Outlook For 2016 And Beyond

by: Matthew Castel

Summary

Monetary policy will remain a key theme, and market participants will remain on edge as the Fed struggles to get its rate manipulation just right.

The price of oil will stay low and volatile. Thus, competing forces will influence US economic growth. Consumer and non-energy corporate earnings could benefit, while the energy sector struggles.

As capital markets begin to get more conservative, a sort of mini-correction may start to roil the start-up ecosystem.

New patterns of consumption as well as artificial intelligence will have a far-reaching effect on corporate America.

How we chose to address inequality will shape the future.

Since the writing of this article at year-end 2015, we have experienced some significant market moves. In the past week, we've been through such "fear-filled" days as China's stock market has taken a dramatic tumble. Although this has created a lot of bearishness and confusion regarding China, my outlook remains unchanged.

As we reach the end of 2015, many market participants are dusting off their crystal balls, preparing their predictions for 2016. Coming off the worst year for asset allocation since 1937, dubbed as "The Year Nothing Worked", perhaps this year's predictions will be all the more important.

So far, as the forecasts begin to come out, it shouldn't come as a surprise that 2016's annual stock market predictions are looking quite bullish. Early consensus estimates indicate that the average return predicted on the S&P 500 is around 7-11%. Should we be surprised? Probably not, given that on an annual basis the S&P 500 is positive about 80% of the time, and has averaged about a 12.74% return in the post-war era. Thinking in terms of probabilities, it would appear that the year's predictions aren't really telling us anything we don't already know.

Now, we can argue all we want about the wisdom of these pundits or why they continue making predictions in the first place, but perhaps the most important takeaway about yearly market forecasts is the negative effect they can have on investor psychology. For most individuals, investing is a long-term activity. Stocks and bonds are long-term instruments. Thus, looking at our investments in one year increments can detract from this reality and cause us to make poor investment decisions.

Stocks and bonds are long-term instruments with an average lifespan of around 16 years. Furthermore, successful investing requires consistency and predictability, and it is only over time that returns take on these qualities. Thus, in response to such yearly forecasts, investors would do well to remember that a more useful frame of analysis for one's stock market investments is at minimum 3-5 years. It is for this reason that instead of presenting a simple one-year outlook for 2016, I've chosen to discuss some trends that I believe will play a key role in shaping market conditions well beyond 2016.

The Fed's Actions Will Remain Crucial To The US Equity Markets

On Wednesday, December 16, Janet Yellen held a news conference where she announced the Fed would raise its benchmark interest rate for the first time since 2006. This raise was exactly what the market anticipated, as it was only a quarter point, the pace of the hike would be gradual, the Fed's outlook on the economy was upgraded and the belief that inflation would rise to its 2 percent objective was confirmed. To more sophisticated market watchers, this amounted to a non-event, as the move was the most anticipated rate rise in history. Nevertheless, this rate increase was uncharacteristic, as most increases occur to stave off inflationary pressures and come when investor appetite for risk is increasing. The data does not confirm either of these two factors, suggesting that the Fed's reasons for moving rates may reflect its fear of losing credibility rather than its faith in the strength of the US economy.

Either way, history suggests that such small initial rate increases generally do not move markets, and thus, the key question is the timing of future rate increases. With inflation running far lower than the Fed's 2% target, the risks of tightening too much, too soon remain severe. The strong dollar, weakness in emerging markets, stagnant domestic wage growth and looser monetary policy elsewhere give the Fed little margin of error to address any threat of recession. Furthermore, many have suggested that market mood has become dependent upon the support of central banks, leading to the irrelevance of economic fundamentals. As the Fed begins tightening, market mood will re-connect with the fundamentals.

Unlike during 2015, in 2016 good news on the economy should translate into good news for markets. Nevertheless, the Fed will most likely proceed cautiously with further rate hikes, knowing full well that a sharp rise in bond yields, spreads and the US dollar in 2016 would have a debilitating effect on economic activity. So all in all, 2016 (and potentially beyond) is shaping up to be a year of continuing uncertainty.

Monetary policy will remain a key theme as the Fed struggles to get its rate manipulation just right, and market participants will have to wait a little longer to get a clear signal that economic conditions have improved enough to begin "safely" allocating unprecedented cash reserves.

Nevertheless, it is maintained that not only will the consumer be stronger in 2016, but the euro will rise relative to the USD as the market inevitably prices in the end of quantitative easing in Europe beyond 2017, in addition to modest growth within the region. Big bulge, trust and regional banking sectors in the US will be the greatest beneficiaries, since this "peak rate" thesis leading to a slight drop in the USD will increase the value of loan portfolios (in addition to exposure at the short end of the yield curve), all the while enhancing yields extracted from stronger economic actors.

Major world events (this is a rare year of having the euro, the Olympics and a US election) will have a slightly positive incremental impact on spending as well, leading to earnings growth a few basis points greater than expected. Furthermore, if both oil prices and Chinese growth stabilize, market participants may wish they had allocated their cash reserves sooner, as it won't be a bust we will be worrying about, but a boom.

The Price Of Oil Will Stay Low And Volatile

In 2015, oil prices have slumped to levels not seen since the dark days of the last recession in 2009. The energy sector has become the biggest job cutter of 2015, and is set to remain so in 2016. Having led the nation's economic growth, oil-rich states, including Texas, Oklahoma and Colorado, are now facing unemployment, which could surpass the national rate next year. Not to mention the damage such a fall has caused to entire nations such as Canada and Venezuela.

