Feature Stories | Dec 21 2015
This story was first published for subscribers on December 10 and is now open for general readership.
By Greg Peel
Central Banks
It is an unfortunate reality of the post-GFC world that movements in asset valuations have been less determined by fundamentals and more determined by global central bank policy. Fundamentals have certainly played their part – we need look no further than demand-supply imbalances forcing commodity price collapses, for example, but commodity price falls have been exacerbated in 2015 by a rising US dollar.
Which brings us back to central bank policy. 2015 has been a year dominated by the endless debate of just when the US Federal Reserve will implement its first interest rate hike in nine years, thus beginning a new tightening cycle. Late in 2014, most were convinced that cycle would begin in March. It didn’t, so June became the obvious choice. June came and went, so there was little doubt September would provide lift-off.
But it didn’t. 2015 has seen the highest level of market volatility since 2008 – the year of the fall of Lehman. We’ve seen commodity prices collapse, further. We saw Greece come very close to exiting the eurozone, again. We saw the Chinese stock market bubble and bust and a slowdown in the Chinese economy put the frighteners through markets. And we saw the Fed baulking yet again in September, thus drawing much criticism, because of global growth issues that have never been within the Fed’s mandate previously.
But despite all the volatility, equity markets are all currently set to end the year around about where they started. And now the world is convinced the Fed will raise in December. Really convinced this time. Emerging as the theme of 2016 is “When will the next Fed rate rise be?”
For indications, one turns to the famous FOMC “dots”. Each FOMC member provides a new set of dots each quarter, which mark on graphs forecasts for various economic indicators (GDP, inflation etc and importantly, the Fed funds rate) for quarters into the future. The Fed has been at pains to insist the pace of the policy tightening cycle beginning from the first rate rise will be much slower than in previous cycles. Indeed, the latest Fed dots suggest a path as half as gradual as previous cycles, Commonwealth Bank analysts note.
One can also derive the market’s own set of “dots” for the Fed funds rate using Fed funds rate futures prices. CBA notes the current implied trajectory of tightening implied by the futures is half of that of the FOMC dots, which is already half of that of previous cycles.
CBA believes the discrepancy will be used as a policy tool by the Fed in 2016. The Fed will hike in December, as expected, but lower the trajectory of the dots and thus stave off any latent volatility potential that might remain. Not lower by as much, however, as the futures are suggesting. Either way, in commencing a tightening cycle the Fed will introduce the first clear central bank policy divergence since the GFC.
China’s substantial official rate cut in October caused some surprise. The ECB delivered an extension to QE at its December policy meeting and although initially disappointing in quantum, ECB president Mario Draghi has reiterated his intention to do “whatever it takes”. Japan continues to keep its powder dry, but is retaining an already substantial QE policy. Many had expected the Bank of England to have raised its rate by now, but no one expected a hike ahead of the Fed. Expectations of a BoE rate hike have now been pushed out towards mid-2016.
The rest of the world is easing.
The Greenback
In 2015, both commodity markets and US equity markets ran into a strong headwind in the form of a rising US dollar, which undermined the value of commodities priced in dollars and undermined the earnings of US exporters. The US dollar rose on anticipation of the double-whammy of Fed tightening in 2015 and easing just about everywhere else. The easing part has proven right, but the tightening part has had to wait right up until year-end.
The dollar also rose on expectation that once the Fed tightening cycle began, it would look like every other tightening cycle. This meant a 25 basis point hike on day one, and then 25 point hikes at every six-week meeting thereafter until interest rates reached a “normal” level. We now know this is not going to be the case. Just join the dots. Therefore, there is a school of thought that the US dollar has already peaked, even as we await confirmation of a December Fed hike.
Of course there are two sides to every exchange rate equation, and on the other side, most other central banks are in easing mode. Hence there is upside risk to the US dollar index anyway. But what most analysts do agree on is that 2016 will not see as furious a rally in the dollar index as did 2015. Rebasing from January, that headwind will subside.
This is also good news for commodity prices.
Any End In Sight?
