Uncommon Sense: 3 Surprises in Store for Investors in 2016


It’s that time of year again. Wall Street pundits are dusting off their crystal balls to forecast what’s ahead for the economy and markets. However, most 2016 outlooks tend to fall into the “more of the same” category and are forgotten by Groundhog Day.

Rather than offering a generic prediction of a 10% rise in the S&P 500® Index—which, by the way, is its average annual return since 1928—I’m offering a trio of decidedly non-consensus developments that I see in store for investors in 2016:1

1. The US dollar plateaus


The US dollar has been climbing steadily since 2011, with a big rally in late 2014 and early 2015. In anticipation of Federal Reserve (Fed) interest rate hikes, the dollar jumped in short bursts in 2015. But like ripping off a Band-Aid, the anticipation was worse than the action.

Source: Federal Reserve Bank of St. Louis. Period shown is January 1, 2013 to December 11, 2015.

Past performance is not a guarantee of future results. 


I'm not sure the dollar will rise all that much after the Fed begins policy normalization or Mario Draghi does “whatever it takes” to cure the ills of the European economy with additional currency debasement. I believe the Fed will keep monetary policy conditions very accommodative in today’s uneven economic environment. When it comes to actual tightening and hikes, I see the Fed being more bark than bite.

In addition, improving twin deficits have been a tailwind for US dollar strength. Moving forward, both budget and trade are likely to reverse course next year and cap dollar gains. Look for dollar strength to soften in 2016.

2. High yield bonds rebound


The dual threat of higher rates and rising defaults in energy companies due to crashing oil prices has resulted in considerable widening of high yield spreads. Investors often overreact in the near term, and this emotional reaction has created an opportunity for those willing to accept the risks.

Source: Federal Reserve Bank of St. Louis. Index shown is the BofA Merrill Lynch US High Yield Master II Index. Period shown is January 3, 2012 to December 16, 2015. Bond prices and yields move in opposite directions.

Past performance is not a guarantee of future results. 


I acknowledge that defaults are likely to increase as credit weakens in the energy and materials sector. Yet, once oil and other commodity prices establish a floor, which may be happening now, defaults are likely to be less than expected. 

Large portions of the high yield market continue to demonstrate solid fundamentals. Corporate profits are high, balance sheets are healthy and cash is plentiful, which should result in lower-than-expected defaults for the rest of the high yield market. I expect interest rates to remain much lower than most expect in 2016. If the US economy is improving, then high yield should come along for the ride. Given today’s exaggerated wide spreads, I expect high yield to perform better than most are expecting in 2016.

3. The US industrials sector recovers and outperforms the broader market


Worries over slower growth, a rising US dollar and falling exports hurt the industrials sector in 2015 with the S&P® Industrial Select Sector Index down nearly 9% for the year.However, I expect industrials to be among the leading sectors in 2016. 

The industrials sector has historically performed well in the middle of the economic cycle and underperforms in recessions.3 The mid-point of the economic cycle is defined by slowing profits and rising rates. US corporate profits peaked since the financial crisis and have been decelerating for the last couple of quarters, while the Fed raised rates in December.4 Despite a hardly noticeable early cycle phase, the long economic cycle is aging and we’ve quietly reached the mid-point.


Source: spindicies.com. Index shown is Industrials Select Sector Index. Period shown is December 17, 2012 to December 16, 2015.

Past performance is not a guarantee of future results. 


Industrials have trailed the market in recent years and, as a result, are inexpensive relative to their own history and other sectors. As I’ve already discussed, I expect US dollar gains to be limited in 2016, which should boost exports and provide a tailwind for industrials. Finally, discretionary spending by the government is expected to increase by 8% in 2016—the first spending increase since 2009.5

Industrials will be the primary beneficiaries of increased government spending and a flattening US dollar. I believe that that many of the benefits are being underestimated by investors, which is a big reason why I have conviction on industrials. At the same time, easy year-over-year comparables should lead to upside revenue and earnings-per-share surprises for the sector.

Going against the grain


When it comes to investing, especially in the short term, the one thing investors can count on is that there will be surprises. Plunging oil prices, Chinese currency devaluation and a fickle Fed were just some of the surprises in 2015. Yes, there were some trends that continued, such as strength in the technology and health care sectors. However, I expect 2016 will be another year of many surprises for investors that once again confound the consensus.

To learn more about my counterpoint views, Investment Professionals can access previous Uncommon Sense articles by logging onto spdrs.com.

Definitions

S&P 500 Index
A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.

BofA Merrill Lynch US High Yield Master II Index
Tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch) and an investment grade rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million.

S&P Industrial Select Sector Index
The Industrial Select Sector Index includes companies from the following industries: industrial conglomerates; aerospace and defense; machinery; air freight and logistics; road and rail; commercial services and supplies; electrical equipment; construction and engineering; building products; airlines; and trading companies and distributors.

1“Stock Market Outlook 2016,” Barron’s, as of 12/12/2015
2Spindices.com, as of 12/18/2015
3“Mapping decline and recovery across sectors,” McKinsey & Co., January 2009.
4“Profit Pessimism Rivals Crisis Days as Stocks Support Erodes,” Bloomberg, September 27, 2015.
5"Congress Passes $1.8 Trillion Spending Measure,” The New York Times, December 18, 2015

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