2016 Outlook: Turning insight into action

The following is a transcript of a conference call that took place on January 6, 2016. The call featured David Wertheim, investment product specialist,Larry Adam, chief investment strategist, Deutsche Bank Wealth Management, Frank Kelly, head of government relations and public affairs, Deutsche Bank, U.S. and Latin America and Owen Fitzpatrick, head of U.S. equity.

David Wertheim:Thanks so much. This is David Wertheim, investment specialist for equities and alternative investments at Deutsche Asset and Wealth Management and I’d like to thank you all for joining us on today’s call.

Certainly, outstanding opportunity for many of you to hear from some of our best thought leaders at Deutsche Asset Management cause we have three individuals that we’re very happy to have with us today to provide their views and insights in terms of the markets, in terms of investment strategy, as well as the political outlook.

We are going to start today’s call off with Larry Adam. Many of you have heard from Larry before. He is our chief investment strategist for the Americas and he will be providing you with a 35,000-foot overview, top investment ideas for 2016.

Thereafter, we’re going to hear from Owen Fitzpatrick, head of U.S. equities within Deutsche Asset Management and lead fund manager for the Deutsche Core Equity Fund and the Deutsche Capital Group Fund.

And then we’ll round things off with Frank Kelly, our long-term head of government relations and public affairs.

So certainly we’ve had an action-packed start to the year, quite a bit of volatility to start out with the first week. So again very thankful that we had the timing to get all three of our speakers to join us today.

So with that Larry, I’d like to turn things over to you just for you to provide your thematic view of how 2016 could shake out from a multi-asset class perspective as well as from a macroeconomic perspective.

Larry Adam:Sure thank you David and happy new year to everybody. Unfortunately, 2015 wasn’t an especially good year. And you know when you look at the performance last year it was pretty challenging market. I mean, when you look at some of the asset classes like high-yield being down 4.5 percent, commodities being down 25 percent, small cap down 4.5, and emerging markets being down 14.6 percent. Clearly it was challenging.

The only areas that really somewhat stood out was the S&P 500 up 1.4 percent and then municipals, which were up 3.3 percent. Now that was the bad news.

When we look into 2016, despite the volatile start that we’ve seen year to date with the S&P 500 has had its worst beginning of a year since 2008, I actually think that market performance will actually be much better as we progress through this year. And that’s all embedded in our 10 themes for 2016.

And if you’d like to get a copy of that, please call your sales representative because I’m only going to go over them very briefly. But clearly in the presentation we have a lot more details to get into the nuts and bolts of our house view and strategy.

But kicking it off, of the 10 themes, the first one is called the global economy.

No peloton in the tour de global economy.

And that’s a reference point to the fact that when you think about the global economy, while we expect each of the regions to improve globally, the point is that there is no synchronous recovery taking effect.

In fact, most countries are at different states of the business cycle and that’s really highlighted by the fact that the U.S. economy continues to be the leader of the pack.

When you look at our recovery/expansion, we’re entering six-plus years of a recovery.

When you look at Europe and Japan, they continue to spin their wheels and in many ways when you look at Japan, I think the best example I can give to that effect, is that when you look at the size of the Japanese economy, the size of it today is the same size that it was in 2008, 2003, 2001, and even 1995.So they’ve pretty much been at stall speed for almost 20 years.

When you have that type of dynamic, that’s why you continue to see ultra-accommodative policy coming from the Bank of Japan, coming from the ECB.

When you look at the emerging markets, we think you’re going to continue to see a bifurcation there. Clearly, China and India will be the standouts with GDP growth around 5 to 6 percent. The ones that will continue to struggle will be the commodity-related economies: Brazil and Russia.

Now the reason we think that the U.S. economy will continue to expand is because when we look at our fab five indicators, which are five real-time indicators that include for example withholding taxes, jobless claims, vehicle sales, business, and borrowing—all of them continue to be positive and paint a pretty strong underlying fundamentals for the U.S. economy.

And that’s why we believe that the U.S. economy will grow 2.4 percent in 2016.

Another reason why we don’t think you’re going to see a recession in the U.S is because it is an election year. And historically when you look back it is very rare for the U.S. economy to have a recession in an election year. And it makes sense because both sides, both parties really want the economy to look as good as possible to maximize their chance of getting elected.