According to the data, the September quarter of 2015 saw some big inflows into commodity-based exchange traded funds following several quarters of outflows. It seems the bottom-pickers had begun to move in. Unfortunately for them, the timing was not so good. We’ve since seen both oil (WTI) and iron ore under the US$40 mark. Copper has continued to slide. Aluminium cannot gain any traction. The brief moment in the sun for nickel, thanks to Indonesian export bans, has well and truly turned into a dark cloud.
The question nevertheless remains: Just how much lower can commodity prices go?
2015 has proven to be the worst year for commodity prices since 2008. The good news is that 2015 also featured a strong rally for the US dollar, and that is not expected to be the case in 2016, at least in terms of magnitude. Aside from the rising greenback, the leading cause of the 2015 commodity price collapse was the realisation that China was slowing and demand was thus falling. A decade ago, when much of what is now over-capacity in commodity markets began to be developed, the theme was very much one of commodity “super-cycle” and “stronger for longer”. Some capacity – take LNG for example – actually takes a whole decade to develop. It is thus little wonder history is an ever-repeating cycle of commodity booms and busts as the demand-supply lag rolls ever on.
The “super-cycle” tag is now consigned to history. “Stronger for longer” has now been very much re-evaluated. That is not to say, however, that demand from China is reversing. One need only look at Australia’s September GDP result to note the strength in volumes of bulk material exports to China. It’s only the prices that bring the dollars, and thus the GDP points, down.
One might even cite Saudi Arabia’s stoic belief that a combination of US shale production and rising global demand (Read: China, and other emerging markets such as India) will force the stabilisation of oil prices in 2016, thus negating the necessity for OPEC production cuts. The pace of global demand growth has slowed below levels wildly assumed ten years ago, but demand is not falling – it continues to grow but at a more modest pace.
Which leaves the supply-side as the issue.
2015 has been a year in which the resource sector has madly embarked upon cost cutting programs. First to go were ambitious growth plans. Then came cuts to services outsourcing, which in Australia resulted in the collapse of mining/oil & gas service sector share prices. Then came efficiency and productivity drives (Read: job losses). Then came capex wind-backs. Then when nothing could stem the tide of falling commodity prices and resource sector earnings, finally came production cuts and mine closures. Take global resource giant Glencore’s late 2015 responses as an example.
It thus stands to reason that these cuts and closures and efficiencies will have to have some effect on the supply-side eventually. Citi is tipping mid-2016 as the point many commodity markets will begin to finally tighten. The sharp decline in US shale oil rig counts should, for example, begin to have a meaningful impact on oil production growth. Mining supply cuts could support a rebound for some metals.
But as much as the developed world rushes to force the end of plunging commodity prices and resource sector earnings, the elephant in the room remains China itself – not on the demand side, as the world has now come to readjust its thinking on Chinese GDP growth, but on the supply side. Steel production and base metal refining remain in a state of extreme overcapacity in China. Until this issue is addressed, the rest of the world can only do so much, without a lot of joy.
The China Conundrum
Back when “super-cycle’ was the mantra, no one was ever expecting Chinese demand could take a significant hit just from a government crack-down on corruption. Back in the days when the Kyoto Protocol dominated the world’s thinking on climate change, no one ever anticipated it would now be China leading the global charge towards renewable energy solutions. Shadow banking? What’s that?
The economic slowdown in China lends a lot to the government’s slow but determined progress on economic, financial and social reforms, designed, aside from anything else, to make China’s economy akin to Western economies and therefore ultimately dominant. Slow, but in many cases clumsy, it should be acknowledged. Take the government’s intervention this year into the Chinese stock market as an example, and the central bank’s sudden, sharp and globally disruptive devaluation of the renminbi.
Underpinning the government’s policy is a desired transition away from an export-led manufacturing economy feeding consumers in the rest of the world towards a domestic economic engine driven by over a billion Chinese consumers. At the same time, Beijing has to quietly deflate the Chinese debt bubble that began to accelerate in 2009. Fundamental to the transition is the need to tackle the issue of overcapacity in Chinese heavy industry, which to a great extent is the root of today’s weak commodity prices.
