ALTERNATIVE ASSETS LOOM AS BEST BET / THE FINANCIAL TIMES COMMENT & ANALYSIS

Alternative assets loom as best bet

John Authers

Gentle shift towards cheap stocks in emerging markets has better chance of working in 2016

 

©iStock

 

 

At last, 2016 is here. It is now incumbent on this column to suggest what investors should do to position themselves for the next 12 months.

 

There are two problems with this task. First, and foremost, I do not know what will happen in the next 12 months. Neither does anyone else. The best I can manage is some scenario analysis.

Second, a 12-month calendar year is arbitrary. Unless you are planning for some unusual splurge of expenditure on New Year’s eve, you should almost certainly be planning very much longer term, certainly with any money that you cannot afford to lose. Positioning for the next five or 10 years would make sense.

A final caveat is that we are coming off a year when, very unusually, the main asset classes of stocks, bonds and cash were almost identical to each other, and all almost exactly flat. We need not have worried about allocating between these assets — and the way to make money was to try to profit from the rise of the dollar and the fall of commodity prices, or to play with real assets such as property.

 

Sum these factors and the advice will echo that of previous years, which is to have a balanced asset allocation, rebalance so that at the margin you sell securities that are high and buy those that are low, and restrict shorter term bets to tweaks within this structure.

For those who must look to the short term, what are the likeliest scenarios for 2016?

 

Let us look at stocks, the strongest performing asset class in the long term, which should most of the time make up most of an investment portfolio. A stock is worth its future stream of earnings, discounted by a suitable long-term interest rate. So let us break this down to the two issues of earnings and rates.

Earnings for the US S&P 500 fell slightly last year. Brokers’ analysts, as polled by Thomson Reuters, expect 8 per cent growth next year — although most top-down analysts expect the outcome to be lower than this. European earnings, coming off a very bad year, are expected to rebound somewhat more.

 

So that is the base case — a “blah” but positive recovery for US earnings, thanks largely to the low base of comparison for energy companies, with a more robust recovery in Europe. As US valuations are steep, this would not pull share prices up very much.

An alternative scenario is that US earnings continue to tank — because higher wages and higher interest rates eat into margins, while commodity prices stay low, messing up corporate pricing power.

China, in this scenario, probably drags into further difficulties, which means that European earnings — rather more dependent on exports to China — also suffer, and the European economy fails to achieve any lift-off.

For profits to recover more strongly, we require a more genuine, full-blooded economic recovery. That is probably because the US consumer starts buying more, using the savings that cheaper oil has generated, and so revenues increase. Despite the obvious angst in the US, reflected in the presidential campaign so far, higher wages, higher house prices and cleaner household balance sheets all suggest that this is not far-fetched, albeit unlikely.

Now, for rates. The market thinks that the Federal Reserve will raise rates twice next year. The Fed itself has forecast that it is more likely to do so four times. From two to four rate rises is the base case — reflecting an economy where unemployment remains under control, but recovery does not accelerate significantly from where we are now.

 

To undershoot this, we need commodity prices to fall further, and for the Fed to be scared by another wave of deflationary pressure — most likely felt through another rise in the dollar. To overshoot, we need true evidence of inflation, presumably driven by a resurgent US consumer.

 

In the former case, the positive effect of low rates for stocks is cancelled out by poor earnings. In the latter, the positive effect of higher earnings is cancelled out by higher rates.

So the base case is for a “blah” year, with risks skewed towards something worse. The most positive version of the “base case” — in which the Fed stays at the easy end of expectations, while profits enjoy an unspectacular rebound — would make for a decent year for stocks, however. It is hard to find any scenario in which bonds are exciting, given the price at which they start.

2016 could look like 2015, when alternative assets proved the best option. The best chance of good money within stocks and bonds, as this column argued a year ago, might be a gentle shift towards the stocks that look cheapest — in emerging markets. That did not work last year. It has a better chance of working next year, as emerging assets are even cheaper and European assets are cheap, while US assets are no less expensive than they were a year ago.

 

If, as is quite possible, buying cheap stocks does not work this year, the chances are that it will work in the longer term. As ever in 2016, it will pay to take the Long View.