At first, the culprit was deemed to be excess supply in the form of over-extraction, yet the oil market is being decimated by a perfect storm, which will cause further volatility and lower prices beyond 2016 (in the $40-60 range). Three distinct forces should be considered. The first is a destabilization of the supply side due to the onset of shale energy technology. The second is the demand side which has been thrown into disarray by weak global growth and a more severe downturn in emerging economies (think China and Brazil). Finally, OPEC's influence and effectiveness as a swing producer on the downside (by reducing output when prices are low) has been put in jeopardy by the US.

This has dragged Saudi Arabia into a dangerous a game of chicken (flooding the market to lower prices further) against US producers. Over the long term, this might be a good thing, as natural market forces of supply and demand could fully shape price, yet the short- and medium-term risks of this arrangement are significant. First, oil-producing nations have varying degrees of economic resiliency in the face of lower prices, which could lead to political crises and further global instability. Secondly, Saudi Arabia is taking a risk betting against the innovation and tenacity of American oilmen, who are working tirelessly to further reduce extraction costs.

As a result of ongoing volatility and low prices, two competing forces will influence US economic growth. On the one hand, the consumer and non-energy corporate earnings will benefit from lower oil prices. Consumers could spend their windfall from lower energy expenditures on domestic consumption and thus drive growth. On the other hand, the energy sector remains a key US growth driver, with positive spillover effects flowing through the entire economy. Any protracted weakness in this sector could certainly slow growth.

Capital Will Get More Selective

In 2016, founders will find it harder to raise capital at all stages (seed, series A and late stage). With America's Federal Reserve beginning to raise rates, we should expect a shift in the funding environment moving the balance of power from entrepreneurs to investors. In the "unicorn" environment in which we find ourselves (144 unicorns valued at $505 billion, most of which are unprofitable), such belt tightening would be a welcome development.

As the capital markets begin to get more conservative, a sort of mini-correction may start to roil the start-up ecosystem (this may already have begun in light of mutual fund valuation write-downs and the growing number of "down rounds"). This correction would be a welcome development, as it would leave the start-up ecosystem healthier and more disciplined.

Strong firms would begin to stand out from a crowded field of pretenders. Achieving "unicorn status" would become less of an end in itself, and instead simply be the result of a business with sound fundamentals. Finally, private markets would begin to regain their role as a precursor to the public markets instead of shielding weak firms from the more rigorous scrutiny and pricing associated with an IPO.

New Consumption Patterns Will Continue To Change Corporate America

"The more things change, the more they stay the same." This saying certainly applies to many classic retailers like Macy's (NYSE:M), Nordstrom (JWM) and Sears (NASDAQ:SHLD), who are playing by old rules and failing to capture the new American consumer consciousness. Besides re-shaping American banking, the financial crisis triggered the beginnings of a fundamental change in consumer values. More is no longer better. Mindless consumption is losing its luster, and individuals are no longer allowing themselves to be manipulated into buying the "latest thing". Instead, consumers, and especially Millennials, are shifting their focus to value and experience as they focus on personal growth, collaboration and inner meaning.

In the On-Demand Economy, consumers are becoming more content living with less and more focused on getting the most bespoke experience for their dollars. This shift in the American consumer will have a far-reaching effect on corporate America. It will make winners out of companies who are able to build the best relationships with their customers and give them exactly what they want when they want it, and losers out of those who continue to focus on inauthentic discounting and commoditization.

Artificial Intelligence Will Change The Way We Solve Problems

As computers became smarter and faster than ever before in 2015, AI moved from the fringes of the news media to prime time. Cloud computing infrastructure has become more powerful and affordable, while software development tools, neural networks and data sets became more accessible and plentiful.

With consumers and machines producing more data than ever before (think smartphones and IoT), AI has become one of the most transformative opportunities of our time. Tech's largest players have taken note, with Google (GOOG, GOOGL), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT) and IBM Corp. (NYSE:IBM) each operating their own AI labs and viewing such research as a critical driver of future growth. Although many discuss the existential threat posed by AI, the main thrust of such research focuses on teaching computers to think for themselves and improvise solutions to common problems.

How We Chose To Address Inequality Will Shape The Future

As a topic I've been following for a long time, inequality is now receiving more attention than ever before. The publication of Thomas Piketty's best seller Capital in the Twenty-First Century catapulted the topic into the media's consciousness, and world leaders have taken notice. Dignitaries such as Barack Obama, Hilary Clinton, the Pope and the IMF's Christine Lagarde have gone so far as to shape the discourse surrounding inequality as "the challenge of our time".

Yet, perhaps the most shocking indicator of the growing unequal distribution of wealth was Mark Zuckerberg's public promise to use the vast majority of his fortune to support charitable causes. Much ink was spilt in both the media and the blogosphere dissecting the righteousness of this act as either self-serving or truly altruistic, but I believe these discussions wholly miss the mark. What such extreme philanthropy suggests is how such a fortunes can be accumulated in the first place, and whether it can ever excuse the unequal distribution of wealth it typifies.

Morals and ethics aside, what is so concerning about the rise of inequality is that growing wealth concentration can cause people to lose faith in the fairness of their "liberal" market-oriented system. Disillusionment of this nature could lead to political crises and socio-cultural instability. Extreme inequality evidences inefficiency, and thus exposes the weaknesses of our current capitalist system. We have moved towards a "winner takes all" society in which industry is concentrated and competition is stifled. Thus, contrary to those who believe that the best way to respond to inequality is to raise taxes, it is pre-tax inequality which should be addressed. Moving forward, it will be the creation of pre-tax corrective policies that will shape both the contours of our economic system and the fabric of our society for years to come.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.