While Beijing has to date managed to kill off the “shadow banking” practice of using stockpiled commodities as collateral for loans, and has managed to close down capacity on the basis of heavy pollution and/or energy inefficiency, there remains a long row to hoe. And the government has to tread carefully.
As Morgan Stanley suggests, Beijing must act with consideration to social stability. Morgan Stanley believes the transition to a focus on growth in consumption and services is the right way to go, as does the general analyst fraternity, but addressing overcapacity will lead to slower wage growth, thus weaker demand for consumption and services and resultant deflationary pressures. In short, Beijing cannot simply close down a whole lot of loss-making nickel smelters, for example, overnight, and thus force widespread job losses, without a sharp economic and social impact.
It is on that basis Morgan Stanley has lowered its China GDP growth forecasts to 6.7% in 2016 and 6.6% in 2017. The broker believes Chinese growth will remain in a downward channel as Beijing tries carefully to manage the transition.
It must also be remembered, amidst all the angst over falling commodity prices, that there are two sides to every story. A big story for 2015, as perceived by just about every economist at the end of 2014, was the positive impact lower oil prices would have on the global economy outside of the energy sector, and particularly on the biggest economic driver of them all – the US consumer.
What went wrong?
The New US “Normal”
Morgan Stanley admits it was a mistake, a year ago, to underestimate the length of the lag between the lower oil price and its positive impact in certain market sub-segments. Morgan Stanley is hardly Robinson Crusoe in that regard. Corporate earnings in the US fell short of expectation in the September quarter, largely because of the strong dollar impact, but also because analysts were still anticipating a boost to consumption thanks to low oil prices.
Not all consumer sectors have failed to respond to low oil prices. Commentators have been gob-smacked every month in 2015 when US new vehicle sales numbers have been released. Cheap finance is one explanation, but oil prices clearly play a direct part.
Not so direct is the boost to general consumption thanks to the reduction in required household spending lower oil prices should have provided. This is where forecasts of a revived US consumer have fallen down. Perhaps one might suggest the GFC made so many US consumers so shell-shocked that they have vowed never to stretch their spending ever again. At least for a generation. Research from Alliance Bernstein actually supports that suggestion.
The years 2008-09, Alliance Bernstein notes, saw the most severe market-induced credit crunch since the Great Depression and in those two years US household borrowing unsurprisingly declined. In 2009 the Fed introduced QE and the US economy began to recover.
While economists expected US households to continue to de-lever for some time as the recovery progressed, the “normal” process of deleveraging results in borrowing growing at a slower pace than income growth. Never, Alliance Bernstein points out, has de-leveraging in a time of economic growth meant actual declines in borrowing. But in two of the past five years, the US experienced declines in household borrowing. Indeed, the 1.0% cumulative increase in US household borrowing from 2010 to 2014 represents the slowest pace of growth in any recovery post-War.
That, right there, might explain why US consumers have not redirected the benefit of lower petrol prices into greater spending as all were expecting. The GFC has provided a painful lesson in the benefits of saving.
Alliance Bernstein further notes that three of same past five years, US government spending declined. The 2.0% growth in government spending over the period 2010-14 represents, again, the slowest pace recorded post-War.
Put the two factors together and one could draw the conclusion that 2.1% US GDP growth over that period is “the new normal”, Alliance Bernstein suggests. There has been much talk post the GFC of “normal” growth having to be recalibrated down from those halcyon days pre-GFC. But because the pace of growth in household and government spending was so abnormal over 2010-14 in a context of 70 years, Alliance Bernstein suggests the parameters of “normal’ could again be altered in coming years.
A “new new normal”?
In the September quarter 2015, US household borrowing marked its largest quarterly gain since 2007. Five years of deleveraging and austerity have left US household balance sheets in much better shape. Economists were wrong to assume the US consumer would make a raging comeback in 2015 thanks to lower oil prices. But given oil prices are unlikely to return to US$100/bbl anytime soon, or ever, maybe 2016 will be the year the beneficial impact starts to translate.
