The Blog

2016 - A Goldilocks Year?

A Goldilocks Year, not too hot, not too cold is our central scenario for 2016, and it would look something like this-

Global growth 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 stabilizes, but the ECB 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 BOJ 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 USD. 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, over 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 USD 3.33 trn, from USD 3.44 trn the month before.

However, December's US employment report was very encouraging and, as I write, on 12th Jan., international stockmarkets seem to have decoupled to a certain extent from the Chinese market, which fell another 5% yesterday. 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 stockmarket into perspective.

In the absence of a widespread EM crisis, Chinese market falls won't stop the Fed in its tracks. Even in China, the stockmarket 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 twenty 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 9 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 unstable equilibrium.

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; either-

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$ it sells to protect the Chinese 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.

Or, (probably much worse for markets)-

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 yrs, and 1.35% over 5yrs. 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?

a) Goldilocks

• 'Risk-free' government bonds to suffer - conventional yields rise more than expected; US 10-yr 3.25% at year-end, (currently 2.15%), vs. expectations for 2.75%.

• Inflation protected bonds in US and UK outperform conventional.

• But corporate bonds have a 'yield cushion' already.

• Equities move sideways again-but I prefer Japan-P.E.'s of 15.5 are historically below average. Favourable macro and monetary policies.

• Commodities continue to under-perform.

• Foreign Exchange-don't 'over-think'. Look for US$ strength; everyone else harbours currency weakness as an ambition, but the Fed is not overly pre-occupied with the US$, 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 Black Swan

• '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.