INSIGHTS

From a very high level view, most monetary policy around the world is still incredibly stimulative. From Europe and Japan applying “American”-style QE to China having reduced their interest rates six times, the world central banks are providing lots of liquidity and at very low rates. Even the U.S. Fed will likely remain very accommodative as they begin the long road to normalized policy. What is the likelihood of success? We think very high. We believe that 2016 will be very good for earnings in the United States but even better in Europe and Japan. Our belief is that the U.S. economic expansion is likely in the 7th or 8th “inning.” Europe, Japan and China are just starting the game. They have huge upside potential. We would point out that the JP Morgan Global Purchasing Managers Index (PMI) turned positive in October 2015. Global PMI is a very good leading indicator and good things happen to earnings and equity prices when global expansion starts. Although the first two months of 2016 have not shown higher PMI, the three-month moving average continues to be positive.

Further, a thorough study of history of years when markets have been within plus or minus 5% gains and losses are followed by a year with spectacular results. The following graphic below lists every grinding year since 1950. The average gain in the year following grinding is 26.35%. This is definitely not consensus, especially after the rocky start to 2016. However, the ending innings of a bull market are generally the most prolific. This bull market is seven years old and is potentially getting long in the tooth. However, bull markets don’t die of old age. The final months are generally when some of the biggest returns are made.

Past performance is not indicative of future results.



We think that the amalgam of easy, cheap and plentiful money will result in higher investment in plant, property and equipment. On top of that, add a layer of cheap inputs like energy and commodities and that makes for very robust business growth. The “cherry on top” will be a catalyst that has been created by so much sideline cash. Portfolio managers are underinvested and have high amounts of cash. As prices rise, they will be pushed to invest more. Note the graph below that demonstrates the current and excessive amount of cash in funds. It’s not just funds that are cash heavy, note the record hoard of cash at households, banks and in reserves. That cash is not earning any return. Sooner or later the penalty of holding cash will give way to the owners seeking better returns.

Remember that the strong dollar actually had the effect of reducing earnings on U.S. companies that engage in global business. Rising economic expansion in the rest of the world along with a slow-to-act Fed will actually weaken the dollar. According to Mr. Tom Lee at Fund Strat, those headwinds will actually turn to a tailwind for earnings in 2016. Higher earnings should translate into higher equity prices.

Markets have become sour on energy and materials. Emerging markets have been in a precipitous bear market for the last four years. The two tend to move in tandem. Most believe that these assets and markets will continue in 2016. Emerging markets are a mess with a strong U.S. dollar making the situation worse.

Rising global economic growth should create positive demand for those things that have faltered this year. Energy and materials have been in a very long four-year bear market. It is not just one commodity, all commodities across the board have suffered. New supply projects in development, and those that were planned, have been abandoned. Capital formation to allow for the development of new projects is nowhere to be found. The result is that supply is reduced in the face of cycle-low prices. The strong dollar has exacerbated the troubles for those countries that produce the lion’s share of energy and materials. Commodities and oil are quoted in dollars and when the dollar rallies, the result is that countries with weakening currencies suffer. However, as global economic growth resumes in 2016, energy and materials will benefit from the increase in demand and the destruction of supply. Countries that produce energy and material will benefit. A weaker dollar actually magnifies this tailwind.

The first few months have signaled a bottoming process in many commodities. It appears that gold, copper, iron ore and oil have recently bottomed, or are in the process of bottoming. The months that follow could be prolific for investors who can stomach the volatility. Further evidence of the recovery in oil includes the recent huge secondary equity issuance by a number of companies. Many of these secondary offerings had to be upsized because of overwhelming demand. We believe that willing capital to scarf up these deals tends to mark bottoms.

The recent change in Global PMI actually signals good times ahead for energy and materials, not bad. An upturn of Global PMI to the extent seen in the 4th quarter of 2015 foretells a much brighter picture for 2016. Research provided by U.S. Global Investors notes that a bottom generally forms within 30 days of a bottom in Global PMI. From that inflection point, the odds greatly favor a rise in the prices of oil and materials. The first three months of 2016 appear to support the bottoming of many commodities, including oil.

Finally, the changing faces of emerging market countries is quickly swinging from anti-business socialism to pro-business governments. Recent elections in Argentina ditched the nearly 13-year reign of the Kirchners – a regime that oversaw a sovereign default, run away inflation and nationalization of over half of the country’s largest oil company, YPF. The new president, Mauricio Macri is a formal civil engineer and ran on a pro-business platform. The government changes are not just in Argentina. Brazil has witnessed the downfall of socialist President Rouseff. Her second term has witnessed a crumbling economy, accusations of bribes and other corruption. She was just brought up on impeachment charges that appear to have legs.

