What will happen in the markets in 2016, and how do you optimize portfolios for those conditions? Here’s your inside scoop.
Looking ahead to 2016
As slow global growth continues, the question on many people’s minds is: Are we on the brink of a worldwide recession?
“That’s the pivotal question heading into 2016,” says Kurt Reiman, global investment strategist at BlackRock in New York, because it determines your investment strategy.
In a recession, you preserve value with ballast. This includes dividend-yielding stocks; otherwise, you go for cyclical exposure in the stock market.
His firm doesn’t predict a recession, which he defines as below 3% growth in economic output. But, he expects markets to remain volatile amid recession concerns.
Also on the horizon: a rate hike by the Fed. The challenge for advisors is to mute volatility while preparing for the prospect of higher interest rates.
Nassau, Bahamas-based portfolio manager James Harper of Templeton Global Advisors says, as a long-term investor, he looks for value. But the current environment of low growth and low rates favours a growth-investing style. Growth is hard to find; so solid companies, like Amazon and Google that grow, regardless of macroeconomic events, trade at a higher multiple relative to
“The difference in valuation between growth and value style is as high as it was in the [dot-com] bubble back in 2000.”
Growth has outperformed value the last nine years, which is unprecedented, he says. But, in the long term, statistics show value investing outperforms 56% of the time—and a rise in rates tends to favour value.
“Value is the place you want to be positioning today,” says Som Seif, president and CEO of Purpose Investments in Toronto, explaining that a few high-growth companies that are heavily weighted on the S&P 500 drive the index. For 2016, he predicts value companies worldwide with sound financials will outperform growth companies.
What other opportunities can you look for now?
Europe and Japan
“I think Europe is probably two years behind the U.S. on its growth,” says Seif. So look for deals as the declining euro improves the economy.
Harper agrees. His fund takes advantage of European financials, which were trading at historically low valuations of 0.3× or 0.4× book value in 2012 and are currently at 0.7× and 1.0×, respectively.
“We still have overweight positions in those companies because they’ve effectively rebuilt the balance sheets [and] rebuilt capital. Return on tangible equity is starting to improve, and we think loan conditions are improving in Europe.” His fund has Italy’s UniCredit, which trades at 0.7× book value, U.K.’s Barclays Bank (0.75×) and Switzerland’s Credit Suisse (0.9×).
But Brett Grantham, portfolio manager at 3Macs in Toronto, is taking a wait-and-see approach in Europe, citing uncertainty arising from the refugee crisis, the budget crisis in Greece and Portugal, and the potential exit of Great Britain from the EU.
Reiman says, like the euro, Japan’s weaker currency boosts competitiveness and EPS. And, both markets present opportunities because they’re not as commodity-sensitive as Canada and the U.S. “You’ll get less exposure to energy and materials,” and a more diversified exposure at a discount.
“Japan is trading at a 50% discount on a price-to-book basis relative to the U.S. and, in both markets, they’re growing profits,” says Reiman.
“There’s a new shareholder-friendly culture emerging in Japan—that is a sea change.”
Harper also takes advantage of continued devaluations caused by low oil prices. In Q1 2015, he increased his positions in oil services companies Subsea 7, Petrofac and Technip. Prices have since dropped another 10% to 15%.
“[Energy] is probably one of our biggest overweight positions. Again, we’ve tried to look at companies where we think there’s a long-term future and balance sheets are very strong.”
He also holds both Baker Hughes and Halliburton, two big companies exposed to the oil services side of the market, with a merger in the works.
Grantham takes a defensive approach. But positions in low-cost gas producer Peyto, which still has earnings, and royalty company PrairieSky, with its diverse holdings, enable alpha gain with less risk. “[PrairieSky’s] principal business is cashing cheques, and they have no debt.”
PrairieSky recently added to its royalty land holdings, buying from Canadian Natural Resources. (Laird Grantham, Brett’s partner at 3Macs, says about their recommendations: “Our clients own these investments, and we personally own these investments.”)
Healthcare and tech
Harper’s overweight healthcare. About three years ago, he bought pharmaceutical Teva at a low valuation when its MS drug went generic, causing concern about profits. “They’ve managed to cut costs, and operations have become much more efficient, so earnings have really come through faster than the market expected.” It’s trading at 11× P/E.
Grantham was surprised by the rapid decline in U.S. healthcare valuations in 2015, due in part to Hillary Clinton’s health care proposals.
His firm took the opportunity to add to positions in drug company Gilead (which produces drugs for treating AIDS and hepatitis C, and trades at 10× P/E), healthcare producer Stryker (gurneys, joint replacements, surgical equipment) and pharmacy benefit manager Express Scripts. He also found a deal in generic drug producer Mylan when a purchase by Teva fell through. He expects the business to grow in volume, at the very least, due to demographic trends.
Within tech, Grantham sees value in online advertising (Google, Baidu), with its growth potential and ability to target and interact with consumers. Increased data traffic makes content delivery (Akamai) and content creation (Chinese gamemaker NetEase) attractive. Another deal: down-and-out IBM, which he considers undervalued. “They’re changing the DNA of the company,” he says, going from hardware to software and services. “It’s a good risk/reward opportunity.”
Here’s where things get tricky. If interest rates rise, “what’s your diversifier?” asks Reiman. “The downdraft in the stock market wasn’t met with a rise in prices in the bond market of the same order of magnitude,” probably because foreign central banks liquidated assets—a large share of which are government bonds.
“So you have the volatility in the stock market, and the bond market may not continue to provide that normal diversifier that people had gotten used to in the aftermath of the financial crisis. That’s what I’m thinking about a lot.”
An unconstrained approach to fixed income will be key in 2016, he says. “It’s about having global exposure, being able to be flexible on your maturity exposure.”
Grantham is staying away from long-term bonds. Instead, he looks to corporate bonds with “improvement potential in the underlying credit rating of the issuing institution,” combined with an attractive price and a decent yield.
Two of his firm’s choices are Parkland (Canada; pays over 5% yield to maturity) and Level 3 Communications (U.S.; slightly below 5%).
Good as gold?
Seif says gold is often an emotional investment and, as such, has no peer correlation. Its illiquidity is another negative. “What you’re trying to achieve with gold […] is purchasing power protection in a portfolio.”
Adds Reiman: “If I’m looking for safety, I would rather look to, at this point, dividend-yielding stocks.” He explains that, if interest rates rise, there’s more competition for gold in the market. Although stocks, too, are affected by rising rates, they’ve already underperformed, he says, and those such as utilities and telecoms are relatively recession-proof because people buy from businesses in these sectors regardless of the economy.
Grantham maintains a small position in gold, but he’s not adding to it. He sees it as a hedge against volatility in other asset classes, which have inflated. “[If ] both bonds and stocks are falling [in price], and we are printing money [using low rates and quantitative easing], gold may be the place to be.”