Here we are with the 31st edition of The Ten Surprises. As loyal readers know by now, my definition of a Surprise is an event I believe is probable, with a better than 50% chance of happening during the year, but which the average professional investor would only assign a one-in-three likelihood of taking place. Over the years I generally have five or six of the Surprises pretty much on target (they have multiple components), but I don’t develop the list to get a high score. My objective is to present concepts that I believe could have an impact on the financial markets but are generally unanticipated by most investors. I would describe my 2015 edition as below average after a good year in 2014. I had a number of Surprises partially “right,” but I missed several important events, including the terrorist attacks in Paris and California, the delay in the increase in short-term interest rates by the Federal Reserve and the weak performance of the U.S. equity markets.
My first Surprise last year expected the Federal Reserve to raise rates early in the year rather than in December, so I got this one clearly wrong. My reasoning was that the Fed had kept rates near zero throughout the recovery and was anxious to move to a more normal policy position. For that to happen, the governors had to feel that the United States economy had developed enough natural momentum on its own to continue growing with less monetary accommodation. Because I believed back then that the economy was headed toward a 3% real growth rate by the end of 2015, I thought the Fed would have the confidence to act early. As events developed, the economy was weaker than I anticipated and the Fed delayed increasing rates until the end of the year (even though the economic data were mixed at the time of their decision).
The second Surprise was my expectation that cyber terrorism would become a serious problem during the year. Foreign computer-savvy operatives are clearly using techniques to invade the networks of both corporations and government agencies. While this problem has existed in a minor way in the past, it has escalated significantly in 2015. So far, however, the cyber security efforts at financial institutions seem to be working, given that no major bank has been forced to suspend service to its depositors. Nonetheless, the risk is self-evident and further efforts by cyber rogues are likely to create major problems in the future.
The third Surprise was that the Standard & Poor’s would rise 15% in 2015. At the beginning of the year, most forecasts by analysts and strategists were for a 10% increase. The surprise would be a market that either did better than that or was down for the year. Since I was optimistic that the U.S. economy would continue to grow during 2016, I opted for the positive view. As it turned out, the combination of a strong dollar and declining oil company profits caused S&P 500 earnings to decline. As a reflection of this, the index saw a decline of less than 1%, a far cry from my estimate. Concern about the Federal Reserve raising short-term interest rates hung a cloud over the market all year.
The controversial decision by Mario Draghi to increase monetary expansion at the European Central Bank was my fourth Surprise, and that turned out to be right. He recognized that without a vigorous program of monetary stimulus, Europe was in danger of moving back into recession. He had said earlier that he would “do whatever it takes” to prevent another recession and he made good on that promise in 2015. As a result, the euro weakened against the dollar, helping European exports and diminishing overseas earnings of American companies. The Surprise further suggested that Europe would suffer a recession anyway and that Germany would be particularly hard hit because exports to China and other trading partners would decline. Happily, Europe had a better year than that with the economy growing at more than 1%. Europe, like the United States, would have had better results with more fiscal spending, but the various parliaments were not supportive of that policy. Politically, there was a shift to the right, as I expected.
I focused on Japan in my fifth Surprise. I thought Shinzo Abe’s combination of fiscal and monetary stimulus would enable the economy to achieve modest growth. The second and third quarters were in recession, although the fourth quarter is now expected to show real growth of 3%. I thought the Nikkei would be flat in yen and down in dollars. As it turned out, it was up in both yen and in dollars, so I was correct on the currency depreciation, but the market did better than I thought it would.
I was right in my sixth Surprise, which said that the Chinese would acknowledge that their economy was no longer growing at 7%. They also required more fiscal and monetary stimulus to prevent a hard landing. The government seems to have deemphasized its rebalancing program (which favors consumer expenditures over investment) to achieve growth. Fewer jobs were created in 2015 than desired, but we did not see the publicized popular protests that I feared. In addition, China did not mount the major effort to deal with its pollution problems that I expected.
In the seventh Surprise I said that the drop in the price of oil would push Iran to reach an agreement on its nuclear program. I don’t know whether a decline in the price of Brent oil into the $40s was the trigger, but a deal with Iran was reached amidst considerable controversy on both sides. Verification is the principal U.S. concern. As a result, there was no significant rally in world equity markets after the accord was signed.
In the eighth Surprise, as I expected, a peace accord between Russia and Ukraine was agreed upon, giving Eastern Ukraine autonomy. On the other hand, I thought Vladimir Putin’s popularity would weaken and he might resign, but that was clearly wrong. Wishful thinking, I guess. Putin remains in firm control of Russia and his desire to establish himself as an international power figure remains unabated. As part of an attempt to achieve his objective of being viewed as a world leader, he used military force to back Bashar al-Assad in Syria. The last element of this surprise, that the price of Brent would rise toward $70 by year-end, did not happen.
For the ninth Surprise, I thought there would be trading opportunities in the high yield market. There was a narrow window in April–May where this was true, but high yield was down for the year. Spreads with Treasurys, while narrowing in a rally during much of the year, widened at the end. This volatility created both opportunity and danger, particularly in the energy and commodity-related lower-quality high yield sector of the market. China’s weakness caused a second leg down in this asset class in the last half of the year.
