How to Be the Ultimate Contrarian Investor in 2016

Break away from the herd.

Where Should You Invest in 2016?

It's hard to beat the crowd when you're a member of the herd.

To this end, we've compiled six ways investors can seek to escape the consensus Wall Street bubble by examining some of the more "out-of-the-box" calls for the year ahead. Be warned: It's difficult to be both different and profitable.

"Simple contrarian strategies can perform spectacularly well at big macro turning points, but they underperform the rest of the time," cautioned equity strategists at Citigroup led by Robert Buckland. "Most of the time it just makes you poor."

If your heart is still set on taking the road less traveled, here are the ways to do so in 2016:

From divergence to convergence

This year, Wall Street has been enthralled by the divergence trade—that is, the decoupling of the Federal Reserve from other major central banks and its subsequent effect on interest rate differentials and currency valuations.

But this theme may have been priced into financial markets too thoroughly when it comes to the U.S. and European Union, setting the stage for a convergence trade in 2016.

Count Deutsche Bank in the camp that considers the divergence theme near its best-before date.

"The end of 2015 is marked by the unusual combination of the Fed likely to tighten policy, while the [European Central Bank] delivered additional easing (albeit below heightened expectations)," wrote strategists led by Francis Yared in a report dated Dec. 10. "While this policy divergence could persist early in the year, there should be some partial convergence later in 2016."

"Using the Fed’s forecast of the U.S. unemployment rate and the ECB’s forecast of the euro area unemployment rate we are currently at peak divergence between the Fed and the ECB," added Torsten Sløk, Deutsche Bank's chief international economist, in a note published the following day.

Deutsche Bank's convergence trade recommendation is to buy 30-year U.S. Treasuries and sell German bunds of the same duration.

Bloomberg

Moreover, in accordance with the notion of "peak divergence," analysts at UBS expect the euro to end 2016 at 1.17, relative to the greenback.

“What we have been highlighting is the pricing is very extreme,” Themos Fiotakis, co-head of rates and foreign-exchange research at UBS’s investment bank, told Bloomberg's Simon Kennedy. “The market is pricing a remarkable confidence in a full Fed tightening cycle and on the other hand recessional conditions in the euro-area.”

The consensus among analysts surveyed by Bloomberg is for the euro to weaken in the first half of 2016 but to end the year virtually unchanged vs. the U.S. dollar.

Goldman Sachs, however, anticipates that the divergence trade has room to run in the foreign exchange market. In less than 12 months, Chief Currency Strategist Robin Brooks expects the euro to fall to parity against the greenback.

Ring 10 bells for the 10-year

In October, Steven Major, HSBC's head of fixed-income research, took a hatchet to his end-2016 U.S. Treasury yield forecast, making the team's call for the 10-year the lowest on the Street, at 1.5 percent.

Bloomberg

Major said that a soft global-growth environment, a Fed tightening cycle that will prove more gradual than the dot plot, and spillovers from accommodative policy deployed abroad should put a cap on longer-dated U.S. yields.

“Our lower yield views are part of an international story, one that sees the ECB stuck in dovish mode well beyond the end-2016 forecast horizon and headwinds from some emerging markets," he wrote.

Conversely, economists at CIBC World Markets, RBC Capital Markets, Raymond James, High Frequency Economics, and Amherst Pierpont are among a group that expects the 10-year Treasury to be yielding more than 3 percent at yearend 2016.

The median forecast among analysts surveyed by Bloomberg is for the 10-year yield to rise to 2.75 percent by the end of 2016.

Underweight health care

Health care’s rough patch in 2015 centered around certain key figures (namely, Martin Shkreli, Michael Pearson, and Hillary Clinton). But for Ian Scott, Barclays head of equity strategy, the reasons to underweight the sector in 2016 are more top-down in nature.

“Rising bond yields, inflation expectations and decent economic growth should see the hefty safety premium investors are paying for these sectors [health care and consumer staples] reduce,” he wrote in a report dated Nov. 19.

Based on historical correlations with the U.S. 10-year Treasury yield, the strategist found that health care tends to underperform when yields are moving higher.

For a global equity portfolio, Scott recommends exposure of just 3.1 percent to health care vs. the benchmark weighting of 12.2 percent.

