Volatility & Uncertainty to Define 2016

Major challenges facing market participants

Originally published in the October 2015 issue

The list of the major challenges facing market participants as 2015 comes to a close is quite diverse and suggests a volatile picture for various asset classes. In this report, we identify the key economic drivers for Q4/2015 and full-year 2016, with a short commentary on how they may impact prices and market volatility. Our review will include the United States, China, Japan, Europe, emerging markets, energy, and agriculture. Here is the summary.

US growth remains modest, inflation subdued, and an eventual Federal Reserve rate increase is more likely to flatten the yield curve than result in a parallel shift upward in the yield curve.

China’s growth deceleration continues. Most of the impact on global growth and commodity markets has already been felt. The Chinese stock market reacted in 2014 and through June 2015 to Government stimulus (i.e., new loans, lower rates) and not to the sluggishness of exports. Since July 2015, equities have been moving back in line with fundamentals. Further weakness in the Chinese currency (RMB) is likely, as a reflection of slow export growth, although it will not help exports grow any faster. Only stronger global growth will get Chinese exports moving again.
Japan is hardly growing and has no sustainable inflation pressure despite a drop in the yen from 80 JPY/USD in 2012 to around 120 in 2014-2015. Further yen weakness remains a strong probability.

Europe may post small gains in real GDP for 2015 and 2016, after three years of stagnation. Still, the European Central Bank (ECB) is expected to hold rates low and continue to expand its balance sheet after allowing it to contract during 2013 and 2014.

Emerging market countries are struggling with rising political risks and economic stagnation or only modest growth. Currencies have felt the downward pressure. When global equities signal a “risk-on” environment, however, a recovery in emerging market currencies may be quite strong.

Energy markets are entering their second year of a low-price environment and that may bring changes in market dynamics. The downward price pressures from weak global growth have largely been absorbed in prices. The supply increases from the Middle East are also well anticipated. The major development in 2016 may be a slowing of North American production. This production adjustment comes with a significant lag after the price drop, but the lack of new capital investment in 2015 and 2016 suggest the time has arrived.

El Nino is strong, and typically there will be some serious droughts, most likely in Indonesia, Malaysia, possibly Australia and India. Agriculture prices may feel upward pressure during the course of 2016, depending on these weather events.

Fed rate-rise decision
Hardly anyone has failed to get the message that the Fed is seriously considering raising rates. Nevertheless, the timing of any Fed decision has been called into question by Q3/2015 data, including the downturn in Chinese stocks, modestly slower-than-expected US job growth, and continued stagnation in hourly wages and general inflation. The Fed will also consider the possibility (no matter how small) of a US government shutdown related to the debt ceiling debate.

CME’s federal fund futures have reacted by reducing the probability of a rate-rise to well below 50% in Q4/2015. Rate-rise probabilities do not exceed 50% (a virtual coin flip) until the March or April 2016 Federal Open Market Committee (FOMC) meeting, and the end-2016 rate expectations have dropped materially since June 2015, suggesting the market is heeding the Fed’s warning that even if/when it starts to raise rates the pace will be very slow and cautious.

The strongest case for commencing the process of raising rates is that zero-rates was an emergency policy instituted in Q4/2008 at the height of the financial panic. Over 2010-2015, five years since the 2008-2009 Great Recession, US real GDP has averaged a modest 2% annual growth. While the slow rate of growth has disappointed many analysts and the Fed, the economic emergency has been over for years; so why hold on to the zero-rate emergency policy?

The strongest case for delaying any rate-rise is that general inflation is only a little bit above zero, which suggests no urgency despite the unemployment rate having declined to 5.1%, compared to an average rate of 6.1% during the fifty-five years from 1960-2015. In the past, the Fed has based its 2% inflation target on core inflation, which excludes food and energy. This core measure of inflation stood at 1.8% based on data through July 2015. The general inflation rate, however, is only just barely above zero. The Yellen-led Fed has indicated that it wants to make sure that the general inflation rate starts to move back up as expected before taking action on rates. The decline in energy prices and refined product prices in Q4/2014 and Q1/2015 that was the primary cause of the general inflation rate moving close to zero will drop out of the year-over-year percentage calculation in Q1/2016, after which time the general and core inflation rates are likely to converge in the 1.5% to 2.0% range. Nevertheless, some members of the FOMC will use any excuse not to raise rates, and the possibility of a US government shutdown related to the debt ceiling debate adds another element suggesting further delay.

