2015 looks likely to go down as a year to forget for many investors, and 2016 may bring only slight improvement. Developed markets equity valuations have not moved materially over the past year, and earnings expectations for the next 12 months are slightly lower than they were last December. The economic growth backdrop next year may be similar to that experienced over the past 12 months—a mild acceleration is expected across most developed economies, but this forecast is vulnerable to shocks from commodity prices, rate hikes, politics, and other forces. Central bank action is likely to again move sentiment if not underlying fundamentals, but as the third quarter correction demonstrated, it is unforeseen events (e.g., the surprise yuan depreciation) that typically spook markets most.

Twelve months ago we found ourselves constructive on Eurozone and Japanese equities given favorable valuations and earnings prospects, neutral on exposures like UK equities where earnings faced headwinds from high commodity and emerging markets exposure, and slightly bearish on US stocks given high valuations, a strengthening dollar, and stretched margins. While 2015 had twists and turns, as it nears a finish we feel many of these dynamics have played out as expected. In local currency terms, Japanese, EMU, and US equities returned 10.2, 7.2, and -0.3, respectively, year-to-date through December 11, while UK equities suffered losses (-9.0%), as inexpensive valuations were not enough to compensate for plunging earnings.

Valuations have not shifted materially for most of these assets as returns often tracked earnings growth. The consensus expects 2015 EMU earnings growth to be slightly above (11%) the current return when full-year numbers are reported, while weak US returns will correspond to flat earnings (total returns also include dividends). Relative performance may be similar in 2016 given that valuations have shifted little and that analysts expect earnings growth to be similar across most regions (US, Eurozone, and Japanese earnings are all expected to rise 7%–8%, UK earnings slightly less). Estimates are often subsequently revised lower, portending poorly for 2016 returns, though current forecasts are among the most pessimistic they have been in the past 30 years and set a lower bar for positive surprises.

Several wildcards could cause actual events to diverge from these expectations. A rebound in commodity prices would have a marked impact on UK equities as energy and materials account for around 19% of market cap. Given the 50% decline year-to-date in energy sector earnings was also a major drag on profits, a rise in oil prices could have a significant impact on US equities. A strong price rebound seems unlikely to occur in the near term in light of recent events, which include the chaotic breakdown of the OPEC meeting, surging inventory levels, and mild winter weather depressing demand. This said, with data suggesting that US oil production has peaked, demand on the upswing, and announced capital expenditure cuts by producers increasing (in part because capital markets are less accommodating), many forecasters expect (as they did 12 months ago . . .) that oil prices will stabilize and eventually tick up by the middle to end of next year.

Central bank policy and the related concept of currency movements are also likely to again be important for investors. Aside from falling commodity prices, the fear of rising interest rates has weighed on highly leveraged companies, especially in the United States. Should US rates rise more next year than expected or capital markets prove less accommodating, we would expect to see a disproportionately negative impact on small-cap companies given their higher leverage ratios. On the currency side, for many global investors (including those in the EMU and Switzerland), US equities outperformed local equivalents in 2015 due to the dollar’s strength. Most forecasters are expecting a continued, though more muted, US dollar rise in 2016, underpinned by the ongoing dovishness of central banks like the European Central Bank and Bank of Japan. We continue to advise US$-based investors with overweight positions in European and Japanese equities to hedge these overweight exposures, if not more, as currency exposures are ultimately a zero-sum game that serve mainly to add volatility to equity portfolios.

Wade O’Brien is a Managing Director on the Cambridge Associates Global Investment Research team.

For more on our 2016 outlook, see Outlook 2016: Do You Know Where Your Risk Tolerance Is?, published December 7.