Asset Allocation outlook

Preference for equities over bonds as monetary policy divergence peaks

We expect ongoing global growth in the coming months as developed-market downturns and a Chinese hard landing are avoided. Candriam’s asset allocation views for 2016 are built around five overarching investment themes: monetary policy divergence, a continuation of domestic demand as the main growth driver, a convergence towards higher growth rates in the euro zone, the bottoming of commodity prices and the comeback of liquidity risk.

The more constructive economic backdrop leads us to prefer equities over bonds. European, Japanese and, to a lesser extent, Chinese equity markets should be the main beneficiaries. Given the profitability perspectives, market valuations do not represent an obstacle in those regions. Along with record stockpiles and more voluntary production cuts, higher global growth rates should also help commodities find a bottom in 2016. Our bond allocation favours a short duration stance and diversifies away from government bonds in order to catch the pick-up in yields, including those in the high yield and emerging market space. Further, we expect the transatlantic yield spread to tighten in 2016, once the monetary decoupling has reached its climax. Among Alternative Investments, our preference goes to managed futures, as they add de-correlated performance and hold liquid underlyings.

Monetary policy divergence is bringing back dispersion

First, we expect monetary policy divergence to bring back dispersion to the financial markets in 2016. This will translate into investment opportunities as the position in the cycle differs greatly from one region to another. We favour equities over bonds and have a preference for regions at early/mid-cycle, such as the euro zone and Japan.

2015 has set the stage for a peak in monetary-policy divergence in 2016. While, in Q3 2015, the Federal Reserve postponed its first policy-rate increase due to developments abroad, the US economy looks robust enough to withstand gradual rate increases. To be sure, the pace and the slope of increases after the initial move should be slow and shallow. We expect the Fed Funds rate to reach 1.25% by the end of 2016, while both the European Central Bank and the Bank of Japan will leave the door open for further accommodation.

A gradual Federal Reserve tightening is testimony to the current prudent central-bank stance, making us confident that monetary policy errors will be avoided. Further, announcements made last autumn by the Federal Reserve, the European Central Bank, the People’s Bank of China and the Bank of Japan lead us to conclude that these central banks are integrating the monetary policy of their counterparts into their reaction function. Accordingly, we have no strong view on further USD appreciation, nor do we expect a forex war escalation.

Along with the Bank of Japan’s qualitative and quantitative easing, Prime Minister Shinzo Abe is refocusing on the economy. What has been dubbed “Abenomics 2.0” is a broad range of measures intended to reform and support the economy.

Domestic demand as main growth driver

Domestic demand will continue to be the main growth driver. Beyond the repair and recovery phases in the aftermath of the great recession, the expansion is gathering steam. European, Japanese and, to a lesser extent, Chinese equity markets should benefit from this theme.

Cyclical leading indicators point to a continuation of GDP growth while inflationary pressures are contained. While the US has already enjoyed several quarters of strong household spending, thanks to significant employment growth and low consumer price inflation, this phenomenon is now gaining momentum in the euro zone, too. The euro zone, lest we forget, experienced a double-dip recession as the sovereign crisis led to economic and financial fragmentation in the region – thus the lag in cyclical behaviour vis-à-vis the US.

The second engine of domestic demand should be a healthy corporate sector. Clearly, we are witnessing a significant shift towards a service-driven economy, including in China. The relationship between global trade and global GDP has loosened, as the service industry, which is in good shape, is mainly driven by domestic demand.

Euro zone economies converging towards higher growth rates

In our third investment theme for 2016, the euro zone could well surprise on the upside as output growth converges higher throughout the area. Low oil prices, a weak currency, improved credit conditions in the periphery and easier fiscal policy all justify overweighting equities in the region.

Among the tailwinds supporting the European economy are the stabilization at a low level of the price of oil and the weak currency. The euro zone economy as a whole is on the mend, thanks to the improved credit conditions in the periphery. As the European Central Bank will keep a dovish stance throughout 2016, broaden its quantitative easing and fuel demand for credit, financial fragmentation should further retreat. In 2015, the average cost of borrowing of non-financial corporations in the periphery has narrowed by an additional 60bp in the core European countries, after 50bp in 2014 and 20bp in 2013.

Additional support should come from a more favourable policy mix through fiscal easing. This fiscal easing could act as a stabilizer in the case of a negative shock. After years of fiscal restraint a handful of spending reasons will end up in discretionary fiscal easing: austerity fatigue, the electoral timetable, spending linked to the refugee inflow in Germany and increased security and military spending. This increases our confidence in our overweight stance on euro zone equities. On the fixed income markets, where European yields remain historically low, this could lead to a tightening in the transatlantic yield gap, once the monetary decoupling has reached its climax.

We will have to deal with a higher liquidity risk

Recent volatility spikes, as seen towards the end of Q1 2015, remind us that liquidity can evaporate quickly in financial markets. As our portfolio construction is mindful of this, we can take more risk on the most liquid asset classes and increase diversification.

During the most recent volatility spikes, we saw that market liquidity remained ample on the most liquid securities, while conditions were deteriorating in the less liquid ones. This bifurcation of liquidity implies higher financial vulnerability. In our understanding, this trend reflects both cyclical conditions (strong corporate bond issuance over previous quarters) and post-crisis structural changes in the markets (tighter risk management and regulatory constraints).

While some measures of liquidity such as bid-ask spreads have not necessarily deteriorated, liquidity buffers held by dealers have been trending down in some market segments, while flows into ETFs that claim to provide “daily liquidity” have risen significantly. This mismatch has led us to increase diversification and allocate more risk on the most liquid asset classes.

Commodities should bottom in 2016

Finally, we expect commodities to find a bottom in 2016 as the “super-cycle” that began in the early 2000s has been purged. More fundamentally, cutting production from oil to mining will help rebalance markets that have been in oversupply for years.

Download the latest edition of our magazine “Perspectives” to find out more about our asset allocation outlook.