Central Bank Policies
Following Mario Draghi’s statement made at the December meeting of the ECB, the global macroeconomic environment should be dominated by a dichotomy of central bank policy this year. On the one hand, the December 2015 rate rise by the U.S Federal Reserve and 2016 rate hike schedule should tighten conditions in the world’s largest economy; one that had been at near zero rates of lending for almost a decade. In addition, the United Kingdom’s Central Bank governor, Mark Carney, has suggested that British consumers should expect a rate rise at some stage owing to a period of solid economic conditions and firm wage growth.
On the other hand, loose monetary policy in Japan and the Eurozone are fending off the threat of deflation and hoping to stimulate growth in these stagnating economies. The clearest sign of these policies has been observed in the forex and bond markets, hopefully supporting the export markets in these countries and keeping borrowing costs very low (and negative in a number of circumstances!). Furthermore, China has also kept its monetary policy very loose, in the wake of weak growth. We don’t see this policy reversing in 2016 as the full effects of the policy changes work their way through the economy.
Government Borrowing Costs (10 Year Bond Yield) – Increasing Order of Perceived Risk
The growth story this year should come largely from economies which rely on domestic demand and the export of services to advanced economies. Commodity countries can expect tough headwinds as the demand for their product subsides. This is covered in more depth in the ‘Commodities’ section.
Advanced economies with loose monetary policy can expect a pickup in consumer expenditure as the low to negative interest rates incentivises consumers to spend instead of save. Exports should also experience a net increase due to weaker exchange rates, however this is predicated on the assumption that their trading partners come to the table with a demand for these goods. Regarding this, the major trading partners for Europe and Japan are the United States and China, which are both set to grow this year, albeit at a slower rate than previously for China.
We don’t think that 2016 will be the year of the developing country, however certain countries within this broad group that are not reliant on the export of commodities should continue to grow at a healthy pace. India should outpace China next year as the fastest growing large economy as they are well positioned for the forthcoming economic climate.
Net Commodity Exports as % of total GDP (2010-13 Average)
Source: The Economist
The huge amount of supply in the market combined with flat to decreasing commodities demand has resulted in a sell-off in the commodities market. As of writing, the Bloomberg Commodity Index had hit its lowest level in 16 years. We expect that 2016 shouldn’t be much better for commodities, as producers adjust their capital expenditure while producing as much as possible from existing plants in an attempt to maximise revenue. This is effectively what is prolonging the slump at this stage and we expect this to persist at least until the end of this year.
Bloomberg Commodity Index - 16 Year Performance
The impact of cheaper commodities serves to reduce the input price in goods, reducing their cost. This is one of the key causes of the ultra-low inflation environments in Europe and Japan.
Furthermore, the price of oil has continued its decline lately, as more and more production enters the market. We suspect that the global oil market should continue to be oversupplied this year. OPEC recently elected to abandon their previous production target, instead producing more in a desperate attempt to put U.S Shale out of business. On that score, while rig counts have been dropping and prospective capital expenditure cancelled, the efficiencies that have been achieved in shale oil production mean that production has been increasing and the marginal cost falling. Therefore it is still in the best interests of existing producers to maximise revenue by continuing to pump oil. For this reason, we do not expect a change in the oil market in 2016, at least from the supply side.
A key risk to this assessment is, however, geopolitical instability in the Middle East. Most recently, with the execution by Saudi Arabia of a prominent Shiite cleric (and the subsequent cutting of diplomatic ties between Iran and Saudi Arabia) fanning the flames of tension between Sunni and Shia Muslims. The situation could degrade significantly, prompting worries about supply from OPEC’s largest producer.
On the demand side, China’s November demand did increase by 11%, however this could be largely attributed to strategic reserve building by the National Petroleum Reserve. The IMF predicts that the world economy will grow at 3.6% this year, half a percent greater than 2015. This should support demand for oil somewhat, but in our view the supply side is the key driver.
We suspect that the U.S Dollar is overvalued and may well begin to decline in strength on a trade-weighted basis starting in the second half of 2016. This view is based upon the real effective exchange rate for the Dollar which is overvalued by historical standards. Commodity currencies can expect to remain weak, in the absence of further central bank actions. The Yen and Yuan should continue to be weak currencies this year as the stimulus measures persist and the Yuan gradually moves to free float against the U.S Dollar.
The Euro’s path is not so clear-cut, however to the extent that the European Central Bank ramps up their Quantitative Easing Programme to try and stimulate inflation more than the market expects, we expect the Euro to weaken on a trade-weighted basis. On the other hand, the market does discount their future expectations; if economic conditions in Europe surprise to the upside then the Euro should strengthen.
