The Outlook for 2016
by George Hatjoullis
This blog is best read in conjunction with the previous two. The purpose is to set the present gloom and doom in context. There are problems but there is tendency for the chattering classes to overstate the negative and ignore the positives. They do the opposite in bullish times. The chattering classes consist of the media in its various guises, and forecasters and strategists. The tendency to exaggerate arises because the rewards in this class of functions tend not to accrue to those that get it right but those that get themselves noticed. The tendency to exaggerate is thus built in.
Inflation and Monetary Policy
The most noticeable feature is an absence of inflation outside of a few countries. This may seem odd given how ‘easy’ monetary policy has been for the last 6 years. In part it reflects the bursting of the commodity and oil price bubbles. Huge investment in these sectors has created enormous capacity and only a slight dip in demand can have a disproportionate impact on prices. It is A-level economics. If the marginal revenue exceeds the marginal cost you may as well keep producing. Prices will keep falling until, globally, marginal revenue equals marginal cost. Of course, this is an oversimplification but it gives a flavour of what is going on. Over optimistic forecasts led to too much investment and now we reap the reward.
For most of the globe it is a reward. Lower oil and commodity prices raise margins in downstream production and eventually reach the consumer as lower goods prices. It will cause dislocation in some sectors as bond and shareholders face losses but unless these financial assets have been leveraged into the system in an opaque manner, as happened with sub-prime debt, it should not lead to a systemic problem. It is part of the normal ebb and flow of financial markets in a market economy.
The oil and energy complex of prices is particularly interesting because there is a structural element to the price fall. Alternatives are beginning to look viable and the social pressure to switch away from burning fossil fuels has reached critical mass. The long run equilibrium price of oil has dropped and quite a bit. No one can put a number on it yet but my guess is that it is below the present level. This does not mean we will not see some sharp jumps from current levels. It means progressively lower highs. This is going to have some large geo political consequences as oil and gas reserves are quite concentrated geographically. In 2016 it means most consumers will have more discretionary income especially in energy importing regions like Japan and Europe.
Another noticeable feature of major economic regions has been slow nominal wage growth. This has contributed to the absence of inflation and in part been sustained by the low inflation. In a market context, wages and inflation are in part jointly determined (in a heavily unionised context wages become exogenous). There has also been steady employment growth and the stable nominal wage growth may well have played a part. There does not seem to be any evidence that this scenario is changing very much so the growing pessimism seems a bit exaggerated.
My own view (as regular readers that have understood my blogs will know) is that the absence of inflation also reflects a structural change in the nature of money creation that has rendered monetary policy less effective. This arose out of the financial crisis and the clamour for banks to lose the too-big-to-fail status. The clamour has succeeded and bank money over and above the insured amount is no longer the equivalent of cash. It is a loan to the bank. It always was in principle but never in practice.
The maximum stock of money is now capped. It is capped by the number of separately licensed banks. It does not matter how much liquidity the CB pumps into the system, the amount of insured deposits possible is capped. National Savings in the UK offer another outlet but even this is capped. If the amount of genuine money (as opposed to commercial bank liabilities) is capped then inflation is constrained. It is clear from responses that few, if any, have properly grasped my observation so I repeat it as often as possible in as many ways as I can. [No doubt when someone in the public eye says the same thing it will be picked up. Getting myself noticed was never my talent].
One problem for the global economy in my framework is expanding the money stock. It is like being on the gold standard and there being a maximum amount of gold. Economising on gold (debasing the coinage) or monetary financing would solve the problem. However, I am not expecting this to happen in 2016. It is more likely that inflation will remain flat and maybe deflation threaten once again. Conventional monetary policy cannot effect this situation very much and might even make it worse.
The world has talked itself into balanced budgets and low government debt. The bias against government borrowing arises from the same taboo as monetary financing. It is rooted in a distrust of government and a desire to minimise the size of the state. Government activity typically redistributes resources from those that have them to those that do not. It redistributes from rich to poor. However, as poor people tend to spend most of what they have such redistribution tends to boost spending. So at a time that inflation suggests the economy is operating below potential, government policies are being focused on reducing demand. It is unlikely that fiscal policy will positively contribute to demand in 2016 unless it is to finance a war.
The aversion to government borrowing is ideological. Anyone that doubts this consider housing. There is clearly a shortage, especially in London. The government can borrow at 2.5% for 50 years. If it borrows to build houses and supporting infrastructure it will almost certainly reap a social return in excess of 2.5%. Indeed, whilst I have not done the sums, it will almost certainly earn a marginal tax return in excess of 2.5% over the 50 years. If nothing else it could let the properties for more than 2.5% yield! There is no reason not to be building houses and other infrastructure other than ideology. The government debt would be supported by a long term asset, namely the housing stock.
The acronym was coined by the strategist Jim O’Neil, now Lord Jim, to represent Brazil, Russia, India, China, and South Africa. Jim had a talent for getting himself noticed. Note this is two commodity producers, one oil producer and two consumers of both. Of the five I would suggest that India will fare the best in 2016. India is a services economy rather than a manufacturer and this is a still growing sector. The low oil and commodity price environment only helps India.
China on the other hand is a problem. It is in part the reason there is a problem. Exaggerated expectations of the growth of China demand for oil and commodities contributed to the investment boom. Moreover, even the most casual observer will have noticed that, in the last year, stock market wobbles have begun in China. If there is a financial system that has problems it is the Chinese system. Fortunately, the Chinese system is not yet fully integrated into the global system so the fall-out is limited. However, the rest of the world is not immune to this huge economy as the oil and commodity markets will attest.
Russia has many problems of which the oil price is just one. It also faces sanctions and many border disputes, as well as a war in Syria. Russia still has the capacity to be self contained and muddle through. Brazil and South Africa less so, especially as both serious governance problems. The long term potential of all 5 economies remains exciting but it will not be so good in 2016. China will remain a source of volatility but none are likely to derail the global economy. The BRICS have come a long way but are not yet that important. One thing is for sure (as I always argued) Emerging Markets do not constitute an asset class. They are just many individual markets. Treat them as such.
The USA remains the largest and most important economy. The US Dollar remains the international money of choice. The US economy is doing fine. The one potential destabilising factor is the rising interest rate environment. The good news is rates will probably not rise very fast. The impact of rising interest rates depends in part on the extent and distribution of leverage within the system. If rising rates start causing general distress it will be clear quite quickly and the Federal Reserve will slow the process. I doubt however that it will reverse any rate hikes that have taken place. The Fed hikes are rooted in the idea of an equilibrium real interest rate and it is trying to return to this rate. Rate moves will be one-way for the foreseeable future.
For many, like me, asset markets are the reason to think about these broader economic and geo-political issues. The death of the defined benefit pension means many are now at the mercy of financial markets to generate an income once paid employment ceases. The optimists would describe 2016 as an ‘opportunity’. The pessimists as a ‘bear’ market. I am inclined towards the optimistic view. Equity markets will go lower and have already begun to do so. However, as the earlier blog indicates, the downside may not quite qualify as a bear market, at least not in all countries. It is a good year to look at sector and country selection with extra care. Unfortunately, this is a sophisticated approach, beyond most even with help. This blog is not written for the sophisticated (they can look after themselves).
So what simple strategies might pay off in 2016? First, do not be in a hurry. Markets will not run away on the upside. Second, do not get too negative whatever the experts tell you. Third, have some cash available to invest (if you do not already). Finally, ask yourself where you think markets will be in 5 years time. This year is a corrective year in a long term uptrend.