Hermes' Nusseibeh: Reasonable Economic Growth Anchors Constructive Case For Equities in 2016

Dec 11 2015 | 7:08pm ET

Market predictions for the new year are coming in fast and furious as 2015 winds down. Among them is an interesting missive from Saker Nusseibeh’s team at Hermes Investment Management, which along with thoughts on the markets, also notes that rising political risk and increasing impact from climate change may start affecting long-term investment thinking.  

Overall, Hermes is generally optimistic on 2016. “Interest rates will rise from current levels, with the tightening starting in the U.S. and followed in a staggered fashion by the UK and eventually Europe,” writes Nusseibeh in the research piece’s forward. “This, combined with reasonable economic growth in the U.S. and in China, should make for a constructive case for equities.”

Within specific niche areas, however, the picture is more nuanced. Hermes cites a number of areas of potential vulnerability: 

  • Volatility has been on the rise and markets are likely to see further and more severe spikes in volatility in 2016
  • Some decoupling between credit markets and equities has taken place. This trend is likely to continue, but the risk that correlations all rise together across asset classes is very real
  • Liquidity risks remain most prevalent in the credit market, but there are genuine dangers of spillover to other markets in the event of financial stress 
  • Hermes expects markets to remain fragile and vulnerable to shocks.
  • Risk of contagion is on the rise and portfolios may appear more diversified than they actually are. Financial markets are inherently unstable and represent a challenge for even the fittest-for-purpose risk models – investors should be aware of their limitations and the potential pitfalls into which portfolios might be led.

Hermes also provided some thoughts on the macroeconomic outlook:

"We are still expecting baby steps toward policy exits as central banks with “skin in the game” avoid taking the market off-guard," writes Neil Williams, group chief economist. "The outlook revolves around four beliefs:

"First, U.S. and UK real policy rates will stay negative into 2017 and “peak” rates will be much lower than we are used to. Eight years after the first traces of crisis, we have moved to a two-speed recovery. In the lead are the U.S., Canada, Australia, New Zealand and, for the first time, the UK. In the slow lane are Japan, the Eurozone and some emerging markets. The Eurozone will continue to lack fiscal union. Greece may restructure, but this will likely be felt more by official institutions than private markets. And, like Japan, the ECB may have to extend its liquidity.

"Second, lower peak rates could be delivered by the Federal Reserve and Bank of England selling some of the government bonds bought under quantitative easing (QE). A risk to the pound, though, is the ‘known unknown’ of the UK’s EU referendum.

"Third, China is slowing, but has the ability to soften the landing. The effects on leverage and deflation need to be watched, but the Fed may not be knocked off course.

"Fourth, despite pockets of vulnerability, a blanket emerging market crisis seems unlikely. Few have fixed currency pegs to protect, so foreign exchange reserves need not be exhausted. Ultimately, they too may try QE."

From a macro sense, Hermes suggests that 2016 will be more like 2015 than 1994, when U.S. rate hikes hit most assets hard. The policy ball, however, is in China’s court, writes the investment firm.

Other key hightlights:

  • In equities, Hermes does not see the slowdown in growth as the start of another recession, but rather as a mid-cycle correction. Given the high levels of corporate investment still coming through, it predicts the economy and the markets will continue their upward trajectory in 2016. Opportunities will continue existing in undervalued companies demonstrating a blend of strong growth and quality, writes the firm, while from a regional perspective, Japan looks cheap compared to both the U.S. and Europe, as well as to its own history.
  • On emerging markets, Hermes feels the 2016 outlook is positive for the manufacturers, such as China, India, Taiwan, Korea, Poland, Hungary and Mexico, which make up over two-thirds of the MSCI Emerging Markets Index. Conversely, the outlook is neutral for the commodity producers, Russia, Indonesia, Brazil and South Africa, which contribute around 20% to the same benchmark. With Chinese growth continuing to moderate, commodity demand will remain modest, but since the PBOC is in an easing cycle, economic activity relating to housing in top-tier cities, services and e-commerce will remain healthy. Meanwhile, Indian growth should improve over the course of 2016 as public sector bank balance sheets are recapitalized, while Taiwan and Korea should see earnings and economic growth able to support equity prices. Meanwhile, Eastern Europe and Mexico are making slow but steady progress in terms of both their economies and earnings, according to Hermes
  • Commodity-based economies, however, are facing headwinds that could continue should the Fed raise rates. Although commodity currencies have already caused pain for investors, there could be more to come depending on policy responses, writes Hermes. Russian, Indonesian, Brazilian and South African leaders have left investors uninspired, focusing on populist declarations rather than long-term structural reform. If this is not corrected, Fed rate hikes could spell more weakness for their currencies and economies. Overall, the firm notes, after four years of underperformance, the relative performance of emerging markets may start to stabilize. Given the potential trough ahead for emerging market currencies as well, Hermes notes that next year could be an interesting long-term entry point for the asset class.
  • In credit markets, Hermes writes that 2016 is likely to be characterized by the same challenge as 2015: how to identify asset classes which represent value in a low rate and low credit loss environment. Investors must ask themselves whether they are being paid sufficiently, on an absolute basis, for the risks they are assuming as well as, at least in some asset classes, increased levels of illiquidity. 2016 could also see another year of spread decompression between low and high quality credit corporate names, according to Hermes, as investors become more discriminating about risk. While rating agencies are already voicing concerns about the high preponderance of covenant-lite loans in the U.S. leveraged loan market, the European leveraged loan market feels less frothy than its U.S. counterpart, notes Hermes, and is still likely to offer relative value through 2016.

Established in 1983 as the primary manager of the BT Pension Scheme, Hermes Investment Management is one of the largest institutional asset managers in the UK, with £29.5 billion assets under management and £146.6 billion in assets under advisement.


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