With the end of the year fast approaching, it’s time to write about market expectations for the new year in addition to reviewing developments over the past 12 months which will be tackled over the next few articles.

Over recent days, many international research houses have published their predictions for 2016. This article will endeavor to summarise the various views among the main international economists.

Following the much-anticipated interest rate hike by the Federal Reserve last week (the first interest since 2006), which came a week after the announcement of additional monetary stimulus by the European Central Bank, the key theme that will influence markets during 2016 is undoubtedly the monetary policy divergence between these two central banks.

The Fed and the ECB are moving in opposite policy directions as the US economy is strengthening while Europe is struggling with tepid growth, high unemployment and anaemic inflation which is far below the ECB’s target of two per cent.

Officials of the Federal Reserve claim that strong growth across the US economy will allow rates to rise “gradually but steadily” over the next 12 months, to a median forecast of 1.375 per cent by the end of 2016 – indicating three or even four additional increases of 25 basis points next year.

Meanwhile, immediately following the ECB announcement, the ECB president stated that “there is no particular limit to how we [ECB] can deploy any of our tools”. Draghi confirmed that, if required, the ECB’s mandate would intensify efforts to support the eurozone economy and boost inflation toward its two per cent goal.

So how is this affecting market predictions for next year?

Most economists predict that the euro will continue to weaken towards parity against the US dollar. One investment bank in particular believes that the euro will weaken to as low as $0.90 which would prove to be benficial to European exporters and equity markets in general. The general consensus among various analysts is that European equities will continue to outperform US equities, as favourable foreign exchange movements are expected to support upward revisions in European corporate earnings forecasts for 2016 and 2017. Moreover, European equities are more attractively priced than US equities and various analysts claim that while Europe is still considered to be at an early stage of an economic revival, the US economy can stall in an increasing interest rate environment.

Many local retail investors experienced the most volatile year in the bond market ever. The significant rally in Malta Government Stock prices during the first four months of the year and the subsequent decline in May and June was followed by intense volatility from one week to the next in the ensuing months. Since movements in MGS prices are based on eurozone yields, local investors need to bear in mind international bond yield predictions for 2016.

Significant volatility throughout the year

Most analysts believe that bond yields will continue to edge higher during the course of 2016 with the benchmark 10-year German bund yield rising to between 0.9 per cent and 1.1 per cent. Their rationale is that in view of a series of interest rate hikes anticipated in the US leading to higher yields especially when compared to present German bund yields, investors would switch out of European bonds and into the higher yielding US bonds.

This would result in a decline in eurozone bond price and a corresponding increase in yields. Additonally, by the end of 2016, they believe that the market is likely to begin to anticipate the end of the ECB’s QE programme which is currently expected to last until March 2017. This would imply a decline in bond prices given current yields at around 0.60 per cent.

On the other hand, in an article published recently in the Financial Times, the global head of fixed income research at HSBC explained the rationale behind his expectations for yields in both the US and the EU to decline in 2016 rather than edge higher. He expects a rather unconventional outcome with the Federal Reserve possibly reversing its tightening policy due to declining inflation expectations and weaker forward-looking data. In the EU, he expects the benchmark 10-year German bund yield to decline to 0.2 per cent by the end of 2016 which would translate into a significant increase in bond prices from current levels. A rather contrarian view to that of other analysts.

The main focus during 2016 is therefore likely to be on the monetary policy decisions that the European Central Bank and the Federal Reserve will announce, and to what extent these will differ from current expectations. The ECB disappointed markets two weeks ago with its decision to reduce the deposit rate to -0.3 per cent and to extend the current QE programme until March 2017. Many analysts had predicted an even sharper decline in the deposit rate and not only an extension of the QE programme but rather an expansion in the size of the bond buying from the current €60 billion per month to between €75 billion and €80 billion. Further developments on this front are therefore likely to impact equities, bonds and currencies over the course of the next year.

Some analysts predict that monetary stimulus across the eurozone could be extended further in 2016. However, with data indicating that growth across many eurozone economies is indeed picking up and with the euro largely anticipated to stay weak or indeed weakening further, the need for more action from the ECB should abate. In fact, one investment bank in particular claims that during the second half of 2016, the ECB will begin to discuss the merits of a tapering, i.e. a reduction of the QE programme for 2017. Such changes in Central Bank policy expectations will likely translate into significant volatility throughout the year.

Last week’s interest rate lift-off by the Federal Reserve could unsettle financial markets during the course of next year if the Fed tightens monetary policy more than expected (the markets seem to be pricing in just two interest rate rises next year but Fed officials are mentioning four) or if other central banks follow the Fed’s example. The prime contender is the Bank of England which is widely expected to start raising rates between the second half of 2016 and the first half of 2017, depending on the timing of their referendum on the EU as well as on the basis of data on the British economy.

Amid clearly diverging monetary policy in the US and the eurozone, the EUR vs USD exchange rate is widely expected to move further towards parity, albeit with some volatility, in 2016. If this continued devaluation in the euro materialises, it would be very beneficial for the eurozone as it would boost exports across the region.

One bank in particular has a contrarian view on currency movements. They expect the euro to strengthen significantly against the dollar with a forecast of $1.20 by the end of 2016. They are of the view that given the continued weak inflation outlook, the Federal Reserve will need to pause or even revert back to looser monetary policy during the course of next year leading to a weakening of the US dollar.

The ongoing differences in the views of some of the major central bankers will bring about significant periods of volatility next year including possibly sharp movements across equity, bond and currency markets. Investors should therefore brace themselves for a very challenging year ahead.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

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Edward Rizzo is a director at Rizzo, Farrugia & Co.