Euro vs USD – 5 Year Performance
While U.S equities had a turbulent 2015, we suspect that they may once again stay flattish in the year ahead due to their already ambitious valuations and the impact of a gradual monetary policy tightening cycle for 2016. A bizarre aspect of this turbulence is that a large contributor was the steadily falling oil price. However, economic theory would suggest that a decrease in the oil price would serve to increase the disposable income of the average household and therefore have a net positive impact on the economy. Even after removing energy stocks from the S&P 500, performance was still flat. To the extent that the rout in the oil market was demand driven, then this situation would make sense as lower demand means less growth. However, as mentioned in the section titled “Commodities”, we feel that the oil market drop is supply-driven.
As growth picks up in the U.S and unemployment falls even further, we expect slight inflationary pressure moving up to the Fed’s target of 2% over the medium term.
U.S Unemployment Rate Since 2009
European equities should perform well in local currency terms this year as the Eurozone economy gains growth traction and the effect of cheaper commodities transmitting to the price of goods ideally stimulates demand. There is no guarantee the Euro will weaken further this year, as its value may reflect the effects of monetary policy already and it is likely too weak against the dollar currently. Our view is that the Dollar’s strength is out of line and should weaken over the coming years.
Asian and Asia Pacific equities should be led by India in 2016. Accommodative monetary policies should buoy growth and reduce the risks of hard landings. With China being a major consumer of Japanese, South Korean, Hong Kong and Australian exports, these countries are likely to feel the pinch somewhat. However, to the extent that the Chinese consumer is strong in 2016, many of these countries (barring Australia as a commodity exporter) may fair quite well. India derives a mere 5% of export demand from China and the rest primarily from the European Union and the U.S. We suspect that with monetary easing in the one and a very high purchasing power in the other, Indian exports should do well this year.
U.S Real Estate will likely continue to strengthen this year, as growth continues. There should be a muted impact from a rate rise as it is a very small increment (1/4 of a per cent). Furthermore, the reducing unemployment and strengthening wage levels in the U.S bodes well for growth in rentals. Internationally, Real Estate should generally benefit from very low interest rates, particularly in the Eurozone. The influx of migrants may prove to have an upward effect on property demand, and the low mortgage rates should entice buying. Commercial Real Estate may see some pick-up from the low rates and favourable expansion opportunities, as well as weakening exchange rates and hopefully increased economic activity.
In terms of distressed equity, Greece looks to be a very compelling long-term holding. The first review of the bailout programme, where the creditors will evaluate the progress Greece has made in implementing the bailout package reforms, should be completed by the end of February. The completion of this first major hurdle is likely to increase confidence and allow the go-ahead for further reforms and bailout funds. By mid-2016, the market can expect a lifting of the financial sector capital controls and a return to normality for banking operations. The long-term outlook will then be a return of Greek equities to their fair value as the (over-estimated) political risk subsides.
If the climate change summit that recently took place in Paris has told us anything, it is that world leaders are starting to unanimously worry about their reliance on carbon. While renewable energies are certainly receiving a lot of attention, the dialogue is increasingly focussing on nuclear strategies. While a few countries are very much anti-nuclear, the general consensus appears to be that nuclear energy is a necessity as it does not produce carbon emissions and is also a reliable source of baseload energy. The global sentiment change toward nuclear as a realistic, environmentally conscious form of power should continue to gather momentum this year.
Carbon Dioxide Measurements – 2005 to Present
The rise of the Chinese consumer began in 2015 as the world took notice of China’s economic transition from investment-led growth to domestic consumption-led growth. Furthermore, with the recent abandonment of the one-child policy, China’s demographics will be supportive of increased consumer spending in the coming years. The key variable underlying Chinese demographics will be the fertility rate in China, which the government is officially attempting to boost.
The growth in the Indian economy is one of the major stories for 2016, as the world looks to the country that has overtaken China as the fastest growing large economy. With further economic reforms in the pipeline, strong demographics and favourable geographic trade compositions, Indian services may prove to be an excellent investment; comprising 35% of total exports. In addition, with the government focus on infrastructure investment for 2016, Indian construction could also provide significant upside.
With healthcare outperforming all other sectors in the U.S for the past 5 years, the question is whether this will persist throughout 2016. One of the important determinants of healthcare demand is demographics – the older the population, the more demand we expect there to be for healthcare. With the steady aging of the baby-boomers, the United States’ demand for healthcare should continue to grow. Healthcare is a very touchy subject in the U.S due to its extreme cost and lack of public provision; the question for investors is whether government policy will have a downward impact on healthcare companies. Investors largely judged Obamacare as being very positive for healthcare companies, as the spectacular growth coincided with the policy’s enactment. Taking less of a focussed approach, a good investment may be in global healthcare, as demand continues to come from aging populations.
In conclusion, we expect that 2016 may deliver slightly positive returns from global equities as underlying fundamentals catch up to market valuations. The commodity market rout, including the oil market, should persist as the slow moving supply-side attempts to adjust to the market conditions. In light of this, volatility may be a lot more prevalent than it has been in the past few years, with several wild sell-offs already being experienced on the Chinese stock exchanges. However, pockets of opportunity will present themselves as solid and dependable industries are sold off amid the fear. We expect the big themes of climate change, the Chinese consumer and Indian economic growth to gain momentum