The US government is about to embark on a massive multi-year highway and mass transit infrastructure program. Funds will be passed through to state governments, and onto local governments. Throw in a return to growth in defence spending, and Alliance Bernstein calculates US government spending could increase by 200 basis points in 2016 – which would mark the greatest acceleration since 1999.
Morgan Stanley has reduced its expectations for US corporate earnings growth in 2015 and 2016 from previous forecasts. The broker expects 4% overall growth in 2016. However, given US earnings growth in 2015 should come in at around 6% if the energy sector is excluded, and given energy sector headwinds will decline in 2016 (the oil price will not fall by as much again and the US dollar will not rise by as much again), Morgan Stanley suggests its 4% forecast could potentially be conservative.
The broker nevertheless forecasts only moderate price/earnings multiple expansion in 2016, due to muted economic growth and the Fed tightening cycle, to 16.6x. Plugging earnings and PE forecasts into the equation renders a 2016 year-end target for the S&P500 of 2175. At the time of writing, the S&P500 is at 2077.
UBS is on the same page. The broker believes that with equity markets trading at, or somewhat above, historical fair value ranges, the prospects for a material re-rating of stocks (increased PEs) are limited. Much of the returns to shareholders over 2016 will thus come down to pure earnings growth.
UBS also expects the impacts of a stronger dollar and falling oil prices to fade in 2016, thus adding in still-solid profitability outside the energy sector, overall earnings growth should revert to a mid to high single-digit percentage pace.
World in Transition
For UBS, 2016 is shaping up as one which will see the world in transition.
The US will transition away from an era of zero interest rates and zero inflation. It is somewhat discomforting to realise that there is a whole cohort of financial market traders, brokers and fund managers, with up to nine years’ experience, who have never experienced a Fed tightening cycle. Late next year also brings a replacement for Barrack Obama.
Europe has now constitutionally established a QE program. Europe continues to transition as a political and economic bloc, UBS notes, and this will bring new challenges at every turn.
New challenges indeed. At some time in 2016, some are assuming September, the UK will vote to stay in the EU or not. While most commentators assume a “stay” victory, a “Brexit” would cause major financial disruption. UBS would also have prepared its 2016 outlook publication before the Paris attacks, which, along with Syrian mass migration, create the real risk of the rise of far right nationalist parties across Europe.
China, as noted, is transitioning from a manufacturing-led economy to a consumption-led economy, but is also transitioning from a state-directed economy to a free market. Both these shifts will create uncertainty over China’s growth path, UBS suggests. Other emerging markets will need to find new growth drivers, the broker believes, and will likely be pressured by US interest rate hikes, which will draw US investment back home.
Globally, UBS’ 2016 portfolio allocation involves a preference for equities over government bonds, a preference for eurozone and Japanese equities, and for US investment grade credit.
Credit Suisse is among those expecting global growth to pick up slightly in 2016, to 3.4%, led by growth in the US and Europe and supported by an eventual but partial rebound in emerging market growth some time in 2016. Emerging markets will nevertheless remain a risk element until that time, and Credit Suisse is among those warning that while 2016 should be a year of modest growth, it will also be another year featuring episodes of heightened volatility.
As suggested earlier, we can all look forward to another year of pre-guessing the Fed. Assuming December finally brings a rate rise, 2016 will be all about predicting the next one. And the next one. Wall Street will be up and down wildly on jobs reports and other influential data releases, again. While much emphasis has been placed on the slow pace of the upcoming cycle, any anticipated acceleration to the cycle will prove disruptive, particularly for emerging markets.
There is little disagreement among economists that China’s rate of economic growth will continue to slow. There is only disagreement about just how “hard”, or not, the landing will be. Credit Suisse warns further monetary policy easing in China will not prove effective. UBS suggests China can “both slow quickly and avoid a hard landing”.
Credit Suisse also raises the issue of European political risk. Far right, anti-immigration nationalism aside, elections in both Spain and Portugal will reopen the austerity argument and again potentially threaten the eurozone’s stability.
Will Greece make it through another year?
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