2015 was characterized as a year with an uneventful first half that saw the S&P 500 trade within a narrow range from January to July before seeing a noticeable uptick in volatility in August through the rest of the year. It is important to remember that the month of August saw more than a 12% drop in the S&P 500 at its worst point. Nevertheless, the year ended flat for US stocks with the S&P 500 index declining slightly in price terms (-0.73%) but rising slightly (+1.38%) when you factor in dividends.
Capital preservation will be key in 2016 and more so during the first half. Similarly, interest and dividend income will be very important this year and will constitute a big portion of total return for 2016
We believe 2016 will be similar to 2015 in many ways though we think that volatility will be front loaded. Whereas last year was characterized by the markets’ anticipation of a Fed rate hike that was delayed until December, we think 2016 will be characterized by 2 main pressure points: concerns about slowing global economic growth and fears of a domestic recession induced by a perceived hyper active Fed when it comes to raising interest rates. While fears of a global slowdown in growth are valid, we feel that a US recession is unlikely as the Federal Reserve is in no hurry to raise interest rates as it clearly demonstrated in 2015. It is apparent that Janet Yellen prefers to err on the side of being late than early when it comes to rate hikes. Stocks here in the US will likely price-in both of those fears early in the year only to have stocks rebound in the second half when the Fed proves to be much less hawkish than anticipated with the economy stagnating rather than contracting. Nevertheless, stocks are likely to end the year flat to negative as there will be few catalysts to warrant higher stock prices later in the year or to price-in for 2017.
Where to invest in 2016
It will be a challenging investment environment amid this economic forecast. Capital preservation will be key in 2016 and more so during the first half. Similarly, interest and dividend income will be very important this year and will constitute a big portion of total return for 2016 as capital gains will be meager and hard to find in our opinion. Reducing risk and increasing sources of income should be main attributes of portfolio construction in our opinion. Below is our outlook for the main asset classes we follow and how we anticipate allocating assets to each.
Stocks: When it comes to US stocks, we believe reducing beta and overall portfolio risk will be prudent in 2016. As such, we are reducing allocations to stocks in general but more so in small and midcap stocks. Any exposure to stocks should be primarily in big cap stocks with more emphasis on defensive and dividend paying stocks whose dividends are backed by solid balance sheets. We believe REITs and Preferred stocks are poised to offer some of the most attractive returns in 2016. Outside the US, we are maintaining exposure to developed markets stocks while still reducing emerging markets exposure during the first half of 2016 at least.
Bonds: We are increasing allocations to bonds particularly Treasury bonds despite low yields. You can’t but increase allocations to Treasury Bonds given that our goal is capital preservation in the short term. As mentioned in our forecast, we believe that fears of rapidly rising interest rates are likely overblown and there is no safer ship when it comes to a sea of volatility when it comes to markets in the first half. We are also paring exposures to high grade corporate bonds in the first half of 2016 as there are increasing fears of contagion from a liquidity-driven junk bond selloff. With the situation in Puerto Rico coming to a climax, we see good opportunities in Municipal Bonds and we are positive on the asset class.
US Dollar: Risks to the down side when it comes to the dollar index as a whole as we think all the good news is already priced-in. The potential for the Fed to be less hawkish than anticipated will be a negative catalyst. Any further strength in the EUR/USD will likely depend on how aggressive the ECB is in maintaining and or extending its quantitative easing program.
Gold: Amid volatile equity markets, a steady to a declining US dollar, and a benign interest rate environment, Gold will likely not go any lower but still not march much higher either.
Oil: A lot of negative news is already reflected in the price of oil though oil prices can go lower even more if global economic growth disappoints. However, the silver lining is that oil producers are already producing near capacity and a stagnant global economy combined with a stagnant or a declining US dollar will actually prove to be bullish for crude oil at these levels. We see oil as a great natural hedge to any portfolio that is positioned for slowing global economic growth.