Economic Insights – 03/12/2015

Towards the turn of the year

Maybe in the greyness of late November it is normal to want to hurry on into a new year but 2016 is going to start with a raft of unresolved problems carried over from this year. On the gepolitical front, Syria looks like getting a lot more complicated while on the macroeconomic front global growth looks as fragile as ever. Central banks are still acting as if they are in charge of something more than how investors will second guess each other’s reactions to the latest announcements and pronouncements. Making money in 2016 looks like being even more difficult than in this year of skittish volatilty. There are only 23 days trading left to add to/rescue/conserve any hard-fought gains of 2015 and few trends suitable for befriending.

Chart 1:  Worth following the money?


Chart 1 is of cumulative net investment into and not between US and European equity funds. The graph on the right is consistent with the outperformance of the major European stocks indices in 2015 after a relatively lean 2014 and in anticipation of an ECB-fuelled recovery. The recovery aspect is highlighted by Milan’s leading the way (see Table 2), which has more to do with its having fallen furthest than some sort of sentimental Italian connection with Mr Draghi. It is also interesting to note that it has taken 8 years to get back to the funding levels in Europe before crisis struck, whereas the inflows into the US after two strong years of stock market performance have gone into reverse in 2015, which again is consistent with US stocks’ stuttering progress in 2015. Where the money is going instead is a very good question. Some of it will have gone to Europe and some may well have stayed in the US in cash or bonds but much that found its way to Emerging Markets will have since returned, which again is reflected in the dismal performance of most EM indices throughout 2015. Even Chinese equities, despite all the official maipulation….er….support (the patriotic China Team may now own 6% of the market) ….look like ending the year badly hit by new scandals as well as profit-taking. It seems reasonable to doubt that US equities next year can continue to get the same support from share buy-backs at the same time as corporate earnings stand still. Any weakness there or elsewhere could fuel even more  M & A deals next year, albeit they will be pressed to match the sheer size of deals in 2015.

Chart 2 Global M & A: essential market support in 2015


Source Bloomberg via Financial Orbit

Whereas the ECB has so far fuelled only hope in European equity markets it is has already made investing in Eurozone sovereign bonds a bonanza for speculators (see Table 3), especially those willing to ride the convergence in yields of so-called ‘peripheral ‘countries. In fact, Greece excepted, the riskier the country hitherto the bigger the fall in yields. Good news indeed for punters on Italy (again!), Spain and Portugal!  A different sort of speculation, on interest rate hikes, has made investing in US Treasuries and, to a lesser extent, gilts much more problematic and also means the year is ending with a surge of corporate bond issuance in the US. Corporate debt has more than doubled in the US since 2007 while the interest rate burden has risen by a third despite average interest rate levels falling by a third. Unsurprisingly, around 50% of the corporate bonds around the world are ‘junk-rated’  with yields of 8% or more. The number of defaults in 2015 has reached 101 including 62 so far in the US and 21 in Emerging Markets. This is still some way short of the heavy defaults recorded in 2008-9 but nor is it a trend that will turn benign next year.

Chart 3 Heavy borrowing can seriously damage your health


Source FT

The real disaster area has, of course, been industrial commodities but grains have suffered too and even gold has slid to six-year lows (see Table 4). It has been a second terrible year for oil, which now seems to be settling into a $40-55 price range. This has in turn hit hard Emerging Market currencies, notably the real and the rand, and also the commodity-associated Australian, Canadian and New Zealand dollars. There is already talk that these are the recovery plays for 2016 but this flies in the face of economic fundamentals and sounds more like punters talking their own book.

The US dollar is still riding the prospect of the FOMC’s hiking in two weeks and its trade-weighted index has just touched again the witching 100 level. It has seen off all major challengers with the yen and pound holding up better than most, albeit for different reasons (see Table 4). The euro is by far the main casualty against the dollar and just about everything else except the oil-beleaguered Norwegian kroner. The odds of EUR/USD reaching parity are increasing but it will not be straightforward as many traders will be tempted to cash in their profits now that Thanksgiving is past. It could well happen in thinner trading over the peak festive season (and could well take with it GBP/USD below $1.50 again after its brief flirtation on November 30th). This appears to be what Mr Draghi wants, despite his disingenuous denials, but it could for many investors take the shine off gains made in European equities and sovereign bonds.