In the U.S. in particular, Scott's peers are much more bullish on the outlook for health care. Equity strategists at UBS are overweight in the sector, citing its “earnings momentum, strong top-line growth, attractive dividend yield and potential for further share buybacks” in a report dated Nov. 10.

David Bianco, Deutsche Bank's chief U.S. equity strategist, concurs with that call. 

“We expect 6-per-cent sales growth from health care in 2016, well above nominal GDP and S&P 500 sales growth,” he wrote. “We expect 6 to 9 per cent EPS growth. We doubt the S&P delivers better growth.”

Bloomberg

Don't eschew the steepener

In the run-up to and commencement of liftoff by the Federal Reserve, the U.S. Treasury curve flattened, with yields on two-year sovereign debt rising, while its 10-year counterpart treaded water.

History is on the side of the flattener; the curve has tended to take such a shape prior to and amid previous tightening cycles. But Bank of America Merrill Lynch thinks this time is different.

"We have maintained that the curve flattener is the wrong structural trade for this hiking cycle," wrote Shyam Rajan, head of U.S. rates strategy.

The easing cycle that just ended, he noted, was novel in that the central bank's accommodative policy directly affected both the short and long ends of the yield curve. The private market will have to absorb much more duration than it did during the last cycle, according to Bank of America.

"The only reasonable rationale connecting the Fed to a flattener is the market pricing in a dramatic policy tightening mistake (beyond policy normalization)–an unlikely scenario where the Fed continues on its hiking path with the market pricing in pessimistic longer-term expectations," he wrote. "In our view, one of two scenarios will play out as to how the market will price the Fed in 2016 – slower (pace of hiking) and lower (terminal rate) path or faster and higher."

The consensus estimate is that the spread between 10-year and two-year Treasury yields will continue to compress in 2016. Strategists at Citigroup go even further, writing that strong employment gains could prompt the market to price in "a major flattening of the curve."

The Fed has indicated it will continue its reinvestment policy until the normalization of monetary policy is "well under way," a pledge that has helped support longer-dated Treasuries in the new regime's early days.

The Loon soars above the Eagle

No one could accuse Société Générale of being bearish on the greenback.

“The move may be more muted than over the past 18 months but the dollar will rise further in 2016—because it can,” wrote Vincent Chaigneau, global head of rates and FX strategy. “The U.S. economy is best positioned to withstand a strong currency, which will help contain home-born inflation.”

Among the world’s largest developed economies, the strategist sees one currency dethroning King Dollar in the year ahead. 

“The Canadian dollar is the only G10 currency we expect to outperform the U.S. dollar in 2016,” he wrote, forecasting USDCAD at 1.31 by the time 2016 winds to a close.

Bloomberg

Broadly, SocGen sees oil-related currencies recovering next year.

Conversely, Steven Englander, head of G10 FX strategy at Citigroup, warned that “there is a high risk that USDCAD will have to go well above 1.40 in the first half” in a report dated Dec. 6.

Morgan Stanley, for its part, expects USDCAD to end 2016 at 1.44, according to forecasts compiled by Bloomberg.

Growth > value redux

At first blush, it seems unusual to suggest that a portfolio composed of high-flying growth stocks could be a contrarian play.

But across Wall Street, strategists at Bank of America, JPMorgan, Barclays, and PIMCO are all bullish on value, looking for inexpensive stocks to outperform in 2016. This change in leadership will be grounded in firmer economic growth and a rising rate environment, according to proponents of value stocks.

Fundstrat’s Thomas Lee has gone as far to suggest that the FANG stocks—Facebook, Amazon.com, Netflix, and Google (Alphabet)—make for better shorts than longs in the year ahead, based on the historical performance of a previous year’s big winners.

Bloomberg

HSBC, however, doesn’t think a style rotation is in the works.

“2016 will be a ‘more of the same year’ as non-cyclical growth and momentum will be the key alpha strategies again,” wrote analyst Volker Borghorr in a report published on Dec. 11. “The world has not really changed with regard to style investing in the last three years and we doubt that 2016 will deliver a big swing.”

This view is aligned with the other key manner in which HSBC’s strategists are marching to the beat of a different drummer in 2016. They are calling for a substantial decline in the U.S. 10-year Treasury yield amid an environment in which growth remains relatively scarce.

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