Wednesday, January 27, 2016

Outlook for 2016

Happy New Year! 2015 is behind us with the markets providing plenty of volatility and ending nearly flat. The Dow Jones Industrial Average returned -3.45% and the S&P 500 returned -2.15% excluding dividends in 2015. All things considered, and all the risks facing the current economic climate, that is not bad at all. But then again, we have been stagnant for a year and that means your investments – stocks, bonds, cash have not grown. But don’t be too hard on yourself. 2015 has not only been a rough year for retail investors like you and I, its been tough even for the professionals and one of the hardest years to make money in.

Following is a chart from Bespoke Investment Group summarizing 2015 asset class performance.

Asset Class Performance Summary 2015

Outlook for 2016

2016 is expected to have a similar economic environment as we see the Fed tightening further following a December 2015 rate hike. The projections from economists vary – with some arguing that the Fed cannot raise rates  anymore to some economists predicting 2-4 raises this year. But as we all know, predictions are wrong all the time and investors will have to watch the drama unfold as the global economy faces risks.

There are more risks overall than investors like to see. The markets are still close to all time highs as the bull market enters its 8th year and appears to be running out of steam (although technically 2015, the market ended negatively, but just barely). The crash in the commodities market has led to repercussions in the high yield bond market, China market collapse, geo political tensions etc. Companies have taken on an immense load of debt due to low interest rates and used the funds to buyback stocks instead of investing. The US dollar continues its strong path and continues pushing higher with the threat of deflation lurking.

So, whats an investor to do with all these risks facing the economy?
  • Equities: Equities have been the go-to place for investors looking for any sort of return on investment and are able to stomach some risk over the course of last year.
    • United States: The US equities continue lingering near all time highs (except for some sectors such as energy and materials – more on this below), and the strong US$ provides headwinds on international revenue and earnings.
    • Developed Countries: Developed countries whose economies depend on commodity prices such as Canada and Australia have seen their stock markets collapse. Unless the commodity prices change direction (look towards US$ and demand from China for a turnaround), these markets will continue to underperform. Other developed economies such as Europe and Japan have done very well as the policy has been to ease monetary and fiscal policies.
    • Emerging markets: some markets such as Brazil, and China have dragged the whole index down while countries like Russia have had a great return in 2015. Emerging equity markets in general seem to be attractive as regions such as Southeast Asia provide immense growth opportunities thanks to a booming population. But again, investors have to be careful as indices priced in US$ may not see great returns, thanks to the strong US$.
  • Fixed Income: The US Fed is increasing rates, which means that bond funds will continue falling as the rates rise. Staying short-term focused is the way to go in fixed income. On the other hand – for non-US investors, most countries are easing and cutting interest rates in order to spur their respective economy. Again, staying in short-term-focused funds is the way to go.
  • Commodities: The commodity collapse has been the biggest story for over a year now. The commodity market is closely tied to the US$ as most commodities are internationally traded in US$. Commodities are expected to have another rough year in 2016, but could possibly see a change in direction – esp if we see the US$ bull market come to an end. For non-US investors, the picture may not be as bad as the US-centric media may paint. For e.g., gold may be down 10.4% in US$ terms, but is up 7.0% in CAD$ in 2015.
  • Real Estate: The low interest rates over the past few years has re-inflated the housing market in the US and elsewhere. For now, the market remains peaked and remains dangerously close to toppling in countries such as Canada. The Bank of Canada (BoC) has acknowledged that the market is overheated and probably in a bubble and is hoping for a slow landing. However, the BoC is not doing the market any favors as it continues to cut rates (more rate cuts are expected in 2016, and the potential of negative rates if economy does not recover).
  • Foreign Exchange: This is the big one to watch that ties all the other markets together. Even if you don’t trade FX on a regular basis (I don’t either), watching this market provides insight on how the overall economy is changing and catch & understand trends. Currency trends have implications on commodities, equities, real estate and fixed income markets to varying degrees. As it stands, the US$ is expected to continue is bull run as it gets even stronger in relation to each of its pair currencies in 2016. The 3-year US Dollar Index chart is presented below.

US Dollar Index 3-yr

The Sectors

Note that I list some basic outlook for each sector and present my picks of stocks. These picks are by no means a recommendation to buy now. These are the companies that I am already invested in or looking to invest in as I find them attractive and a strong investment case can be made for them. Of course, I cannot cover every single companies and there may be better companies out there that are more lucrative. If you have comments or input about a better company than presented below, please feel free to share your thoughts in the comments section below.

Basic Materials: This was the worst performing sector in 2015, and there are plenty of opportunities for investors. The crash in the commodity prices has created an cyclical low and plenty of deep value finds exist. Some indications suggest that they bottom hasnt been found yet, but for long term investors some amazing opportunities present themselves. Investors should keep an eye on China (demand for commodities) and the strong US$.

My Picks: Agrium Inc (AGU), Dow Chemical (DOW), Ecolab Inc (ECL), gold/silver/other mining companies.

Communication Services: Telecom companies are starting to turn into utilities as the need for communication becomes essential. Most companies are fairly valued and provide a bit of growth while providing great current income with the high yields.

My Picks: AT&T Inc (T), BCE Inc (BCE), Verizon Communications Inc (VZ).