Now because it’s an election year when I look at the equity markets, it’s actually a positive for the equity markets. And if you look at the last 20 elections, if you look at the 12 months leading up to those elections, 17 out of 20 times you’ve seen positive performance for the equity market on average being up 9.9 percent. So that tends to be a positive.

Now the one thing that I think will occur because of the election is that you will see an uptick in volatility and the reason for that is because the market doesn’t’ like uncertainty and right now there are plausible scenarios that range from a Republican sweep to a Democratic sweep, depending upon turnout. When you have that spectrum of outcomes, that’s going to lead to more volatility in the marketplace.

Our second theme is called our consumption assumption. Shop till you drop America and world.

And the reason for that theme is that when you look globally, not just here in the U.S. the global consumer continues to strengthen their spending power, whether it’s because of lower energy prices or job creation or wage increases. They continue to improve and that is the basis for a lot of the strength in the U.S. economy and more importantly in the global economy.

The resultant theme to invest in there is consumer discretionary and that continues to be one of our favorite sectors here in the U.S.

If you wanted to go more specifically, I would tell you that this is the year where selectivity is going to be critical.So if I dig down even deeper, some of the themes that we like there for example we like online retailers as opposed to brick-and-mortar retailers.

We like retailers that have home improvement or provide experiences like restaurants or tourism. We also like advertising because in this year particularly you’re going to see a massive increase in advertising because of the election, where it’s expected you’re going to see $11.4 billion of advertising around the elections.In addition, you’re going to see an uptick in advertising because of the Olympics, another $1.5 billion.So advertisers should benefit from this environment.

The third theme is monetary policy divergence.

Clearly the Fed for the most part is going it alone and we’ve articulated the experience of one of where the Federal Reserve is basically taking the training wheels off the U.S. economy.

And what happens when you take the wheels off of a bike and someone’s on it? There’s always concern whether or not they’re going to fall or wobble. And that, in and of itself, is additionally going to lead to more volatility in the equity markets.

And if you look back historically, 12 months after the Federal Reserve raises interest rates, you do get more volatility. On average, you get four pullbacks and on average they’re around 6.5 percent.

The one point that I will tell you though, is that we will likely view those pullbacks as buying opportunities because it is very rare in the first 12 months of a tightening cycle that the bull market does end.

The fourth theme, global inflation.

Yes we expect an uptick in inflation, just a modest uptick. But the bigger part of that theme is that you want to be in sectors of the market that have pricing power better than inflation. That points us to an investment that we like and this is REITs.

And when you look at REITs, overall, you continue to see occupancy rates moving higher. You see on average, rents moving higher by about 3 percent. That’s well above both headline and core CPI.

Economic growth continues to improve from our perspective and from a technical basis, REITs are set to become the 11th sector of the S&P 500 August 31.

And if you look at a study that was done by Raymond James, they show that if you look at mutual funds in aggregate, mutual fund money managers are underweight REITs by about $95 billion.That equates to about 10 percent of the market cap of REITs.

So that means that we believe that even if they get close to neutral, that could bring significant cash flow into that space during the second half of this year and that as well should help support REITs to move higher.

The 5th theme, the U.S. dollar. We think that the U.S. dollar will continue to appreciate. Our forecast is 0.95 for the euro, 1.30 for the yen.

The main driver of why we think the U.S. dollar will continue to appreciate is that monetary divergence and if you look back historically at previous tightening cycle’s no less than five other of the G10 central banks have raised interest rates in concert with the Fed.

On average more than seven of the nine remaining G10 central banks raise in concert with the Fed. This particular cycle, we only see one other possible bank moving with the Fed and that’s the Bank of England.

When you have one versus more than seven, clearly the Fed is going it alone. Short-term rates will move higher, interest rates will move slightly higher. That will bring more money to the U.S. and that will serve as the catalyst to continue to see the dollar bull market continue.

Number six. Global fixed income. We’re not looking for a massive move upward in the 10-year Treasury yield. We think by the end of this year, 10-year Treasury yield will be up to about 2.4 percent. What will continue to keep rates lower than what is quantifiably done when we look at our models is the fact of QE over in Europe.

And when you think about what QE is doing over there, it’s causing 30 percent of the bonds in Europe to have a negative yield already. When you look at the ECB they’re buying five times the amount of debt that Germany is issuing.

Those dynamics are going to keep yields lower. That’s going to cause more money to flow from Europe to the U.S. as for higher yields and that’s going to continue to put a lid ultimately on where rates can go.

