Questions That Will Move Markets

November 30, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

New Year’s is the time to make predictions. Thanksgiving is the time to ask questions about the coming year. Asking those questions is often more important than coming up with precise answers.

Market participants often take the opposite approach, asking only the questions frequently emphasized in the media. But going beyond what’s right in front of us can lead to more valuable insights. Below are six important questions on my list for the coming year:

1. How fast will the Federal Reserve increase rates, and when will it stop?

Whether the Federal Reserve had raised rates in September, does so in December or waits until January is important, but not as important as the pace of increases and the stopping point. Nearly seven years removed from the market bottom, market participants are conditioned to very low rates. Within the market, there lingers a deep-rooted belief that rates are going back to normal. I don’t think they are.

My expectation is for rates to increase in December and then increase every second or third meeting. That pace would put short-term rates at about 1% by the end of 2016.

The potential opportunity in this timeline is that if participants overreact to an increase followed by strong data, they will push yields higher. If this happens, it may be a great time to buy intermediate and long-term Treasury ETFs, such as the iShares 7-10 Year Treasury Bond (IEF | A-55) and the iShares 20+ Year Treasury Bond (TLT | A-83).

If rates are expected to rise rapidly, we would expect the dollar to increase too. If the U.S. economy stays strong, international hedged equities would be attractively positioned. International stocks could rise from the benefits of improved economic growth, and hedging the currency means any dollar appreciation associated with higher rates won’t harm investors.

2. How will investors react when they find their portfolios are sensitive to changes in interest rates?

As I mentioned above, investors have become conditioned to low rates. While Treasury bonds offer the purest exposure to changes in rates, other asset classes have high sensitivity too. Corporate bonds, especially high-yield bonds, benefit from plentiful liquidity. If rates rise, liquidity drops. That drop in liquidity could make owning corporate bond ETFs, such as the iShares iBoxx $ Investment Grade Corporate Bond (LQD | A-77) and the iShares iBoxx $ High Yield Corporate Bond (HYG | B-68), more volatile.

Convincing retirees to emphasize income-producing securities isn’t difficult, because the rate decline has allowed valuations to rise on other income-producing securities. Will dividend investors continue to purchase suddenly volatile, high-yielding strategies when bonds offer higher rates and less risk?

The potential for investors unloading high-dividend-paying stocks through the Vanguard High Dividend Yield ETF (VYM | A-97), the Schwab US Dividend Equity ETF (SCHD | A-92) and other high-yielding ETFs leaves portfolios more sensitive. For investors seeking low volatility and less interest-rate sensitivity, the PowerShares S&P 500 ex-Rate Sensitive Low Volatility ETF (XRLV | D-70) offers an interesting opportunity.

3. Will the margins of international companies expand toward the level of U.S. stocks?

The U.S. business community has recovered from the financial crisis more quickly than other regions. Margins in the U.S. now outpace developed and emerging international segments. Should international markets achieve improved efficiency, earnings should rise and valuations could too. Even if international markets narrow only 50% of the gap in coming years, I would still expect a sharp rally in broad international markets, such as in the iShares Core MSCI EAFE (IEFA | A-95) and the iShares Core MSCI Emerging Markets (IEMG | A-99).

4. If commodity prices stay low, who benefits?

The easy version of this question is: What will happen to commodities, including energy, next year? Uncertainty regarding Chinese growth makes this a difficult question to answer. Will the Chinese return to infrastructure investment as a key lever keep GDP strong? Will the government let growth drift lower and rely on reform and consumer spending to fuel growth? Those are easy questions to ask but difficult to answer.

Instead, the first question seeks to find long-term winners from commodity price declines. The iShares MSCI India (INDA | C-96), the iShares MSCI Japan (EWJ | B-98), the Vanguard FTSE Europe ETF (VGK | A-97) and other commodity importers benefit from lower prices.

India, in particular, has the capacity to grow more quickly with less inflation if commodity prices remain low. Japan and Europe benefit from lower prices too. Make sure prices are analyzed in local currencies. Prices could fall in dollars but rise in euros if the dollar continues to appreciate.

5. Which global governments will surprise the world with meaningful reforms that benefit investors?

Brazil’s government is the one most worth watching. Dilma Rousseff’s administration has struggled with slowing Chinese growth, corruption and persistent inflation. Any reforms from this administration could reverse Brazil’s poor market and currency performance. The iShares MSCI Brazil Capped (EWZ | B-96) would be my choice for investing in Brazil if reforms become a reality.

Italy is another market to monitor. Italian economic reforms slowed in favor of political reforms designed to improve the stability of Italian governments. Once those political reforms are in place, a new election is likely and then economic reforms become possible to implement. The political reform proposal will face key hurdles in 2016, but if approved, the opportunity for additional economic reforms improves. The iShares MSCI Italy Capped (EWI | C-90) is the most liquid Italian ETF. Depending on the outlook for the euro, the Deutsche X-trackers MSCI Italy Hedged Equity (DBIT) may also be attractive.

6. Will military tensions raise the risk premium and undercut the advantages of globalization?

Niall Ferguson, in his book, “The Ascent of Money: A Financial History of the World,” describes how the financial world was caught off guard by the onset of World War I. Investors assumed countries with so many economic linkages would be hesitant to go to war with each other. I hear the same logic from investors now.

This line of thought ignores how China, Russia and other formerly communist countries are relying on nationalism to replace communism as the political ideology that justifies limited democratic reforms. Chinese nationalism is driving a greater degree of brinkmanship in the Pacific and fermenting greater nationalistic feeling in Japan.

While military engagement is unlikely, even the potential for sanctions, trade barriers and other responses offer the potential to move markets.

Conclusion

Predicting questions is probably safer than predicting events, although not much. None of these questions feeds the day-to-day drama that warrants top billing on financial websites. But they will be questions I monitor to better navigate markets in 2016.


At the time of writing, CLS Investments held positions in IEF, TLT, LQD, HYG, SCHD, VYM, INDA, EWJ, VGK, EWZ and EWI. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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