Finally, in the tenth Surprise I thought the Republicans would try to position themselves as the party that could get legislation passed in Washington. At year-end, under the new House Speaker Paul Ryan, the budget bill did receive approval. I did not anticipate the rise of Donald Trump and Ben Carson and the fractious divide in the party that would develop during the debates. At this point, how this will play out at the convention is difficult to predict. The party establishment believes that a ticket headed by extremists would lose in a presidential election, but the extreme candidates are far ahead in the polls and will be difficult to ignore. The Keystone pipeline expansion was rejected in contrast to the view in my Surprises.
So here are the Surprises of 2016. I will discuss them in detail in my February essay.
- Riding on the coattails of Hillary Clinton, the winner of the presidential race against Ted Cruz, the Democrats gain control of the Senate in November. The extreme positions of the Republican presidential candidate on key issues are cited as factors contributing to this outcome. Turnout is below expectations for both political parties.
- The United States equity market has a down year. Stocks suffer from weak earnings, margin pressure (higher wages and no pricing power) and a price-earnings ratio contraction. Investors keeping large cash balances because of global instability is another reason for the disappointing performance.
- After the December rate increase, the Federal Reserve raises short-term interest rates by 25 basis points only once during 2016 in spite of having indicated on December 16 that they would do more. A weak economy, poor corporate performance and struggling emerging markets are behind the cautious policy. Reversing course and actually reducing rates is actively considered later in the year. Real gross domestic product in the U.S. is below 2% for 2016.
- The weak American economy and the soft equity market cause overseas investors to reduce their holdings of American stocks. An uncertain policy agenda as a result of a heated presidential campaign further confuses the outlook. The dollar declines to 1.20 against the euro.
- China barely avoids a hard landing and its soft economy fails to produce enough new jobs to satisfy its young people. Chinese banks get in trouble because of non-performing loans. Debt to GDP is now 250%. Growth drops below 5% even though retail and auto sales are good and industrial production is up. The yuan is adjusted to seven against the dollar to stimulate exports.
- The refugee crisis proves divisive for the European Union and breaking it up is again on the table. The political shift toward the nationalist policies of the extreme right is behind the change in mood. No decision is made, but the long-term outlook for the euro and its supporters darkens.
- Oil languishes in the $30s. Slow growth around the world is the major factor, but additional production from Iran and the unwillingness of Saudi Arabia to limit shipments also play a role. Diminished exploration and development may result in higher prices at some point, but supply/demand strains do not appear in 2016.
- High-end residential real estate in New York and London has a sharp downturn. Russian and Chinese buyers disappear from the market in both places. Low oil prices cause caution among Middle East buyers. Many expensive condominiums remain unsold, putting developers under financial stress.
- The soft U.S. economy and the weakness in the equity market keep the yield on the 10-year U.S. Treasury below 2.5%. Investors continue to show a preference for bonds as a safe haven.
- Burdened by heavy debt and weak demand, global growth falls to 2%. Softer GNP in the United States as well as China and other emerging markets is behind the weaker than expected performance.
Every year there are always a few “also rans” that do not make the Ten Surprises because either I do not think they are as relevant as the ones I picked or I do not have the conviction to say they are probable (better than 50% likely).
- As a result of enhanced security efforts, terrorist groups associated with ISIS and al Qaeda do NOT mount a major strike involving 100 or more casualties against targets in the U.S. or Europe in 2016. Even so, the United States accepts only a very limited number of asylum seekers from the Middle East during the year.
- Japan pulls out of its 2015 second half recession as Abenomics starts working. The economy grows 1%, but the yen weakens further to 130 to the dollar. The Nikkei rallies to 22,000.
- Investors get tough on financial engineering. They realize that share buybacks, mergers and acquisitions, and inversions may give a boost to earnings per share in the short term, but they would rather see investment in capital equipment and research that would improve long-term growth. Multiples suffer.
- 2016 turns out to be the year of breakthroughs in pharmaceuticals. Several new drugs are approved to treat cancer, heart disease, diabetes, Parkinson’s and memory loss. The cost of developing the breakthrough drugs and their efficacy encourage the political candidates to soften their criticism of pill pricing. Life expectancy will continue to increase, resulting in financial pressure on entitlement programs.
- Commodity prices stabilize as agricultural and industrial material manufacturers cut production. Emerging market economies come out of their recessions and their equity markets astonish everyone by becoming positive performers in 2016.
There they are – The Ten Surprises for 2016 and the “also rans.” Now let’s see how they work out.
From October through the end of the year I meet with dozens of friends, colleagues, journalists and self-identified “big thinkers” in search of the best surprises for the following year. I want to thank especially George Soros, who has helped me on the surprises for three decades; my Third Thursday discussion group of former research directors who always have provocative suggestions; Gideon Rose, editor ofForeign Affairs; Jonathan Tepperman and others at the Council on Foreign Relations; and my good friend Richard Chilton. They have been helpful, but the Surprises are my own and, right or wrong, I take responsibility for them.
I am making some changes in the Radical Asset Allocation portfolio. I am reducing Global Large Cap Multinationals from 10% to 5% because I believe their price-earnings ratios reflect the corporate prospects. I am also increasing European equities from 5% to 10%. I am eliminating my long-held 5% gold position because I do not expect much movement in the metal over the next year. I am increasing cash from 0% to 5%. Other allocations remain the same.