Venezuela – long under the thumb of Hugo Chavez and successor Maduro – suffered a change in control of parliament in December’s elections. The economic crises there entails huge debt, inflation, currency devaluation and shortages of necessities. The landscape is changing quickly and we believe for the better for businesses. Look for good things to emerge from emerging markets in 2016. Historically, buying at these levels have been very rewarding to investors.

High yield bonds have been distressed in 2015. In fact, income-producing assets from a number of forms have been a real letdown. With U.S. earnings plateauing, the Fed beginning to increase rates, and energy and materials collapse have created a real fear storm for investors. Volatility has spiked for junk bonds, Master Limited Partnerships (MLPs), Business Development Companies (BDCs) and others. Dividend plays suffered in 2015 as market leadership narrowed. Quite frankly, the markets have priced in a recession rather than a soft patch. Signs of an oncoming recession just are not existent, in our opinion. Recessions come when we see excesses in market valuations, climbing unemployment and a flattening yield curve in U.S. Treasuries. Usually we see these slowdowns after a series of Fed rate increases designed to cool an overheating economy. We see growing employment, a slow expansion in GDP and a still very steep yield curve. These assets are priced for recession and anything short of a recession will prove that these are great buys. High yield returns tend to be correlated more with the equity markets rather than the bond markets. We think much higher equity prices are in store, thus high yield should perform as well.

We think these “income” assets will reverse as economic growth revives dramatically. We find some of the best bargains in the often-hated class of assets called closed-end funds. These funds trade very inefficiently. They consist of professionally managed pools of assets that tend to emit high monthly income. Normally these funds can trade at minimal discounts or premiums to the underlying assets. At the end of 2015 we witnessed discounts in closed-end funds exceeding 15%. Historically this was the time to buy as the market tends to recognize these discounts and they disappear as year-end tax sellers disappear.

According to Merrill Lynch, the first week of March witnessed the largest ever cash inflows into high yield. That $5.8 billion inflow after months of outflows appears significant indeed.

After seven years of zero interest rates, the Fed decided to “liftoff” in December 2015. We think this is the first of many rate increases to come. The real question is, “How quickly will they proceed?” It may not matter much the trajectory of Fed moves as traditionally the markets have led the Fed, not the other way around. Higher interest rates are the product of a healthier economy. If we are right about the expansion resuming in the United States and globally, we believe the demand for credit will rise. As the demand for credit rises against a static amount of credit available, the price of credit will rise as well. We have already seen long-term cyclical growth in housing and autos. We have begun to see an increase in commercial and industrial loan demand. The cost and availability of credit is very good. Banks, who are now limited to more traditional banking functions to generate profits, are focused on loan growth.

Higher interest rates hurt bond prices. As interest rates rise, bond holders suffer as market prices for lower yielding bonds decline. This is referred to as duration risk. Most investors and advisors don’t even remember a time when rates rose and high grade bonds dove in price. Global disinflation has produced a secular bull market in bonds that began in 1982 when inflation was double digits and the 10-year Treasury yielded over 15%. We believe it ended in 2012 when the 10-year Treasury hit 1.38%. Remember that inflation is correlated with interest rates. The U.S. Fed – as well as global central banks – are targeting the creation of inflation. They have unlimited tools to achieve their goals. Our bet is that 2016 will see fruits of their efforts. As inflation returns, higher interest rates will follow.

Since the financial crises, the world has sought refuge in sovereign government debt. Low interest rates have made it incredibly easy for governments and companies to borrow. Higher rated companies and governments have witnessed their interest expenses actually declining even as their borrowing has skyrocketed. Investors have demanded little in the form of interest to park wealth in these markets. In short, record amounts of capital have sought refuge in debt markets at the same time as duration risk is at the highest levels ever. We think this move will reverse as yields regress to the mean. As investor’s safe money begins to be threatened we think the exodus could be profound. Government holders of Treasuries have already started the exodus. Any mass liquidation in bonds will meet much lower trading liquidity willing to trade bonds in the markets. Banks have been downsizing bond operations pulling capital out of these operations. We have heard several of the large mutual fund companies warning of this lack of market liquidity. With traders and advisors not familiar with what a bear market in bonds looks like, the result could be ugly. A true perfect storm potential.

All in all, we think that 2016 will be full of opportunity. We believe that the United States is in the later innings of a business cycle but it is nowhere near over. We think we might be in line for extra innings. Our weaker dollar thesis is key here. We believe that Europe, Japan, China and the emerging markets will shine with economic stimulus taking hold. Higher demand for energy and materials will show that the cycle bottom is in and a multi-year expansion and price recovery plays out. We think that high yield, MLPs and BDCs will be very giving to investors this year. Growing dividends will be in vogue again. Finally, the Fed will remind bondholders the risks surrounding duration in higher grade bond and Treasury bonds. Traders, advisors and clients who have not experienced these types of markets may receive a painful education.