Asset Allocation For 2016
Key views: 1-3 months: short Gold long DAX long XLY / short XLP 6-12 months: short XAUUSD short XLE / long SPX long GBPJPY 12+ months: short R2K / long SPX short AUDNZD In spite of the ugly start of the year, I do not think there have been fundamental changes in the global markets since a year ago. A regime shift actually occurred in 2014-2015. By that time, the global economy had managed to stage a mostly uninterrupted, albeit very slow, recovery. In 2014, it became clear that the global market cycle was entering its late stage. At that time, risk asset valuations had reached “fair value” levels across the asset classes, following 5 years of a fairly re-rating on the back of extremely accommodative monetary policy globally. The Fed then made it clear that monetary policy would gradually tighten and the markets priced this in rapidly, mostly by bidding up the US dollar and selling short dated treasuries. Due to the still deeply embedded remains of the “forward guidance”, the market moves were big, prompting volatility to return to more normal levels not seen in years. At the same time, the US economy began showing signs of mid-cycle dynamics, with the unemployment rate sharply falling closer towards most estimates of NAIRU, consumer confidence rising to cyclical highs and M&A activity surging. The environment in which most of today’s prime-aged investment professionals built their careers is characterized by “irrational exuberance”, with stock market valuations typically ballooning during the bull markets and deflating rapidly during recessions. Many got burned in the process and I do not think that the industry will get ahead of itself once again. It is more likely that valuations would remain at fundamentally justified levels (rather than trending up persistently), with the stock market only collapsing in case of catastrophic outcomes. In addition to the US financial and economic cycles, a few other cycles are important for understanding the current regime. The commodity cycle is still in its downtrend. I do not think anyone is good enough at forecasting spot prices of commodities based on supply and demand fundamentals. The safest strategy is to look at where the trend is and stick to it until it reverses. This is how CTAs have been making money for decades trading commodities and I feel no need to reinvent the wheel. The commodity price decline is fundamentally related to a number of other developments: a continued evolution of the global economy from manufacturing to services, the weakening demand from China, the fracking revolution and more recently the rise of the US dollar. All these interrelated trends are putting an immense amount of pressure on emerging economies. While emerging market currencies have fallen substantially, a more decisive shift from the old growth model will be required in order to adjust to the evolving world. There will inevitably be both winners and losers in this game. Equivalently, the developed market economies are experiencing a similar challenge, with manufacturing and extraction showing signs of continued weakness, and tight financial conditions depressing US corporate earnings. Going forward, I anticipate a continuation of the desynchronized market patterns across the world and return of volatility to normal levels. My hunch is that strategists and fund managers in the industry generally seem to be experiencing quite low levels of conviction in their views. There is also a healthy amount of bears in the market, which should lead to a better balance, despite higher volatility. In such an environment, relative value trades will be a much more important source of return generation compared to simple exposure to broad markets. Quantitative indicators for “alpha potential” from bottom-up stock picking have still not normalized (even though it has improved), so I expect that single stock selection will still struggle in 2016. However, big picture long/short macro positions should work well at the time when most investors continue to fret over whether we are in a bull or a bear market. In 2016, cross-asset performance will be driven by a small number of key risks. The most important ones: US Monetary policy, Chinese economic slowdown and the commodity price collapse. I will be writing about these, as well as about my key trades, in the following weeks, so stay tuned.