WisdomTree Europe: 2016 Market Outlook

Amid the recent turmoil in global markets and the downward trend for commodities, a dramatic shift in monetary policy in the US is poised to create new challenges (and opportunities) for investors in 2016.
WisdomTree Europe’s director of research, Viktor Nossek, believes there are a number of key themes which may emerge next year as central bank policy finally starts to diverge.
Below, Nossek identifies several potential outcomes which could come to the fore, including gains for European equities as QE continues, ongoing pressure on commodities, and why junk bonds will look even more vulnerable as credit spreads widen.
Europe’s Rebalancing Act
Domestic demand-led economic activity, underpinned by a more competitive labour market and a late arrival of easing credit conditions to small businesses, is solidifying Europe’s recovery.
This revival in consumer spending should trigger a virtuous cycle of higher tax revenues and prompt companies to invest more, broadening out Europe’s structurally-led recovery in the process.
Set against a tightening Fed and a weak commodities backdrop, the ongoing uncertainty surrounding exports in Europe is countered by the rebalancing act towards consumer spending, although we are still at an early stage as we head into 2016.
Weak euro, Strong dollar
The ECB is expected to use dovish rhetoric, rather than further policy easing, in its efforts to continue to suppress the euro. Given the upbeat economic outlook for the eurozone, weak inflation will be a secondary concern behind keeping a lid on the single currency.
Any further weakness in the euro will help to boost exports and buy time for domestic demand-led growth to sustain itself.
Persisting expectations of rising US rates and a robust US economy should also help to keep the euro fundamentally weak and the dollar strong, and reduce the pressure on the ECB to provide further stimulus.
While the Fed has finally pulled the trigger moderate US wage growth pressures, coupled with tightening conditions in credit markets, should allow it to postpone further rate hikes into the summer of 2016.
Rhetoric (as opposed to actual policy action) by the Fed will be used to strengthen or diminish the divergence of monetary policy expectations with the ECB, and we therefore expect the euro-dollar trade to remain volatile.
Corporate credit to decouple from sovereigns
The widening of credit yield spreads since H2 2015 is expected to continue in 2016, on the back of concerns over growing levels of indebtedness as US rates rise.
Investors will discriminate more between corporate issuers given heightened default fears, driving the yield wedge between investment-grade debt and everything below it, and between corporate sectors considered higher quality than their peers.
Sentiment in junk bonds, as well as smaller energy and base metals issuers, is expected to sour further and increase pressure on prices of borderline investment-grade credit. It should also mean investors gravitate further into the crowded trade of prime credit issuers in Europe.
Negative yields to persist across safe-haven European sovereigns
High grade corporates and short-dated government debt yields in core regions – such as 2-year German bunds – are likely to see yields fall further, sustaining the negative yield environment which has persisted throughout 2015.
Meanwhile, the expanded QE program by the ECB, coupled with the mild inflation outlook, will further suppress yields of longer dated peripheral government debt. The ECB’s indiscriminate support for eurozone sovereign debt means further erosion of the yield premium of peripheral sovereigns over German bunds is expected.
Commodity producer recession in emerging markets
The economic slowdown in emerging markets should pose limited risks to sentiment in global financial markets in 2016. China’s potential to further lower policy rates, intervene in FX markets to control yuan deviation, and increase public spending will work to cushion any accelerated downtrend in manufacturing.
However, slumping commodity prices mean inflation-adjusted interest rates for producer nations are still too high, and more monetary easing is expected to help commodity exporters further unwind overcapacity. More corporate downsizing, debt restructuring and defensive M&A activity is expected in 2016 as a result, but we are not anticipating major reverberations in credit and equity markets.
Meanwhile crude oil, along with copper, will continue to succumb to weakness and volatility as the outlook for global energy and metals consumption remains deeply uncertain. Low crude oil prices mean large energy players will attempt to squeeze out smaller rivals by increasing production and market share. Overall, output in crude oil for 2016 is expected to increase as a result, albeit at a slower rate than in 2015.
Meanwhile, gold is expected to remain weak, and could well fall below 1,000 USD/oz next year as real interest rates rise in the US. This downward trend should be sustained throughout 2016 following the Fed’s decision to raise interest rates. Higher rates on cash, coupled with a solid US labour market and a recovering consumer in Europe, undermine gold’s appeal as a safe haven, and indeed makes bunds and treasuries look far more attractive as a risk-off trade.
Broad-based appeal for European equities
With core sovereign bond yields suppressed, further interest rate increases expected in the US, and an upbeat economic outlook for Europe and the US, asset allocation is tilted towards overweighting equities relative to fixed income.
In terms of regions, Europe currently has the broadest appeal, with investors able to pursue a series of strategies on the continent. They can position strategically around Europe’s domestic demand-led recovery via small-cap equities – especially if this is overlaid with a quality screen –and this strategy should minimise downside risk while maximising potential rewards.
Alternatively, large-cap equities also remain a viable play. A cyclical, export-biased portfolio is one way for investors to protect themselves from a tumbling euro, and the grim outlook for overseas trade. UK-based investors should consider hedging their exposure if they wish to invest in eurozone equities because of the downside risks facing the single currency.
For income-seeking investors, eurozone equities paying above average dividends remain an appealing alternative to corporate credits amidst rising default fears, and increasing sensitivity to US rate rises. Compared to its historic trading range, the disproportionately high yield premium equities currently offer over fixed income means they are the standout choice for income.
 
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Notes to Editor
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