Prospects still slim for major global economic pickup

23 Dec 2015 | Author: | No comments yet »

A Brighter Outlook for 2016.

2015 has been a year of waiting, worrying and sideways markets. In his 1997 book, “One World, Ready or Not: The Manic Logic of Global Capitalism,” William Greider likens the global economy to a great machine, complicated and powerful, capable of both great creation and great destruction — but with no one at the wheel.

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. Raising it essentially applies a brake to the entire economy, making it more expensive to borrow money for homeowners, small businesses, towns and school districts; depressing investment and, along with it, stifling job growth. In order to answer this question one must first recognise that the real source of cheap capital (and deflation) in the world is not the United States but China. 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. The problem is that such an investment effort cannot be sustained in an economy that has brand new infrastructure and suffers excess capacity in almost every sector.

There’s just one problem with the Fed’s decision to raise rates now, for the first time in nearly 10 years: There is no hill, and there is no bend at the bottom of it. 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.

Given the experience of former investment driven economies like Japan, it is reasonable to expect this rate to drop to somewhere in 35% range over the next decade. 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.

And even though the economy is chugging along far better than it was when the Fed reduced interest rates to the near-zero level where they’ve been for so long, it has yet to fully recover from the shock of a global financial collapse and the deepest recession since the Great Depression. In a ferocious column last September, New York Times columnist Paul Krugman said Federal Reserve officials talk to too many bankers, and bankers really, really want rates to go up.

The important implication from a global perspective is that the persistent gap between China’s savings and investment rates will generate excess savings that will show up as large current account surpluses. Sure, it’s cheaper for them to hold deposits, but bankers make money on the difference between what they pay on deposits and what they can charge for lending — what economists call the net interest margin.

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. He writes: “The appropriate response of policy makers to this observation should be, ‘So?’ There’s no reason to believe that what’s good for bankers is good for America. 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. But bankers are different from you and me: they have a lot more influence.” There simply is no policy argument that can prove that intentionally slowing the economy right now is a good thing for anyone but bankers (and people with very, very large savings accounts; though the impact on savings interest rates is liable to be tiny compared to what happens to mortgage rates and other borrowing costs). 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.

Therefore, theoretically it could ramp up its investment effort and absorb the excess capital (a consumption binge would also achieve this although one hopes that lessons have been learned from pre-2007 period). If the Fed keeps hiking rates under these circumstances, we will have a stronger dollar but not necessarily higher long-term rates for the rest of the world. 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.

It’s also worth noting that European high yield has much less energy exposure and vulnerability to central bank tightening than high yield in the U.S. 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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