Consumer Discretionary: Consumer Discretionary sector has had a good year with some companies doing extremely well. It is the top-performing sector of the economy for 2015. The coming year doesn’t change much for the sector in particular and is expected to do pretty well again.
My Picks: Lowes Companies (LOW), Magna International (MG.TO/MGA), Starbucks (SBUX), Nike Inc (NKE).

Consumer Staples: A sector that is the bread-and-butter for most dividend growth investor. As the headwinds across the world increase for growth industries, investors will turn to consumer staples for the safety. Consumer staples with ties to the commodities market provide better value here.

My Picks: Bunge Ltd (BG), Brown Forman (BF.B), Archer Daniels Midland (ADM), PepsiCo (PEP), McCormick & Co (MKC), Tyson Foods (TSN), Unilever (UL).

Energy: Energy has been beaten down badly and there are plenty of opportunities to be found. If your portfolio doesnt have a too high an exposure to the energy market, now would be a good time to load up. Some of the best run companies in the world with excellent credit ratings are trading at a discount and are prime for portfolio addition.

My Picks: Brookfield Renewable Energy Partners (BEP), Enbridge (ENB), Exxon Mobil (XOM), Kinder Morgan Inc (KMI), Philips 66 (PSX), Suncor (SU).

Financials: One of the winners from the Fed’s tightening cycle. Banks and insurance companies are the big winners when rates rise. Asset management companies are also attractively valued here. In addition, a lot of the companies are trading at low P/E multiples, so plenty of value finds available here.
My Picks: Bank of Nova Scotia (BNS), Berkshire Hathaway (BRK.B), Blackstone Group (BX), Brookfield Asset Management (BAM), Toronto-Dominion Bank (TD), T. Rowe Price Group (TROW), Visa Inc (V), Wells Fargo & Co (WFC).

Healthcare: One of the recession-proof sectors. Healthcare was the second best performing sector in 2015 after Cons Discretionary. Healthcare is the one sector seeing robust inflation for decades now and shows no sign of slowdown. Most companies are fairly or overvalued, so pickings may be slim.
My Picks: Amgen Inc (AMGN), Becton Dickinson (BDX), Gilead (GILD), Johnson & Johnson (JNJ), Medtronic Inc (MDT), Stryker (SYK).

Industrials: Industrials are what keeps the world going round and are an essential part of the economy. There are some subsectors that offer better opportunities than others. Conglomerates provide the safety, while some may be better finds than other thanks to each company’s exposure to the beaten down energy market. Other subsectors to look out for are: railroads (we could possibly see some M&A activity) and defence contractors (who have another great budget to work with and bid projects on – after the passing of the 2016 omnibus bill, and the added threat of escalated geopolitical tensions in middle east).
My Picks: 3M Co (MMM), General Electric (GE), General Dynamics (GD), Canadian National Railway (CNR.TO/CNI), Parker-Hannifin Corp (PH), Union Pacific Corp (UNP)

Real Estate: A new sector will be created for REITs in the GICS after being clubbed with Financials for this long. The sector definitely deserves its own place in the standard as it is unique in so many different ways. The growth in the industry is expected to continue, but might slow down a bit as the Fed tightens policy. This does not mean that the sector will hit the brakes hard, global real estate growth is still expected except for some overheating in some markets/countries.

My Picks: Brookfield Property Partners (BPY), Omega Healthcare Investors Inc (OHI), Realty Income Corp (O), Ventas Inc (VTR).

Technology: The sector with some of the best balance sheets as the companies have turned into cash machines. But there is also some concern of the companies growing too much too fast and some steam needs to be let off. There is also talk of bubble here, as the number of unicorns (private companies valued over $1B) explodes. Something to look out and stay wary of.

My Picks: Alphabet Inc (GOOG)(GOOGL), Apple Inc (AAPL), Qualcomm Inc (QCOM), Texas Instruments (TXN)

Utilities: One of the safest sectors to invest in, although the companies have to adapt to the changing landscape of newly developed technology and new mandates to cut emissions. Companies operating only in electric subsector are seeing  stalled revenues and have resorted to consolidating with gas companies to keep the revenues up. Better picks are the water utility companies, but most are trading at high P/E premium. Utilities have had another bad year in 2015, and knee jerk reaction as interest rates rise could provide opportunities here.

My Picks: Algonquin Power & Utilities Corp (AQN.TO), Aqua America (WTR), American Water Works (AWK), Brookfield Infrastructure Partners LP (BIP).

So, that’s my take on the overall outlook for 2016 and sector-wise breakdown. As mentioned earlier, there are plenty of things to look out for, as the US Fed puts the brakes on the economy by raising rates. In a globally interlinked economy, the Forex market seems to hold the key in how things progress – so my recommendation is to keep a close eye on it to see how things progress. But all in all, retail investors like you and I can’t really do much except be patient and invest regularly – as most of these are out of our control. Do your own research, understand the business behind companies, look for wide moats, try not to time the market, and invest regularly. I wish you the best in meeting your investment and finance goals in 2016!

What are your thoughts on the outlook discussed above? Do you agree or disagree? Share your thoughts in the comments section below.

Full Disclosure: My full list of holdings is available here.

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