Originally published Jan 5, 2016 on Real Clear Markets
by Byron Wien
Here we are with the 31st edition of The Ten Surprises. As loyal readers know by now, my definition of a Surprise is an event I believe is probable, with a better than 50% chance of happening during the year, but which the average professional investor would only assign a one-in-three likelihood of taking place. Over the years I generally have five or six of the Surprises pretty much on target (they have multiple components), but I don’t develop the list to get a high score. My objective is to present concepts that I believe could have an impact on the financial markets but are generally unanticipated by most investors. I would describe my 2015 edition as below average after a good year in 2014. I had a number of Surprises partially “right,” but I missed several important events, including the terrorist attacks in Paris and California, the delay in the increase in short-term interest rates by the Federal Reserve and the weak performance of the U.S. equity markets.
My first Surprise last year expected the Federal Reserve to raise rates early in the year rather than in December, so I got this one clearly wrong. My reasoning was that the Fed had kept rates near zero throughout the recovery and was anxious to move to a more normal policy position. For that to happen, the governors had to feel that the United States economy had developed enough natural momentum on its own to continue growing with less monetary accommodation. Because I believed back then that the economy was headed toward a 3% real growth rate by the end of 2015, I thought the Fed would have the confidence to act early. As events developed, the economy was weaker than I anticipated and the Fed delayed increasing rates until the end of the year (even though the economic data were mixed at the time of their decision).
The second Surprise was my expectation that cyber terrorism would become a serious problem during the year. Foreign computer-savvy operatives are clearly using techniques to invade the networks of both corporations and government agencies. While this problem has existed in a minor way in the past, it has escalated significantly in 2015. So far, however, the cyber security efforts at financial institutions seem to be working, given that no major bank has been forced to suspend service to its depositors. Nonetheless, the risk is self-evident and further efforts by cyber rogues are likely to create major problems in the future.
The third Surprise was that the Standard & Poor’s would rise 15% in 2015. At the beginning of the year, most forecasts by analysts and strategists were for a 10% increase. The surprise would be a market that either did better than that or was down for the year. Since I was optimistic that the U.S. economy would continue to grow during 2016, I opted for the positive view. As it turned out, the combination of a strong dollar and declining oil company profits caused S&P 500 earnings to decline. As a reflection of this, the index saw a decline of less than 1%, a far cry from my estimate. Concern about the Federal Reserve raising short-term interest rates hung a cloud over the market all year.
The controversial decision by Mario Draghi to increase monetary expansion at the European Central Bank was my fourth Surprise, and that turned out to be right. He recognized that without a vigorous program of monetary stimulus, Europe was in danger of moving back into recession. He had said earlier that he would “do whatever it takes” to prevent another recession and he made good on that promise in 2015. As a result, the euro weakened against the dollar, helping European exports and diminishing overseas earnings of American companies. The Surprise further suggested that Europe would suffer a recession anyway and that Germany would be particularly hard hit because exports to China and other trading partners would decline. Happily, Europe had a better year than that with the economy growing at more than 1%. Europe, like the United States, would have had better results with more fiscal spending, but the various parliaments were not supportive of that policy. Politically, there was a shift to the right, as I expected.
I focused on Japan in my fifth Surprise. I thought Shinzo Abe’s combination of fiscal and monetary stimulus would enable the economy to achieve modest growth. The second and third quarters were in recession, although the fourth quarter is now expected to show real growth of 3%. I thought the Nikkei would be flat in yen and down in dollars. As it turned out, it was up in both yen and in dollars, so I was correct on the currency depreciation, but the market did better than I thought it would.
…
So here are the Surprises of 2016. I will discuss them in detail in my February essay.
1. Riding on the coattails of Hillary Clinton, the winner of the presidential race against Ted Cruz, the Democrats gain control of the Senate in November. The extreme positions of the Republican presidential candidate on key issues are cited as factors contributing to this outcome. Turnout is below expectations for both political parties.
2. The United States equity market has a down year. Stocks suffer from weak earnings, margin pressure (higher wages and no pricing power) and a price-earnings ratio contraction. Investors keeping large cash balances because of global instability is another reason for the disappointing performance.
3. After the December rate increase, the Federal Reserve raises short-term interest rates by 25 basis points only once during 2016 in spite of having indicated on December 16 that they would do more. A weak economy, poor corporate performance and struggling emerging markets are behind the cautious policy. Reversing course and actually reducing rates is actively considered later in the year. Real gross domestic product in the U.S. is below 2% for 2016.
4. The weak American economy and the soft equity market cause overseas investors to reduce their holdings of American stocks. An uncertain policy agenda as a result of a heated presidential campaign further confuses the outlook. The dollar declines to 1.20 against the euro.
5. China barely avoids a hard landing and its soft economy fails to produce enough new jobs to satisfy its young people. Chinese banks get in trouble because of non-performing loans. Debt to GDP is now 250%. Growth drops below 5% even though retail and auto sales are good and industrial production is up. The yuan is adjusted to seven against the dollar to stimulate exports.
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