2016 Investment Consensus Looks Lazy…

The investment bank consensus for 2016 is a pretty unanimous (lazy?) extrapolation of recent macro trends. US biotech, the RMB, India, risk parity and the euro are just a few examples this year of North Korean levels of investment industry groupthink going badly wrong and leaving many hedge funds reeling. Asset allocation performance in 2016 will hinge on whether USD/commodity/EM trends persist or to varying degrees reverse, as we think likely. As has been much commented upon, US equity performance has been extremely narrow, focused on 9-10 growth stocks. Indeed, growth as a performance factor has outperformed value (Price/Book) by a large margin in the US and Asia ex Japan, more modestly in Europe while in Japan, our favourite major equity market throughout 2015, value has held up.

There are structural drivers (e.g. our longstanding dematerializing economy structural theme, reflected in the global manufacturing versus services PMI divergence) but relative valuations have now we believe overshot on a cyclical basis. Supporting that thesis, on a CAPE basis, global value is at its cheapest versus growth since 2000; cyclicals are at their lowest relative valuation since the crisis

We maintained a 1.10 fair value USD/euro target throughout 2015 and see no reason to change it now  – the Fed-ECB policy divergence is peaking into Q1, oil at this level net reflationary for Eurozone real economy vs. US and euro supportive while the aggregate current account surplus will test new record highs, offsetting the impact of yield seeking capital outflows. We also saw the JPY as fundamentally undervalued a year ago on a real effective/PPP basis and likely to resist an ongoing USD rally  – while that is now a more consensus view, risks remain tilted toward underlying yen strength and we prefer domestic equity exposure e.g. via real estate, banks and inbound tourism plays. In contrast, a year ago we thought a 5% RMB devaluation seemed likely  – a modest depreciation path remains the base case and for a country focused on attracting $2-3trn of foreign capital by end decade to successfully deleverage its corporate sector (via benchmark inclusion and deeper capital markets), a dramatic FX move looks counterproductive. Meanwhile, the growth data in much loved India looks to us more dubious than in China and underlying corporate debt/ROE and bank non-performing loan trends deteriorating versus consensus expectations…

As for EM FX, the rapid closing of current account deficits as consumption and thus merchandise imports are suppressed reduces funding risks and should lead to a revival in carry trade inflows – local currency debt is a good way to play that surprise and an improvement in overall EM sentiment. Despite fears of an EM debt implosion, ex-commodities EM corporate IG leverage is flat as deleveraging in Asia offsets the pick-up in leverage elsewhere and USD debt, which was our preferred ‘safe haven’ exposure has performed well this year.

While about 7% of the US HY market now in deep distress, trading above 20%, the HY/leveraged loan maturity profile is supportive through 2017. Once crude stabilizes by end H1 and likely trades above $60/bl by year end on a growing perception that the $250bn slump in sector capex will create a supply deficit beyond 2017, energy junk as well as MLPs should rebound. Now that funding options to bridge collapsing cash flows have belatedly closed, US shale output will likely fall faster in 2016 than the consensus expects and prove less elastic to rising prices than assumed – US construction offers a sobering template for an industry that discarded skilled workers who never returned, constraining output capacity.

The US credit underperformance this year reflects the heavier weighting in commodities versus the S&P500 (26% in US HY,, only 18% in S&P) rather than being a recession risk signal. It’s very plausible that US credit will outperform equities in a mean reversion dollar/oil environment. With limited scope for multiple expansion in global equities (ex EM if ROE stabilizes in Asia, likely a good bet), equity index returns should be in line with earnings growth of 8-10% in Europe and Japan and 7-8% in GEM with the US lagging at 2-4%. A sustained USD/oil reversal to say 105-110 on the broad USD index/$50-60 on WTI would boost US earnings momentum by 3-5 percentage points and justify closing the maintained underweight bet.  Oil and the dollar will be key to all else and by mid-year should be surprising a crowded consensus…