Summary views from Pavilion’s Investment Outlook – Q1 2016
China rebalancing its economy towards consumption and services and away from manufacturing and investment-driven growth
- China’s GDP growth remains strong, but is moderating to more sustainable levels. Representing one-third of global economic growth, a slowdown in China negatively impacts world growth and in particular other emerging market countries that export to China.
- As China transitions to a consumer and services oriented economy, commodity exporting countries are affected most negatively, particularly countries exporting metals, which is highly correlated to industrial activity. China represented 44% of metals and 22%of energy consumption during the five years ended 2014. There will be winning industries and economies coming out of the transition but change of this magnitude creates uncertainty and volatility.
- A slowdown in China is causing the yuan to weaken against the U.S. dollar. Chinese authorities are intervening to support the yuan through various means, including selling of foreign reserves. This is having spill-over effects to other emerging markets that may be forced to devalue too.
China GDP Growth Moderating
Low returns projected for fixed income
- In December, the Federal Reserve increased the Fed Funds rate for the first time in nearly a decade. The Fed anticipates raising rates four times in 2016 for a total of one percentage point, although market expectations are for rates to increase by no more than half a percentage point. Meanwhile, monetary policy in most of the rest of the world remains accommodative. U.S. interest rates already are among the highest in the developed world. Further rate increases and resulting U.S. dollar appreciation are destabilizing for emerging market countries, raising their cost of capital and potentially leading to capital outflows. Many emerging market countries already are in a weakened financial state from the impact of commodity price declines. Safe haven demand is rising for U.S. Treasuries as geopolitical tensions grow. In combination, we believe these factors place a ceiling on rate increases in 2016 that is below Fed projections.
- We anticipate that returns from investment grade fixed income will be low, as they tend to be highly correlated with starting yields. The starting yield on the Barclays Aggregate Bond Index was 2.6% at December 31, 2015.
- The high yield bond market suffered in 2015 from rising defaults, declining liquidity and capital outflows. Fitch forecasts the U.S. high yield default rate for 2016 at 4.5%, although excluding mining and energy, defaults are expected to be just 1.5%, well below historical averages. The default rate for the energy sector is expected to reach 11% in 2016. The fallout from commodity price declines along with concerns over rising U.S. interest rates caused investors to pull money from junk bond funds. Unfortunately, liquidity has been declining, particularly within the high yield sector, as regulatory changes and bank capital requirements have reduced bank bond inventories. Yields have spiked to more attractive levels. Core plus and global unconstrained managers should benefit from an increased opportunity set.
U.S. and Developed Markets Yield Curves
Commodities: Energy prices at cycle lows and could remain so during 2016
- Oil prices declined more than 50% during the past 18 months, mainly as a result of oversupply conditions. Rig counts are down and expectations are that supply should fall to levels more supportive of price increases in the second half of 2016. Supply conditions remain uncertain, however. OPEC countries are dependent on oil revenues for budget spending. IMF rough calculations show that prior to the oil price decline, countries of the Gulf Cooperation Council (GCC) were projected to have a combined fiscal surplus of about $100 billion in 2015 and about $200 billion between 2015 and 2020. Now, they are likely to have a combined deficit of $145 billion in 2015 and over $750 billion in 2015-20. OPEC expects to continue producing without a cap and with Iran sanctions having come off, more oil could flood the market near term. OPEC forecasts that it will reduce production by 2019. Demand remains relatively steady.
- Some current forecasts suggest oil will rebound to $70 per barrel sometime between 2017 and 2020. Other forecasts call for $20 oil. We note that oil price forecasts have wide error bands and oil prices have remained low for long periods.
- Default rates are picking up in the energy sector, reaching an estimated 11% for below-investment-grade bonds in 2016 with leveraged loans reaching a similar level of defaults on a trailing twelve months basis.
Crude Oil Prices Declined Dramatically in 2015
Source: IMF. Simple average of three spot prices: Dated Brent, WTI and Dubai Fateh
This is a short summary only. The complete Investment Outlook is a quarterly publication that has more than 30 pages covering multiple asset classes and regions.
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