Chart 4 EUR/USD in November: half-way to parity


And it’s not over yet!

The saddest part of Syrian Crisis is that the plight of people who live there is being increasingly subordinated to geopolitical (=Machiavellian?) intrigue and even here in the UK to the future of the Labour Party. Oil still seems to be the main motivator for many of the protagonists, both in grubby (and dangerous) local trading and in the arcane alliance between Russia and Iran. On oil the US ought to be less interested but there appears to be a division between the more pacific White House and the still powerful NeoCons (=paranoid anti-Russian) elsewhere in Washington. As recriminations reverberate, it seems possible that ISIS has at different times received support from many previously unthinkable sources. What is definite, however, is that no support for ISIS has ever come from European governments, which rightly feel themselves the major losers from the crisis. It is not the suicide bombers and gunmen who are the threat to European stability but the waves of migrants, many of whom are not even from Syria. The first tests of public opinion come with the Spanish General Election, which should mean that Mr Rajoy stays in office (albeit in coalition) and the French Regional Elections, which should make a nice Christmas present for Marine Le Pen. The internal political, economic and social challenges will go on to overshadow not only 2016 but will shake the very foundations of both EMU and EU. No wonder Mr Hollande wants to tackle the problem at its root and is willing to work with anyone in doing so. No wonder that the UK government feels obliged to help and that so many Labour MPs see it as the point beyond which Messrs Corby and McDonnell are merely an embarrassment. There will, of course, be no winners in this terrible business.

As if they had not had enough air time already this year, December is the month of central bankers. First up is the ECB on Thursday with Mr Draghi playing ‘double but not quits’ by increasing and extending monthly QE asset purchases and taking rates deeper into negative territory. So far the Bundesbank has been both disapproving and acquiescent on such looseness and Mr Draghi probably feels he can just ignore the hawks. In fact, he had better not disappoint all the punters who have already priced in something dramatic. One technical hitch could be that if the ECB cuts the rate it pays on deposits by the banks to below -0.3% then there will not be enough German bonds eligible for purchase. So, another weakening of credit quality is looming. Perhaps Mr Draghi should go the whole hog by ignoring German bonds and start buying extra Italian and French ones! After all he is already on the escalator to underwriting all EZ sovereign bonds indefinitely. It is said that investors buying so many bonds with negative rates are banking on selling them on to ‘greater fools’. Any candidates, folks?

No sooner will the ECB have headed off further in one direction than the US November Labor Market data on Friday will almost certainly confirm that the FOMC will head in the other on the 16th. Only a complete undermining of the October numbers plus a slump in November Retail Sales (due on 11th) can stop the first hike now. However, it could well be the only hike for many months thereafter as the divergence with ECB and BoJ (meeting on 18th) could take the dollar to levels where Dr Yellen will meet resistance from her more internationally-experienced colleagues.

Just about every other central bank one can think also meets in December, including our own MPC on the 10th. This may be the occasion when the Committee discusses how their ‘macro-prudential’ colleagues (who reveal the UK Bank Stress Test results on the 1st) are planning to curb reckless borrowing (and lending) of both short-term unsecured personal loans and mortgages. This could be done by raising banks’ capital requirements thereby incurring costs that they would naturally want to pass on to their borrowers. This could be a cunning way to hike rates selectively to prick bubbles while going more slowly on Base Rates. It may also explain why the pound came under some pressure last week as hitherto it has been assumed that the MPC would follow the FOMC after a dignified interval. T

There are at least two ironies in all this central bank huffing and puffing. First, the CPI index in most major economies is likely to increase by around 1% in the first few months of 2016 as the main oil price slump drops out of the calculations. Dr Yellen et al may try to claim the credit but it is simply a matter of arithmetic and does not mean that prices are going up overall (although some in the Services sector will do so). Second, the central bankers still think that what they do will make a difference when the real problem is the slowdown in global demand, led by China but with knock-on effects both internationally and domestically. It really is time to recognise that the Emerging Economies are increasingly setting the pace.

  Chart 5 Memo to Central Banks:  Emerging Economies matter



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