A Goldilocks Year, not
too hot, not too cold is our central scenario for 2016, and it would look
something like this:
accelerates a little in 2016 to 3.5%, after 3.2% in 2015. Inflation in
developed markets (DM) recovers back to 2% targets, but more quickly than
expected in some, so the US and UK have to raise rates more quickly, and
further than expected. Europe stabilises, but the European Central Bank probably eases some more,
to address headwinds from China and emerging markets (EM), and to keep the
euro weak. Japan implements structural reform, (chiefly of labour markets,
including more equality for women, and looser immigration policies), and the
Bank of Japan eases further, once again to keep the yen weak.
Chinese growth eases
to 6.3%-the lowest since 1987 – so the PBOC eases further – two rate cuts,
totalling 50bp, plus 100bp off the Reserve Ratio Requirement, and the gradual
decline of the onshore yuan down to 7.00 against the dollar. Currency wars will
certainly continue unabated.
EM’s generally regain
their footing, and India does just fine, with CPI inflation of around 5%, and
real GDP growth of 7.5%.
Oil continues to fall,
but establishes a US$ 25-40 range.
Markets started the
year very badly, with Chinese markets collapsing from day one. Official Chinese
manufacturing PMI inched up to 49.7 in December versus 49.6 in November, while
the non-manufacturing PMI rebounded to 54.4 from 53.6 prior, but investors
were spooked by the imminent end to government curbs on stock sales, the
Saudi/Iran spat, and a quite rapid depreciation of the yuan in the first week
of trading, during which at one stage it had fallen by 1.5%. The onshore/offshore
Yuan differential widened to 0.18, (2.75%), showing international concern over
the yuan’s likely future trajectory and end-December numbers showed China FX
reserves tumbling much more than expected, to $3.33 trillion, from $3.44 trillion
the month before.
However, December’s US
employment report was very encouraging and, as I write, on 12th January,
international stockmarkets seem to have decoupled to a certain extent from the
Chinese market, which fell another 5% on the 11th. Although the Nikkei fell 2.71%
today when it re-opened after a day’s holiday, yesterday the Mumbai Sensex only
fell by 0.44%, the FTSE rose by 1.47%, the Dax rose by 2.53%, and the
S&P500 rose by 0.09%. Markets seem to be getting the Chinese stock market
In the absence of a
widespread EM crisis, Chinese market falls won’t stop the Fed in its tracks.
Even in China, the stock market plays a relatively small role in the economy,
with consumer and business confidence much less correlated to stock prices, in
contrast to the US, and hardly any correlation at all between stocks and the
real economy – we all know how difficult it has been to profit from Chinese
stocks over the last 20 years, despite the economy’s stellar growth. TV
footage of concerned investors in Shanghai gazing forlornly at a sea of red in
the markets really does give a very distorted impression.
Some fear that we are
approaching our third crisis in nine years – first we had the US mortgage crisis,
then the EU crisis. Is China next, followed by contagion to the wider EM space?
I don’t believe so. Firstly, China has enormous fiscal and monetary resources
at its disposal to revive the economy and to bail-out banks, and secondly
other major EM economies are by and large in a much better position to
withstand a harder landing in China than they were before the Asian crisis in
1998, with much larger FX reserves and much less prevalence of the currency
pegs which were one of the root causes back then.
But…there is still
plenty to worry about.
Chief amongst which is
probably the fact that the world’s most important central bank has just begun
tightening monetary policy, at a time when the next two heavyweights – the ECB
and the BOJ – are still actively easing and may yet ease further. To worry about
the fact that this kind of monetary policy divergence is often cited as one of
the major causes of the 1987 crash, (the divergence being the other way round
back then), may seem simplistic, but the reason one might be concerned is that
such divergence, in and of itself, is a stark reminder that the global economy
is very unbalanced – and so 2015’s lacklustre sideways markets may represent an
I do believe that
there is a much greater than normal chance that we are surprised by a ‘Black
Swan’ outcome, and I can think of two candidates.
The first is low growth, low
inflation, China disappoints dramatically, and the collapse in China’s FX reserves
continues or accelerates – which implies China is indulging in ‘quantitative tightening’. To raise the US dollars it sells to protect the yuan, it first
sells the US Treasuries it was holding – the opposite of the Fed’s QE, or
geo-political risks boil over, and so the Fed has to stop raising rates, or
even cut them again, and fight back with more QE.
The second candidate, and probably much
worse for markets, is that inflation rises much
higher than expected, driven mostly by surging wage growth, China does just
fine, the oil price recovers somewhat, peace reigns, and so the Fed has to
raise rates much faster and further than expected.
Private surveys and
models from the Atlanta Fed and ADP are already suggesting wage growth at 3.5%,
as opposed to the official figure of 2.5% and US bond markets’ break-even
calculations imply inflation expectations of just 1.65% over the next 10 years,
and 1.35% over five years. These figures all suggest ample scope for upside inflation
surprise and surging bond yields. Even in my central, Goldilocks scenario I
expect the Fed to raise by 100bp in 2015 and 2016, with the first hike very
possibly coming in March.
The second Black Swan
scenario, although still unlikely, seems much more probable than the first. So
how would markets fare under a) the Goldilocks scenario and b) the high
inflation Black Swan?
government bonds to suffer – conventional yields rise more than expected; US
10-year 3.25% at year-end, (currently 2.15%), vs. expectations for 2.75%. ?
protected bonds in US and UK outperform conventional. ?
corporate bonds have a ‘yield cushion’ already. ?
move sideways again – but I prefer Japan-P.E.’s of 15.5 are historically below ?average.
Favourable macro and monetary policies. ?
continue to under-perform. ?
Exchange – don’t ‘over-think’. Look for dollar strength; everyone else harbours ?currency
weakness as an ambition, but the Fed is not overly pre-occupied with the dollar,
as the US economy is relatively ‘closed’ – a 10% appreciation of the dollar
knocks only about 0.5% off GDP, and 0.3% off CPI, much less than in more
export-oriented countries, such as Germany and Japan. Long Indian rupee, short
the South African rand may also work well. ?
b) High inflation
· • Risk-free’ government bonds do terribly-US
10-yr 4.00% at year-end.
· • Equities
enjoy a volatile year and lose ground, as the bond market rout overshadows good
?news on commodity prices, including oil, and deflation fears disappear
· • Commodities, including gold, recover ground as
the global economy seems to be accelerating ?again.
· • This despite extreme US$ strength, with EUR/USD
revisiting lifetime lows at around 0.85. ?
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