Prospects Not Good for Major Pickup in Global Economy

23 Dec 2015 | Author: | No comments yet »

A Brighter Outlook for 2016.

2015 has been a year of waiting, worrying and sideways markets. After nine years of rate slashing, emergency stimulus measures, quantitative easing and leading investors on the merry-go-round, the Federal Reserve has finally decided to put up interest rates last night. In fact, with delightful symmetry, it was seven years to the day since the Fed slashed rates to basically nothing, in an attempt to ward off financial Armageddon. A lot has happened since then and I think we can all breathe a mighty sigh of relief that the nonsense is over, although doubtless investors and commentators alike will now immediately start to focus on when the next hike will be. Well, it can’t be as boring as the last eighteen months or so and we suspect that much of the debate will focus on inflation, where there might be a few surprises ahead.

In particular, while participants in the Fed’s December meeting expected a gradual 1% rise in the federal funds rate in both 2016 and 2017, futures markets are only pricing in tightening at half that pace. In fairness to Janet Yellen, she has had a thankless task over her tenure as Federal Reserve Chairwoman, which is easily evident in the pushes and pulls she faced over this latest decision. Yellen has had to weigh up the fact that the US economy is growing solidly (but unspectacularly) at the same time as global growth slowed (temporarily) during the summer. I am sure the Fed, like we have been, have been soothed to a certain extent by recent data out of China, Europe and Japan which shows that growth is OK and most data points have at least stabilised, with some notable improvements, since the summer lull. Moreover, despite the market’s skepticism, we believe the Fed will follow through on its projection of a further 1% increase in short-term rates next year.

Based upon our current forecasts for both global and US growth, we would agree with the Fed that a further four hikes next year, in effect one a quarter/at alternate meetings, is most likely. Our confidence in this has been boosted by three important events in recent weeks, namely, lower oil prices which should help consumers, fiscal agreements in Washington that should boost government spending and incentivize greater capital spending, and the Fed rate hike itself, which should add to consumer interest income more than consumer interest expense. My simple “the morning after the night before” view is that this is a positive sign; to have delayed might have led investors to believe there was something nasty they hadn’t thought about lurking in the shadows, most likely in the credit markets. This sharp decline in unemployment in response to modest GDP growth has been due to slower productivity growth and a decline the labor force participation which we expect to persist, causing the unemployment rate to fall to close to 4% by the end of 2016, far below the 4.7% rate that the Fed projects.

The Fed’s life is made much more difficult because they are effectively setting the risk free rate for the world and influencing the world’s omnipotent currency. Linked to my above comments on the dollar, Yellen will recognise that some soothing of commodity markets would be welcome, not least as it will aid the Fed in the previously futile attempts to get inflation back to 2 per cent. Of course, the sceptics (and I am one of them) could retort that economies tend to have life cycles of their own and the Fed’s meddling could have been counter-productive at times, but the Fed is raising rates with housing starts at a seven year high, auto sales at a ten year high and employment approaching the mark denoted by the Fed themselves as “full employment”. However, with some heavy-handed intervention, the Chinese government has succeeded in stabilizing the stock market and, after a small devaluation, the PBOC has halted further renminbi declines. Without wanting to come across all “galaxy, far, far away” on you all, but the inflationary force has awakened in the US and this will have ramifications for financial markets.

The collapse in oil prices in late 2014 was due to three factors: a slowdown in global demand, a surge in U.S. production and a decision by OPEC to maintain market share rather than cut production. Over the recent past inflation has been suppressed due to significant slack in many global economies, a lack of wage pressure due to persistent levels of unemployment from the financial crisis and a collapse in commodity prices. Firstly, we are approaching what we would consider to be “full employment” in countries such as the UK, Japan and Germany, as well as the aforementioned US, meaning that both the slack in the labour force has been evaporated and there will be rising pressure upon wages. Because of this, it is now expected that global oil inventories will continue to rise in 2016, although more slowly, postponing any significant rebound in prices, with a similar story playing out in other major commodity sectors.

Our belief that commodities are approaching their low points is perhaps more controversial, but we can envisage prices rising next year, as demand stabilises and grows, the efforts to curtail supply by the resources industry take effect and evidence that China is enjoying a moderate economic improvement. As described already, we expect the Fed to use this as one of their key guides to future rate hikes and they will try to ensure that price falls are contained. As we discussed at length at our quarterly investment committee meeting last week, our forecast is for US inflation to start to rise more quickly than investors anticipate and markets are pricing in. Even the latest el Nino wildcard could add to our forecasts, which are currently 50bps higher than market forecasts (priced in to TIPs) and 10 year consumer inflationary expectations.

This gives us great confidence that the inflation-proofing philosophy we have held at the core of our process since we started our business in 2002 will once again prove to be a positive driver behind investment performance. U.S. high-yield bonds may offer more opportunities however, outside of the energy and materials space, in an environment of now relatively high credit spreads and good U.S. economic growth prospects. EM stocks are now quite cheap from a valuation perspective while European earnings should continue to recover in line with an improving European economy.

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