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Uncertainty Looms Over Global Markets In 2016

It’s very clear that both the industrial and manufacturing sectors are in recession while consumer spending slows but remains positive despite lower commodity prices. This divergence can be blamed at least in part on the Federal Reserve’s policy of pursuing a stronger dollar.

The road ahead in 2016 will most likely hold more of the same for both the U.S. economy and commodities despite oil markets gradually rebalancing in supply demand as U.S. production declines. The weakening economy will most likely result in tepid returns in U.S. equities in 2016 after a rather tepid year in 2015. Looking at just a few large cap names in technology (FB, GOOG, MSFT, AMZN, NFLX), most big name companies are well off highs or even in bear markets. It is doubtful any incremental U.S. fiscal spending in 2016 will turn the economy around. Additional monetary stimulus from the EU probably won’t do anything meaningful either.

The pace of China easing may sway things and seems the biggest swing factor in 2016. But valuations are still in the 90 percent of historical P/Es, which doesn’t bode well for returns nor does tepid EPS growth overall for U.S. companies. However, for investors, it has paid to follow Federal Reserve policies in determining asset allocation over the past seven years, buying riskier beta equities in technology/biotechnology and short commodities. The recent rate rise has changed that somewhat as it signaled the Fed has pulled back from the easy money that fueled the asset bubbles the past decades.

Related: OPEC Members In Jeopardy, How Long Can They Hold Out?

Fundamental investing has morphed into guessing what central bank policies will be versus traditional investing, and 2016 won’t be any different. Thus I don’t expect commodity prices to recover as that does not appear to be what the Fed prefers. So 2016, at best, will be a low-return environment for equities as P/Es shrink due to Fed tightening, while commodity prices continue to trade below levels to support free cash flow for the energy sector.

This essentially amounts to a transfer for wealth from the commodity sector to the consumer. Going into an election year that tends to be typical of government as it panders for votes. At worst, the realities of a weakening economic backdrop could spell a deeper decline in equities, although that could remain an outside chance. Plus we have seen the spigot of wild fiscal spending from the $1.1 trillion budget bill that was recently passed, helping to support what little growth we have.

Related: Will Goldman Be Right After All?

Furthermore, whether the Fed is convinced QE hasn’t worked, is simply blind to weakening economic data, or chooses to use a rate cycle as a tool to convince markets the economy is improving, is irrelevant. The fact is that they have chosen a course of raising rates, one that is different from the past. This is why we are starting to see a change in asset price movement compared to the past.

What will be key are those policies that come with a new administration in 2017. A GOP win would probably be pro-growth with lower taxes and regulation, lower U.S. dollar that supports exports, and supportive of commodities, while a democratic victory could see a continuation of the current situation of a low growth environment tied to central bank policies that do not support commodities.

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It is hard to say how it will shake out. The industrial and commodity names are at multiyear lows while technology/biotech have surged to record highs. These are two very different trajectories and looking forward, we don’t know whether the road ahead will continue along a course of asset price distortions, or a fork that will lead to different asset classes outperforming those that did over the last 7 years.

Without being able to predict the election outcome in 2016, it will be prudent to keep cash levels high in order to maintain flexibility. Furthermore with the leading beta asset classes starting to exhibit corrections, there are growing signs that the investing environment is changing, which should give investors pause.

By Leonard Brecken for Oilprice.com

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