2016 will be another year of living dangerously for investors

2016 promises to be a tough year for investors. They will have to contend with an array of dangerous cross-currents that will test nerves to the extreme. There will be few places where investors will feel secure as slower global growth, conflicting policy signals and increased market volatility make rewarding investment opportunities even harder to pick.

Financial market confidence will be running the gauntlet. Asset allocation looks extremely overstretched right now and, with fading fundamental appeal, investor confidence in over-cooked equity markets could end up in sharp retreat next year. Anything that upsets expectations about access to cheap and easy money in 2016 will take its toll.

The global economic outlook carries lots of health warnings right now. While there has been a lot of positive carryover on growth expectations for the US, UK and Europe, thanks to QE’s legacy, the outlook still remains clouded in doubt. Risks are mounting that world growth could slip back into the doldrums in 2016.

The dramatic drop in global commodity prices this year and the 15 per cent collapse in world trade flows over the last 12 months are symptomatic of deep cracks in global demand. Certainly, the International Monetary Fund’s projection for world growth to pick up to 3.6 per cent next year from 3.1 per cent in 2015 looks highly questionable. There is a strong probability that world GDP growth will drop back below 3.0 per cent again in 2016.

The global economy is not rushing into a deep stall just yet, but the pace of economic activity definitely looks under threat, a key bearing on whether the six year old global equity rally sinks or swims in 2016. Hopes for faster growth are absolutely crucial for stock markets sustaining good forward momentum next year.

US Federal Reserve policy intentions are critical for market morale staying upbeat. Rising US interest rates are already underway, but this is only the first step back to normality. There is a bigger shock waiting in the wings from the likely changeover from quantitative easing to quantitative tightening at some future stage.

Ominously, Fed Chair Janet Yellen has already warned markets that the US central bank’s balance sheet will shrink ‘considerably’ once the US economy has reached maximum employment. We are not too far of that point right now.

As the US’s QE-driven liquidity boom was the catalyst for the post-2009 global asset rally, the market’s dread of the Fed down-sizing its balance sheet will mark a major turning point. In spite of all the continuing monetary pump-priming from other economies, any hint of a future Fed switch from US QE to QT will be cathartic.

The Fed’s 4-1/2 trillion dollar stockpile of QE assets, already accounts for about 27 per cent of US GDP, far above its historic 6 per cent holdings. When the garage-sale of QE assets starts for real, the market impact will be significant, setting off a chain reaction of rising bond yields and higher borrowing costs.

Despite all the Fed’s bravado about US economic prospects, consumers, businesses and investors are bound to feel the pinch. And there will be wider consequences too, as the world weighs up the Fed’s return to tighter policy as an iconic first retreat from global cheap money.

This is not good news for global investors who are overweight equities and banking on faster global growth and continuing cheap leverage to keep the rally extended. If risks remain tilted to the downside and investor confidence dives, then flight-to-quality flows back into safe haven government debt and a dash-into-cash could slam global stock and credit markets hard in 2016.

One thing is clear, safe haven bolt holes will stay in high demand. In a risk-off environment, investors will seek safety in the US dollar and Swiss francs. The yen is bound to get a lift as Japanese investors seek sanctuary in their home market.  Slower global growth and heightened financial market tensions will be bad news for commodity currencies like the Canadian and Australian dollars and the higher-risk emerging markets.

The return of risk aversion will be very bad news for investors generally. There will be little comfort in traditional safe haven bond markets like German government debt, where a large part of the curve is already steeped in negative yields.

2016 could mark a year for investors to hunker down and wait for better times. Unfortunately it could be a long wait before the good times roll again.