“Cheers to a new year and another chance for us to get it right.”
Three years ago, the IMF projected that the world economy would be back on track by 2015, growing at 4.8 percent. To date, this forecast has been downgraded to 3.1 percent. It is reasonable to expect further global economic divergence in 2016: developed countries will stand on different phases of recovery cycles; China-led (manufacture-heavy) emerging countries will continue to combat deflationary forces, debt burden and excess production capacity; while Brazil-led (natural resources-dependent) emerging economies will fight against challenges of currency depreciation and capital outflows. Hence, this article illustrates three major macro themes that investors need to be aware of in 2016.
Fed’s Interest Rate Decision
The magnitude and pace of rate hike in 2016 will be closely watched. The Fed-funds rate projections suggest that the medium value benchmark interest rate will be 1.375 percent at the end of next year (see figure below). Since the Fed only raises interest rates a quarter of a percentage point at a time, this suggests that there will likely be four hikes next year.
On the other hand, Janet Yellen has quoted the Taylor rule in many occasions as the reference rule to explain her views on rate policy. An explanation can be found in her speech in the March:
“For example, the Taylor rule is Rt = RR* + πt + 0.5(πt -2) + 0.5Yt, where R denotes the federal funds rate, RR* is the estimated value of the equilibrium real rate, π is the current inflation rate (usually measured using a core consumer price index), and Y is the output gap. The latter can be approximated using Okun’s law, Yt = -2 (Ut – U*), where U is the unemployment rate and U* is the natural rate of unemployment. If RR* is assumed to equal 2 percent (roughly the average historical value of the real federal funds rate) and U* is assumed to equal 5-1/2 percent, then the Taylor rule would call for the nominal funds rate to be set a bit below 3 percent currently, given that core PCE inflation is now running close to 1-1/4 percent and the unemployment rate is 5.5 percent. But if RR* is instead assumed to equal 0 percent currently (as some statistical models suggest) and U* is assumed to equal 5 percent (an estimate in line with many FOMC participants’ SEP projections), then the rule’s current prescription is less than 1/2 percent.”
Suppose we adopt RR* of 2 percent, based on the latest economic projection by the Fed, the United State can reach the peak of the short term cycle and hit an inflation rate at about 2 percent by 2018-2019. As for the labour market, despite unemployment rate felling to 5 percent recently, labour force participation rate is also at its 10 year low with just over 62 percent. There is still room for labour force to reach full capacity, and we expect the Fed to complete the rate hike when unemployment reached 5 to 5.8 percent. Thus, overall we will get a Rt of about 3.2 percent. If we follow Fed’s existing pace of rate hike, the Fed may complete the whole rate hike cycle earliest by 2019. Of course, we need not be fixated by the assumption of a 25bp rise in each decision, since each decision will also be closely measured against economic performances in the world.
Emerging Market Risk
After 2008, extensive QE programmes adopted by the United State, Eurozone and Japan washed markets with liquidity and channeled excess fund to flow into emerging markets (EM). After the first Fed rate hike on last December, EM countries are now facing the pressure of capital outflows and hence depreciation pressure on their currencies. On the other hand, global economic slowdown and withering commodity prices continue to hurt EM countries through exports. Internal downward pressure exacerbates the depreciation stress. As such, investors need to be wary of potential debt and currency risks in EM countries and not to be caught off guard as we have seen from cases of plummeting Argentina’s Peso and Azerbaijan’s Manat.
In the short run, countries with relatively high foreign debt and/or low foreign exchange reserve face higher possibilities of capital run and would find it difficult to re-finance in the international debt market. For example, Brazil has the second highest dollar denominated debt in the world after China and will feel the pain of further “lift-off” by the Fed. Russia currently has a external debt to foreign reserve ratio of more than 100 percent; with sanctions and commodity headwinds, it will struggle to finance for government revenue if dollar is to strengthen further next year. In the long run, economic stability assessed by GDP growth rate, unemployment rate, inflation rate and private sector debt is a gauge to looming crisis. Roiled by conflicts, Ukraine’s GDP declined by 12 percent in 2015, distressing a government that is already running a budget deficit. South Africa, with an unemployment rate of more than 25 percent, is also exposed to risk of social instability and difficulty in fiscal management.
The unpredictable and untraceable geopolitical risk has been coming under the spotlight more and more frequently in recent years. Starting from the Ukraine crisis at the beginning of last year, the market has confronted a number of events such as conflicts in Libya and Syria, and the rise of ISIS. Sluggish economic has bred doubt and discontent of the vox populi, stimulating politicians to “flex their muscles” rather than to negotiate with regard to foreign affairs. Many of the Latin America countries rely heavily on exporting primary products: iron ore from Brazil, soybean from Argentina, and crude oil from Venezuela. Slumping commodity prices have slammed their economies and stirred up social discontent. For example, Moody has recently downgraded Brazil’s credit rating to junk on the basis of “worsening governability conditions and increased risk of policy paralysis,” after Congress opened impeachment proceedings against President Dilma Rousseff. In Argentina, the left also faced major electoral setback as Mauricio Macri won Argentinian election to end 12 years of Peronist rule. Under severe recession and failed austerity, the right-wing is transforming the political landscape in Latin America.
In Europe, the timing and outcome of the referendum on UK’s membership of the European Union is a key political risk. Although the best guess is that UK will remain in the EU, uncertainty abounds in the age of populism and volatility is unmuted. Should there be a Brexit, there will be a rebalance of power within the Europe Union, and possibly a rise of Paris or Frankfurt as financial centres in the cost of London. Moreover, investors will have to reconsider exposure to UK assets, trade and capital flows will also decline between Europe and the UK. These will likely exert an upward pressure on banks’ funding costs, leading to tightened credit conditions in the home market and downward pressure on economic growth.
2015 has been a very volatile year fueled with China woes, commodity market plunge and divergent monetary policies. According to Schroders, the volatility index was up 241 percent in 2015. Billionaire hedge fund investor Bill Ackman has told clients that 2015 could be his firm’s worst year ever. Similarly, Warren Buffett’s Berkshire Hathaway shares were down more than 11 percent year to date. In 2016, soft recovery accompanied by above-mentioned risks should be the main theme in the market. Nevertheless, investors can yield modest, yet steady returns on relevant assets if they do not chase for high returns blindly, but rather hold more realistic expectations for their investments.