An Islamic State (IS) affiliate downed Russian Metrojet Flight 9268 in October. In November, IS-affiliated terrorists launched a series of attacks in Paris. These two events suggest a significant change in the behavior of IS. Prior to the Paris attacks, IS appeared to be focused on building a caliphate in Syria and Iraq. The shift to terrorist acts suggests a new strategy.
In this report, we will recap the two strategies radical jihadists have employed against the West, highlighting the differences between al Qaeda and IS. We will examine the current stalemate that exists in the area IS currently controls and how IS may adjust its future strategy. As always, we will conclude with potential market effects.
In this report, we will offer our outlook for the upcoming year. Twenty-sixteen could be an interesting year—presidential elections will be held, the Federal Reserve could tighten monetary policy and the geopolitical landscape will likely remain complicated. We will begin the report with our base case for the economy, equities, debt markets, the dollar and commodities. From there, we will examine the “known unknowns,” which could undermine our base case.
Summary: Our Base Case
No recession in 2016.
Slow economic growth, low inflation.
An S&P 500 of 2214.39, based on earnings of $121.67 and a P/E of 18.2x. If our forecast undershoots the market, it will likely be due to further multiple expansion. We would only consider foreign developed for risk-tolerant accounts and continue to avoid emerging equities.
The 10-year Treasury yield should be in a range of 1.90% to 2.25%. Corporate spreads should contract.
We expect the dollar will remain strong and commodity prices will be weak.
On October 31st, Russian Metrojet Flight 9268 took off from Sharm el-Sheikh, Egypt, at 5:58 local time en route to St. Petersburg, Russia. Within 25 minutes, the aircraft, an Airbus A321, disappeared from radar over central Sinai. By the time radar contact was lost, the aircraft had reached its cruising altitude of 33,000 feet. Shortly thereafter, airplane debris was reported over the area. All 224 passengers and crew were lost, making it the worst Russian civilian air disaster in history.
In this report, we will examine the potential causes of this event. Given that a terrorist group may be the culprit, we will discuss the most likely perpetrator. Next, we will analyze how Russian President Putin will likely react to this event. As always, we will close with potential market ramifications.
Over the past year, oil prices fell sharply into the first quarter, remained rangebound from January through March, rallied above $60 per barrel in the spring and early summer, and then slid to new lows in August. Since the August lows, prices have been in a range between the high $30s and $50 per barrel. In November, prices have been weak, testing the low end of the trading range.
(Source: Barchart.com)
It is not unusual for prices to rally into year’s end due to the rise in holiday driving and cold weather. The latter can lift heating oil demand and refining activity. We still expect a rally to develop into New Year’s but it probably won’t move prices much above $50 per barrel.
A much bigger worry for prices develops in early 2016. Refinery maintenance begins soon after the New Year which will depress demand. If production levels remain elevated, prices are vulnerable to breaking into the $30s in early spring.
Portugal held parliamentary elections on October 4, 2015, in which the incumbent center-right Social Democratic Party received the most votes but fell short of an outright majority. Historically, as part of the Portuguese political process, the country’s president tasks the party that receives the most votes with forming a government. However, in this case, the center-left opposition party and some far-left parties have formed a coalition, together garnering a majority of votes and currently awaiting presidential approval to form a government and take control from the center-right party.
This week, we will look at the current political environment in Portugal. First, we will start with a brief history of Portugal. We will then turn to the economic conditions leading up to the most recent elections and discuss the election results, the change in coalition powers and the possible path of developments going forward. As always, we will conclude with market ramifications.
There is no doubt that the EU migrant crisis is a catastrophe in terms of human costs. It is fairly evident that the EU was not prepared to deal with the magnitude of migrant movement into the region. This crisis also presents a political dilemma for Europe and may lead to the re-establishment of border controls, intensify internal schisms over the extent of sovereign/EU authority and possibly sow the seeds of the dissolution of the EU.
Migrant flows from the Middle East and Africa have affected European countries unevenly. The border countries have received heavy inflows of migrants, some of whom wish to stay in those countries, but most continue on to Germany and Sweden, which have indicated openness to accepting immigrants. However, many countries are not open to taking immigrants, either due to a lack of ability or willingness. Each of these countries is dealing with the flow of asylum-seekers differently as their approach is determined by relative economic wealth, number of immigrants and societal structure.
