Business cycle will drive equity valuations in 2016

The business cycle will be crucial for further gains in risk assets next year, now that the global tide of easy money that inflated valuations in recent years has crested, according to the BlackRock Investment Institute’s 2016 Investment Outlook.

Overall, the report counsels investors to pay much more attention in 2016 to the business, credit and valuation cycles, as the impact of the monetary policy cycle fades.

Read: 2016 to be ‘year of global adjustments’ for markets

With valuations no longer cheap and corporate profit margins under pressure in many markets, economic growth is needed to boost revenues. “We expect little or no price appreciation in fixed income and only muted gains for most equity markets in 2016,” the BII notes.

Valuations appear to have leapt ahead of the business cycle in many markets, especially in the U.S. “We have essentially been borrowing returns from the future,” the BII says.

“The outlook is made even more challenging because long-term trends such as aging populations, high debt loads and technological change are intersecting with short-term cycles, meaning that the high growth rates of the past may not return,” says Ewen Cameron Watt, global chief investment strategist with the BlackRock Investment Institute. “But the good news is that we see a modest pick-up in global growth and a renewed investor focus on fundamentals.”

Most equity markets have been running on empty in 2015, the BII notes, with multiple expansion (a rising price-to-earnings ratio) and dividends hiding “sins” such as flat or falling earnings. “The question for 2016 is whether, with global financial conditions slightly tightening, the markets can stand on their own legs,” says Russ Koesterich, global chief investment strategist with the BlackRock Investment Institute. “If companies are to grow earnings, a return to top-line growth is essential — especially for markets where valuations are high.”

The effects of movements in the U.S. dollar and oil prices will be critical next year, the BII believes. Further gains in the dollar would intensify pressure on commodity prices, emerging markets (EM) currencies and U.S. profits by making its exports less competitive. Falling oil prices have dragged down long-term inflation expectations and could encourage some central banks to step harder on the monetary accelerator.

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