Steve Cordell sees the business cycle remaining in the expansion phase in 2016 and discusses why domestic consumer cyclical stocks should fare well in Europe…
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Steve Cordell, Fund Manager, European Equities
Central bank divergence complicates market backdrop
For the global economy, the business cycle looks like remaining in the expansion phase in 2016. This will allow the US Federal Reserve (Fed) to raise interest rates for the first time since 2006. The expectation is currently that rates will rise 0.25% in December 2015 and thereafter it is seen as less than 50% likely that rates will rise any further. This is understandable perhaps when the US economy is struggling to grow over 2% in real terms and inflation is barely above zero.
The growth rate and inflation picture is very similar in Europe, but here the European Central Bank (ECB) is taking a completely different monetary stance by expanding money supply. Recent commitments to remain in a phase of monetary easing have been extended to March 2017, by which time the ECB’s balance sheet will have expanded by €1.4 trillion. This transatlantic divergence in monetary policy makes forecasting 2016 very tricky.
The policy moves are even more confusing in the light of the recent economic data, which has surprised on the downside in the US and on the upside in Europe. Earnings expectations for Europe are expected to benefit from monetary policy easing, a weaker euro as a result, and stronger demand for credit. Yet the latest announcement from the ECB was met by a stronger euro, an ECB survey of small businesses that said availability of credit was no longer an issue, but demand for credit was just not there. The money supply may be expanding at around 11-12% per annum, but demand for credit is not, and with negative interest rates for cash left with the ECB, banks are struggling to grow earnings this cycle.
Consumption to boost Europe’s domestic recovery
The domestic European recovery may therefore not be best played through the banks this cycle, especially if the US credit cycle continues to deteriorate as the Fed tightens policy. Ironically, the US dollar usually peaks as soon as the US raises interest rates, so the export sector in Europe may not find a tailwind from a weaker euro either this year.
Consumers should be the winners again in 2016 as wages grow in real terms and unemployment falls further in Europe. This continues the trend of the last few years, but with fewer governments pretending to hit budgetary targets, thanks to elections on the horizon in Italy and France in 2017, maybe consumption will accelerate in these two countries after years of lagging their German and Spanish neighbours. This should allow domestic growth to match or even exceed the rate of 2015 in the eurozone.
Consumer stocks may perform well; commodities remain unpredictable
The wild card is what happens to commodity prices in 2016. Currently depressed by excess supply globally and slowing demand in China, commodities could see a rebound if the Chinese manage to run down their excess inventories, but supply has yet to contract meaningfully, and it is the contraction of supply that could send prices higher. Oil is the most likely commodity to see such a discipline return first, but with little sign of real distress other than in parts of the US shale oil and gas industry, we may be bobbing along the bottom for some time.
It is the slow speed of nominal global growth that makes this an unusually protracted cycle, and this has driven multiples of growth stocks to high levels. Next year the trends are likely to remain in place, and if the growth stocks tumble it will be because bond yields finally move higher. The US Fed has started that process, but in doing so has made slower growth even more likely. A flatter yield curve in the US would put even more pressure on value stocks and expand the multiple on growth stocks. Easier policy in Europe should, on the other hand, lead to a steeper curve and lower multiples for growth stocks and defensives.
For this reason we continue to favour domestic cyclicals over global plays but we have shifted our preference from banks, where low rates are a hindrance, back to consumer cyclicals where earnings estimates are rising as well as selected industrials. We have moved overweight commodities via oil but with low expectations of a quick return.