Hungary has received an overwhelming number of immigrants due to its location on the main migrant routes to Germany and Sweden. The large number of immigrants, both in absolute terms and relative to Hungary’s population, has overwhelmed the country’s refugee facilities. Hungary has indicated that it cannot accept all refugees without a clear plan from Brussels and has tried various tactics to control the immigration flow, from erecting a 108-mile barbed wire fence to simply facilitating refugee transportation to the Austrian border.
This week, we will look at how Hungary is handling the immigrant crisis and what its actions may signal for other European countries. We will start by looking at Hungary’s history and its position at the crossroads of empires which have shaped Hungary into a country that often directs a changing tide for Europe. As always, we will conclude with geopolitical and market ramifications.
Over the past three years, we have witnessed what appears to be a steady erosion of American power. Russia annexed the Crimea and has encouraged a rebellion in eastern Ukraine, undermining the sovereignty of a European nation. This apparent invasion was considered by Western observers to be the first hostile acquisition of territory since WWII.
The breakdown in the Middle East has become another problem. The U.S. allowed the Arab Spring to unfold with little interference; to some extent, the administration encouraged the developments. The U.S. took a secondary role when intervening in Libya, allowing France and Britain to lead operations. That action has devolved into a disaster; Libya stands divided as various ethnic and sectarian groups fight for control. Syria has become a major problem as well. The administration has pressed for the removal of Syrian President Assad but hasn’t created conditions to foster his exit. The decision not to bomb Syria after Assad used chemical weapons, a self-proclaimed “red line” by President Obama, further gave the impression of disengagement.
Russia’s recent decision to send military equipment and personnel to Syria suggests that Putin is filling a power vacuum in the region. Sunni allies in the region are becoming increasingly concerned that the U.S. is not going to continue to play the role of outside stabilizer in the region.
Yet, the Obama administration recently announced that it would send U.S. Naval vessels within 12 miles of the artificial islands that China is building in the South China Sea. Although military advisors have been pushing for such incursions for some time, the president’s decision to take this rather aggressive step is in direct contrast to the passive response seen in other areas of the world.
In this report, we will examine President Obama’s foreign policy, using the construct of Ian Bremmer’s recent book, Superpower.[1] After discussing President Obama’s foreign policy and the potential effects, we will examine how the next president may shift from the current policy. As always, we will conclude with potential market ramifications.
The Federal Reserve decided not to raise rates in the third quarter. Attention now turns to if, when and how it will raise rates going forward. Although we expect the Fed to move gradually and not cause a recession, the likelihood of policy errors has increased.
We continue to believe both growth and inflation are likely to remain low in the United States. Still, we expect U.S. growth to be higher than that of many foreign countries.
Financial market returns are likely to remain lower than the rates earned in recent years. At the same time, we expect volatility will continue to rise.
Our equity allocations remain focused on domestic stocks and include large, mid and small caps.
We continue to favor intermediate and longer maturity bonds, which should continue to provide diversification and reasonable returns in an environment of low growth and low inflation.
Our style guidance remains in favor of growth over value but shifts from 70/30 to 60/40.
ECONOMIC VIEWPOINTS
Over the summer, investors had to deal with a variety of issues affecting the financial markets. These included Greece and its debt, Middle East turmoil, and currency and equity swings in China. While each of these issues was relevant, none got more attention than the Federal Reserve. Investors watched to see whether or not the Fed would raise short-term rates in September, and what the policy guidance might be going forward. Ultimately, the Fed did not raise rates, acknowledging low inflation, limited wage pressure and weak global growth. This decision created a bit of a relief rally near the end of the quarter, but now all attention shifts to what the Fed may do in the fourth quarter and 2016.
Because we expect economic growth and inflation to remain low, we believe the Fed is inclined to move very slowly and any rate increases are likely to be telegraphed with a high amount of clarity. We don’t foresee a recession, but do recognize that the likelihood of Fed policy mistakes has grown—tightening in a low growth environment can be hazardous. Absent a recession, however, the environment should be reasonably good for investors. Broadly speaking, we expect asset returns to remain lower than recent years and volatility to rise. Less return and more risk is far from ideal, but investors should keep in mind that multiple years of easy monetary policy have created unusually high returns and particularly low volatility. As such, if and when the Fed begins to tighten, the overall return/risk profile should remain attractive, but will probably not be as favorable as it has been.
