The Federal Reserve is likely to drive Canadian equity performance in 2016 by determining the value of the loonie and, if current trends continue, commodity prices. Fed policy next year – the number of interest rate hikes – will reflect the strength of a U.S. economy showing decidedly mixed signals as 2015 comes to a close. To a significant extent, investors will be fumbling in the dark for the correct investment strategy as 2016 begins.
If it's true that in investing there are no certainties, only probabilities (and I vehemently believe this to be true), and successful portfolio strategy involves correctly assessing the relative likelihood of various market scenarios, Fed-centric markets mean the first half of 2016 will be very difficult indeed for investors.
The chain of causation from Fed chair Janet Yellen's decisions to Canadian portfolios goes like this: Higher rates means higher U.S. bond yields, a stronger U.S. dollar, a weaker loonie, declining commodity prices, and it is hoped stronger growth in Canadian exports.
The U.S. dollar doesn't determine commodity prices but reflects the global capital flows that affect demand for resources. Most importantly, investment dollars leaving China to buy Treasury bonds (to take advantage of rising risk-free yields) increases the value of the greenback, but also causes a decline in Chinese investments and Chinese commodity demand.
In recent weeks, the power of the dollar in commodity markets has been considerable. For all the talk of the ongoing glut of U.S. oil in storage, the West Texas Intermediate crude price has been far more sensitive to changes in currency markets than the weekly report on crude storage.
Outside of commodities, the most important Fed-related debate for Canadian investors concerns bond yields. Historically, the all-important five-year government of Canada bond yield (it helps determine the domestic mortgage rate) has closely tracked the five-year U.S. Treasury bond yield.
At this point, however, Canadian bond yields are well below U.S. yields because the U.S. economic growth outlook is much rosier than the domestic forecast. For investors, it would not be good news for Canadian bond yields to follow the conventional pattern and climb with U.S. yields. This would increase borrowing costs when the economy is sluggish and threaten the performance of dividend-paying equities.
I don't know how many times the Fed will raise rates next year and don't really trust anyone who says they do. As Gluskin Sheff's David Rosenberg wrote in a recent column for The Globe and Mail, "The U.S. economy cannot decide if it is strong or weak."
Roughly speaking, the odds of one hike (indicating a weaker than expected U.S. economy), two hikes (growth in line with expectations) and three hikes (growth is above current estimates) appear about equal.
Each of these scenarios has a different set of implications for Canadian investors. The weak U.S. economy and one rate hike combination, for instance, suggests minimal changes for the loonie but weaker Canadian export growth because of disappointing U.S. growth and consumption levels. It may also cause international investment flows back to emerging markets, which would support a recovery in resource prices.
The Federal Reserve, or more accurately the Federal Reserve's policy reaction to U.S. economic growth, will be the primary driver of Canadian equity performance in 2016, in my opinion. The Fed, of course, is a force outside of Canadian policy-makers' control, but Canadian investors should be used to that. The housing bubble was motivated by ultra-low interest rates imported from former Fed chair Ben Bernanke's policy, and China's monetary expansion and construction boom.
It's a cliché to note the future of markets is unknowable, but that seems particularly the case as 2015 comes to a close. Canadian investors should prepare their portfolios – perhaps with higher cash allocations – and themselves psychologically for a confusing start to 2016.
Follow Scott Barlow on Twitter @SBarlow_ROB.