Predictions for 2016

Making forecasts is foolish, but it is my belief that one must have a view on both the economy and on what the market expects of the economy in order to invest with confidence. For example, taking on risk when the market is risk averse is potentially more rewarding than taking on risks when the market demands a high price for it. So that readers may judge how successful (or unsuccessful) I've been in this regard, it has been my custom for a number of years to annually review the success or failure of prior predictions while at the same time offering up predictions for the future.

First, a look at how last year's predictions turned out.

Mostly right: I thought the economy would improve somewhat on the margin, even though the recovery would remain sub-par. The economy didn't pick up much if at all, unfortunately. However, confidence is beginning to return as investors weigh the prospects for significant growth-oriented fiscal policy reform in coming years and as energy prices plumb new lows.

Wrong: I worried that the Fed would be slow to tighten, and that inflation would consequently exceed expectations. I've been wrong on this score since 2009, since inflation remains firmly in check. I consider this a fortunate mistake.

Mixed bag: I thought sharply lower oil prices would liberate a lot of economic activity, boosting growth prospects. While there's some evidence that cheaper energy has been a positive (rising consumer confidence, increased vehicle miles travelled, higher real yields), the energy-producing sector of the economy has suffered significantly, and the shock has had a dampening effect on the larger economy. In short, I underestimated the extent to which oil prices would fall and how damaging the shock of lower oil prices would be to energy-producing sectors.

Mostly right: I thought cash would be an unattractive investment relative to just about everything else, with the notable exceptions of commodities and gold. Equities have managed to generate a modestly positive total return for the year, but corporate bonds have suffered sizable losses, particularly in the high-yield energy sector. Commodities and gold have turned in yet another miserable year, but real estate has done very well, particularly of the commercial variety.

Right: I thought a recession was quite unlikely, and the danger of deflation was exaggerated. Although growth has been far from impressive, the economy has nevertheless managed to grow by at least 2% this year with no signs of emerging weakness. Although headline measures of inflation have been hugging zero, core inflation has been running a solid 1.5-2% for many years and continues to do so.

Mostly right: I thought profits growth would continue to slow, and gains in equities would come mainly from an expansion of multiples. As it turns out, corporate profits actually declined a bit, but PE ratios have risen, and have accounted for the bulk of this year's net gains.

Right: I thought the dollar would continue to strengthen, since the U.S. economy was likely to exceed relatively dismal expectations. As of today, the dollar is up almost 10% against other major currencies.

Here's what I see in my crystal ball for 2016:

I remain generally optimistic, mainly because I think the market is still dominated by risk aversion and caution (e.g., corporate profits relative to GDP are significantly above average, but PE ratios are only marginally above average, and interest rates are still historically low). But it's an optimism tempered with caution. I think the economy can do better than expectations (which are quite modest) even though growth is likely to be disappointingly slow from a longer-term historical perspective, much as it has been for the past six years. I like the fact that the economy still has a considerable amount of untapped potential which could be unleashed with a shift to more growth-oriented fiscal policies. I'm also comforted by the fact that financial markets are highly liquid, systemic risk appears to be very low, and the yield curve is positively sloped (i.e., swap spreads are very low and monetary policy is accommodative). In short, the market is still rather cautious, and expectations for the future are not very optimistic, and that's a low bar to clear.

I know that many argue that risk assets are wildly over-priced because of easy money, but I'm not a buyer of that view. Interest rates are low and inflation is low—despite an abundance of money—because the demand for money and money equivalents is still very strong. The Fed has not artificially depressed interest rates, it has instead responded to very strong money demand by increasing the supply of money. The only way to understand why inflation remains low when cash yields almost zero and equities have an earnings yield of more than 5% is to realize that the market deeply distrusts the ability of corporate profits to sustain current levels.

The Fed is finally in "tightening" mode, but is unlikely to move aggressively, at least for the near term, and that is fully priced into the term structure of yields. Nevertheless, the key variable to watch is confidence. Since 2008, confidence has been lacking and the demand for money has consequently been very strong. The Fed was right to engage in QE, because if they hadn't supplied all the money the market demanded, then we would have had deflation and perhaps another recession. But if and when confidence returns with a vengeance, then the demand for money and money equivalents (of which there is a virtual mountain) could decline faster than the Fed's willingness and ability to offset this by raising short-term interest rates. In short, a substantial improvement in the economic outlook could result in the Fed raising rates too little, too late. And that, of course, would result in a significant oversupply of money, which in turn could fuel an unexpected rise in inflation and higher bond yields. I've been wrong on this score for years, but that is no reason to discount the risk of this happening over the next several years.

I also worry that neither of the current frontrunners—Trump and Clinton—have a good understanding of what ails the economy (e.g., too much government spending, burdensome regulations, high marginal tax rates, particularly on corporate profits, and an impossibly complex tax code). The policies Clinton is advocating would only exacerbate the problems that already exist (more subsidies, higher marginal tax rates, more spending, more regulations). At the same time, too many of the policies that Trump advocates are populist in nature (protectionist, xenophobic, authoritarian) and therefore anti-growth. There's still plenty of time for policy advocacy to change for the better, but until the debate focuses on more pro-growth policies, I doubt that the economy will do much better than 2-3% growth. 

In short, I see more of the same slow progress as we saw this year, but with substantial upside potential lurking in the background. For the time being, this puts a premium on investments that offer more attractive yields than cash (e.g., dividend-paying equities, corporate bonds, and commercial real estate), and it spells more trouble for gold and commodities. I think the odds favor a somewhat stronger dollar, for the same reason as they favor equity investments relative to cash; the U.S. economy still has the potential to surprise on the upside, and there are no immediate reasons to expect economic conditions to deteriorate.

Given the thrashing that emerging markets have endured for the past few years—thanks to a stronger dollar, a better-than-expected U.S. economy, falling commodity prices, and the inevitable unravelling of leftist and statist policies in many of these economies (e.g., Brazil, Argentina, Venezuela, Chile), the coming year is likely to see the beginnings of a long-awaited and much-needed recovery. I note the recent, impressive victory of Macri in Argentina and his rapid implementation of strong, pro-business and pro-growth policies. Argentina looks to be the bellwether for the region, leading the way for similar reforms in Brazil, Venezuela, and Mexico, and even in the U.S. It's not too much to hope for, and it's about time.