If I look at the different sectors within the fixed-income market, I will tell you that we do like convertibles. We do like investment grade. We’re very selective in the high-yield space. Clearly needing a money manager in that space and then we are cautious to slightly negative on emerging market bonds.

Number seven, global equities, all eyes on earnings. This is one-year where I actually think that after a long run by U.S. equities, I think on local currency terms, you actually could see international markets outperform U.S. markets.

And we do have history on our side when it comes to that because if you look back previously at tightening cycles, the U.S. has underperformed in the 12 months after a tightening cycle begins.

Now what will take the S&P 500 higher and our forecast for the S&P 500 is 2,170, it’s going to be bet on the back of earnings.

And while fourth-quarter earnings which are going to start this upcoming Monday are going to remain challenged, they could be down to flat, we think that earnings on a year-over-year basis, will start to move higher as we anniversary the big decline in energy prices, and the strong appreciation of the dollar.

So when you look across all the developed markets, we’re looking for mid- to upper-single digital earnings growth for most of those markets. And that will be what takes those markets higher.

When it comes to, number eight, emerging market equities, we remain underweight emerging market equities. If you think about the fact that during the second and third quarter emerging market economic growth in aggregate was below that of developed market economic growth.

That’s not an environment where you want to be overly aggressive in emerging markets. If you look at earnings, just keep this in mind, that the S&P 500 continues to notch record high earnings.

Earnings for emerging markets peaked in 2011 and have been on a steep slope downward since then. That’s not an environment to be overly aggressive in emerging markets.

I will tell you that if you’re going to invest in emerging markets, we do continue to favor the Asian emerging markets over the Latin American emerging markets.

Theme number nine, equity sectors. I know Owen will discuss this a lot more. I will tell you that our favorite sectors right now are technology, consumer discretionary, and financials. And the primary reason for that is that by our preview those three sectors have the highest growth in earnings estimates for 2016. And that should take those sectors higher.

One sector that we will look for buying opportunities in is going to be healthcare and the reason for that is that I expect to see a lot of political rhetoric around the pricing of pharmaceutical and medical devices. That will likely lead to buying opportunities and I would use them as buying opportunities because longer term healthcare remains one of our favorite sectors longer term because of the demographics and the visibility of earnings going on for years should continue to drive that sector.

And then the final theme is crude oil.

If you look at our forecast for oil, our energy analyst has oil prices moving up to $50 to $55 by the end of this year.

To me, the more important story is what impact does that have on other sectors and asset classes? I will tell you that when it comes to the energy sector in the equity market, our analyst believes that by his models that the energy sector right now is pricing at a price of oil between $55 and $58.

The importance of that is unless oil goes from where it is today, $34, up to $55 to $58, that means that there’s likely going to be further downward revisions in that sector. So as a result, we remain neutral in the energy sector.

One place where a rally to $55 would benefit, that would be in high yield because there has been a very tight relationship with the fact that as oil prices have fallen, you’ve seen significant and dramatic widening of high yield energy spreads.

So conversely if energy prices do ultimately rally, I would expect those spreads to narrow and high-yield bonds and more specifically energy bonds to outperform.

And then the other area that I think $55 would benefit would be master limited partnerships or the pipelines. Pipelines and MLPs had a terrible year last year. Over time, they remain much more dependent on volumes.I think volumes will continue to be healthy. If in fact energy prices move higher, I think that’s the catalyst to see a rebound in that sector in 2016. So that’s an area that we do like.

And with that I will turn it back over to you David.

David Wertheim:OK terrific Larry. Thanks so much and for all of the participants on the line, we will be opening up the call to questions after we hear from our next two speakers. So Larry thank you very much for the review of your 2016 outlook which will be available for all our client partners.

With that, I’d like to transition over to Owen Fitzpatrick. Again, our lead portfolio manager of the Deutsche Core Equity Fund and the Deutsche Capital Growth Fund.

I was hoping you could introduce the audience to your thematic view of the world, how it aligns with Larry’s outlook, and what parts of the market you see the most opportunities for moving into 2016.

Owen Fitzpatrick:Great thanks David.

So just reinforcing what Larry had to say in relation to a top down aspect from an equity perspective, some of the things that we’re facing and the two that had the biggest impact in 2015 and we’ll see that also filter through here at least at the beginning of 2016, and that being kind of the impact of FX. The strong dollar.