1960 to 2060, median ages will shift from 29 and 34 in Spain and Germany to 51 and 50, respectively.6 In Japan, the median age in 1950 was 22. By 2050, it will more than double to 53.7 However, geographic locations like India have more favorable prospects, and China’s recent loosening of its one-child policy could help boost its consumer base as the country strives to become a more service-based economy.

Investment Implications: Sectors, industries, and investment strategies focused on consumer services represent secular investment opportunities given global demographic developments. Health care and related services have become a larger proportion of consumer’s expenses. This will remain an investment theme for those regions with aging populations. Similarly, parts of the technology landscape will benefit from global consumer trends, including increased mobile technology and cybersecurity needs. Evaluating investment opportunities that can take advantage of the durable consumer trends likely to evolve irrespective of economic conditions can provide long-term investor rewards.

Parting Thoughts

2016 is off to a volatile start with a recalibration of growth expectations causing periods of concern. Further, the last few years have been challenging, with diversified portfolios not delivering much reward. Nonetheless, we see pockets of opportunity across asset classes and, per the themes discussed in this piece, we are seeking opportunities across the investment landscape on your behalf.

Sources:

[1] Swanson, Ana. “How China Used More Cement in 3 Years than the U.S. Did in the Entire 20th Century.” The Washington Post, March 24, 2014, Wonkblog. Accessed October 12, 2015.
[2] Summers, Larry. “Grasp the Reality of China’s Rise.” November 8, 2015. Accessed January 9, 2016.
[3] “World Economic Outlook.” International Monetary Fund. Accessed January 9, 2016. 
[4] Pritchett, Lance and Summers, Larry. “Asiaphoria Meets Regression to the Mean.” NBER Working Paper Number 20573. October 2014.
[5] “U.S. Field Production of Crude.” U.S. Energy Information Administration. Accessed January 9, 2016.
[6] “World Population Prospects: The 2015 Revision, Key Findings and Advance Tables.” United Nations. Published 2015.
[7] Ibid.

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VESTED, Winter 2019

We are pleased to announce that the Winter 2019 issue of VESTED, CAPTRUST’s magazine for clients and friends, is now available. Subscribing clients will receive their copies in the mail next week. If you are interested in receiving VESTED Magazine, please let us know via email.

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