Investors seemed to breathe a sigh of relief when the US Federal Reserve finally announced a rise in interest rates at the end of 2015. Stock markets across the world enjoyed a much needed end-of-year bounce. The Fed’s decision was viewed by many as a mark of confidence that the worst of the economic problems brought on by the financial crisis are now behind us. But, as the nervous start to the year has already shown us, there are likely to be more bumps in the road ahead in 2016.

Concern remains over China

As we have already seen, perhaps the biggest concern for investors is that the deceleration in Chinese economic growth turns into a full-blown ‘hard landing.’ Investment spending has long been the engine of the Chinese economy. But residential investment could slow rapidly amid a downturn in the already over-supplied housing sector. And business investment could be reined in if the scale of the non-performing loan problem in the private sector turns out to be even larger than we currently expect.

The implications of this scenario for the Chinese economy are significant: interest rates could be cut to zero by mid-2017, and the renminbi would likely depreciate substantially. But this would not stop Chinese GDP growth falling below 3% next year. The wider effects could result in global growth slowing substantially and oil prices sinking further, preventing any rebound in global inflation. In this scenario, the US Federal Reserve (Fed) would be forced to reverse its December rate hike and would keep rates on hold until 2018. The Bank of England and the European Central Bank (ECB) would be forced to maintain rates at record lows for even longer.

Much still depends on the US Fed

There is also a possibility that markets become increasingly alarmed about the prospect of further US rate rises. Looking at US bond markets, it’s clear that investors anticipate few, if any, US interest rate hikes during 2016. This is at odds with the four hikes outlined by the Fed’s own forecasts last December.

Should US domestic strength more than offset overseas weakness, leading wages and inflation to rise more rapidly than we expect, then the Fed could well hike four, or even more, times in 2016. If the Fed fails to communicate clearly its intentions and the reasoning behind their decisions in such a scenario, then markets could react negatively. We could see a spike in global bond yields and equity markets tumble. A faster pace of US rate hikes than we currently anticipate would also be accompanied by a significant strengthening in the dollar. Together, these developments would hurt growth in the rest of the world – particularly in emerging markets (EMs) with large amounts of dollar-denominated debt.

Secular stagnation and the impact on EMs

Other downside risks are of a longer-term, ‘structural’ nature. Secular stagnation – a persistent weakness in demand that policymakers struggle to deal with and which leads to reduced investment and therefore weakness in potential supply – is a concern for many advanced economies. If this were to occur, the GDP growth of the world’s advanced economies would slow gradually, such that by 2020 it could be around 3% lower than in our current central forecast.

The hit to corporate earnings growth would see advanced world equity markets commensurably weaken as well. But favourable demographics and scope for catch-up growth mean that the EMs would be much less exposed to this risk. Indeed, in this scenario, investors would likely rotate out of the advanced economies into the EMs, giving EM asset prices and currencies a boost. Emerging market catch-up growth is by no means assured, however. Indeed, another of the longer-term risks is that large parts of the emerging world fall into the ‘middle income trap.’

In this scenario, the current slowdown in the EMs causes growth of the capital stock to slow, at the same time as anticipated structural improvements – such as increased labour market participation or crackdowns on bribery – fail to materialise. This combination could lead to a more persistent slowdown in EM growth, with the convergence towards income levels in the advanced economies ceasing. This scenario would see EM currencies depreciate amid widespread monetary policy easing. Meanwhile oil and other commodity prices would fall in the face of weaker demand, leading to slower growth in the advanced economies that are reliant on exporting commodities to the emerging world, most obviously Australia.

Looking on the bright side

Not all risks facing the global economy in 2016 are to the downside, however.

Oil prices have recently fallen to 11-year lows on the back of a steady increase in supply. And if oil prices remain at this level – or fall even lower – over the next year, consumers in oil-importing countries could benefit substantially. Increased real disposable income from what is, in effect, a tax cut could amplify the upturn in private sector activity.

Stronger demand means that, despite an initial decline in inflation below our forecasts, the Fed and other central banks eventually tighten monetary policy by more than we expect. Although commodity-exporting countries, such as Russia, would suffer, overall global GDP growth – and the level of most stock markets – would benefit during the coming year.

One forecast that we can make with certainty is that 2016 will throw up something – perhaps many things – which neither we nor others are expecting. But an awareness of some of the most likely risks, as well as a dose of realism about our inability to anticipate every twist and turn in the economy and in markets, should stand us in reasonable stead to navigate the year ahead.

Find out more HERE about Aberdeen Investment Trusts