It’s also important to factor in ongoing geopolitical frictions. For many years, we’ve written about the withdrawal of the United States from its superpower role. As this trend has unfolded, we’ve witnessed rising regional instability around the world, ranging from the European migrant crisis to China’s territorial expansion in the South China Sea. In addition, the U.S. also faces its own brand of geopolitical change as 2016 is a presidential election year. Although all these factors have varying amounts of direct impact on the U.S. financial markets, they are sources of potential or perceived risk.
To address rising volatility and geopolitical risk, we maintain a diversified posture, one that includes a variety of asset classes. Diversification is important, but so too is the nature of the exposure. Accordingly, we remain overwhelmingly domestic in our equity allocations. This positioning reflects our belief that the U.S. will lead the global economy, making domestic equities relatively more attractive. However, even as the global leader, we expect fairly modest U.S. economic growth, making intermediate and longer maturities more attractive in our bond allocations. We had most of these positions already in place, and therefore we make few allocation changes this quarter.
STOCK MARKET OUTLOOK
Stock volatility has continued to rise in 2015, with some indices dipping near correction territory during the late summer only to recover in October to a range not far from where they began the year. China’s currency, economic growth, equity market volatility and governmental policies often played in the minds of equity investors, particularly in the third quarter. Even more important to investors was Fed policy. By passing on a rate increase in September, the Fed recognized slow U.S. growth and the drag caused by weak foreign economies. So, going forward, we believe the Fed will move very slowly with great transparency. Its policy will remain important to equity investors who will carefully watch to see if the Fed goes too far or too fast.
Fundamentally, stocks remain in good shape, although earnings growth has slowed significantly for many companies. Valuations are reasonable and tend to reflect a degree of risk aversion. This trend has helped curb a cycle of excessive valuation. We continue to favor domestic equities over foreign ones, given our belief that the U.S. should lead global growth trends. We recommend exposures across capitalization sizes and our favored large cap sectors include technology and consumer discretionary, while we are underweight energy, healthcare, financials, basic materials and telecom. Our style bias continues to favor growth over value, although we dial down the bias this quarter from 70/30 to 60/40, reflecting our changing preference for a more balanced posture.
BOND MARKET OUTLOOK
For many years, bond investors have lamented the low interest rate environment and the challenges in pursuing reasonable returns in fixed income portfolios. While it’s true that returns have declined, bonds continue to offer lower levels of volatility and meaningful diversification relative to equities and other asset classes. These characteristics are often overlooked, but when volatility and risk rise in the markets, they become more apparent…and appreciated.
The chart to the right illustrates this point. The prices of the S&P 500 (in red) and the 10-year Treasury (in blue) are scaled to a common value (100) at the beginning of the third quarter. Two characteristics are noteworthy. First, the Treasury price changes are comparatively mild, remaining within a four percent range during the quarter. In contrast, the stock index was much more volatile, with a range of almost 13 percent. Second, note how the 10-year Treasury moved in opposite direction of the S&P 500 (this is called a negative correlation). Having investments in securities that don’t behave in the same manner is an important part of managing risk. So, even while bond returns have not been particularly high, their contributions in a portfolio have been significant.
Source: Bloomberg, CIM
As we move into a period when financial market volatility is likely to rise, bonds can continue to play an important role in helping to address risk. We maintain allocations to intermediate and longer maturities, which we believe can perform well in a low growth environment. We also remain overweighted toward high quality corporate bonds, which we expect to have relatively mild default rates.
OTHER MARKETS
Real estate faced headwinds earlier in the year when interest rates moved higher and investors became concerned about tighter Fed policy. However, this asset class has benefited from the recent decline in interest rates. We continue to believe real estate can play a constructive role in portfolios, particularly where income is an objective. Occupancy and rental rates are keeping fundamentals strong, while foreign investors continue to move into the space.
Our view toward commodities has begun to improve at the margin. However, we remain out of this asset class given large amounts of excess supply capacity for most commodities around the world. Furthermore, China’s slowing growth continues to limit demand and we don’t believe the correction in commodities has yet reached a point where an allocation is appropriate.
On October 6, trade negotiators announced a final agreement for the Trans-Pacific Partnership (TPP), a multilateral trade deal between 12 Pacific Rim nations in both the eastern and western hemispheres.
In this report, we will begin by discussing the nations involved. We will examine some of the details of the treaty. An analysis of the geopolitics will follow along with a look at specific political factors surrounding the treaty. As always, we will conclude with potential market ramifications.
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