Barring a sharp and unexpected rise in the unemployment rate or a dip in the general inflation rate into deflationary territory, the Fed has telegraphed a clear intention to, eventually, abandon its zero rate policy for the federal funds rate. Once the Fed starts raising rates, there will be more to come, even if they are spaced with one or more FOMC meetings in between. And, should the economy unexpectedly slump, for the first time in six years, we will also have the possibility of a cut in rates. This puts the US yield curve in play and will add some volatility to the Eurodollar deposit rate and federal funds rate futures markets. With sustained low inflation the order of the day, however, our base case scenario looks for a flattening of the yield curve with rises in short-term federal funds rates, rather than a parallel upward shift that would also lift bond yields.

China decelerating
China’s economy continues to decelerate, with the decades of 10% real GDP growth fading rapidly into history and not likely to return. The immediate problem for China is two-fold. Export growth has stagnated, mostly because China’s customers are not growing much, and secondly, because of the strength of the RMB versus most of the currencies of China’s trading partners. A perspective on the last decade makes all the difference.

Back in 2005, China was an export machine. Emerging market economies around the world were experiencing strong growth and increasing their trade with China very rapidly. Now, there is a distinct lack of growth among buyers of Chinese exports. Japan is not growing. Europe is barely growing. The United States is a just a steady 2% to 2.5% real GDP growth economy. Brazil has stagnated. Mexico is growing slowly. India is the only bright spot, but there are signs pointing to some bumps on the road.

In 2005, capital was flowing into China, and the People’s Bank of China (PBOC) was buying US Treasuries and other international assets to keep a lid on the value of the RMB. And, in response to the capital inflows, China started to allow a managed appreciation of the RMB against the US dollar.

Now, in 2015, even with a little weakness in the summer of 2015, the RMB is about 25% higher against the US dollar compared to a decade ago. Moreover, the US dollar has been strong against virtually all major emerging market currencies. This has made the RMB very pricey versus the yen, euro, and most emerging market currencies. The bottom line for China is that if its customers are not seeing their incomes grow, then neither will China’s exports – especially if prices have gone up too. Unlike a decade ago, as the Chinese government widens the band within which its currency can move, the RMB is much more likely to sink than rise. A weaker RMB will not help exports much at all, and is a reflection of slower export growth and outflows of capital. We are looking for as much as a 25% depreciation of the RMB versus the US dollar between now and the end of 2017 to better realign the Chinese currency with its portfolio of trading partners.

Our view on the Chinese stock market is that it rallied strongly in 2014 through June 2015 based on lower interest rates and expanded new loans in China that were policies of the government to stimulate domestic growth in the face of stagnating exports. The unintended consequence was that instead of stimulating growth, a considerable amount of the stimulus ended up fueling a stock market rally that was in opposition to the deteriorating fundamentals. If this view is correct, then the reversal in Chinese stocks makes little to no difference for the global economy since the global economy, including commodities, has already felt the impact of the Chinese growth deceleration over the past several years.

Japan not growing
Japan faces an aging demographic pattern, no growth in its labor force or population, and (like China) the customers for its exports are struggling to post even modest economic growth. Even though the Japanese yen has moved from 80 per US dollar back in 2012 to the 120-per-USD territory, this huge drop in the value of the yen has not produced sustainable growth or inflation. Part of the problem is the lack of global growth, yet the bigger problem for Japan is its lack of labor force growth and aging demographics. There is nothing Japan can do about global growth or its demographics. Japan is probably a 1% to 2% real GDP growth country in good times and a no-growth country when global growth falters. That is, Abenomics was doomed to failure. This slow growth outlook for Japan suggests more pressure for further yen weakness. The yen typically makes a relatively rapid jump to a new trading range and then settles into that range for a long period of time.

Regarding Japanese equities, an important caveat is worth noting. When Japanese stocks tumble, Japanese companies typically repatriate foreign earnings, making the yen strong in times of stock market weakness. Causality reverses in calmer times such that when the yen is weakening, it tends to help Japanese stocks rise as non-yen assets of Japanese companies are revalued upwards in yen terms. Regardless of the direction of causality, the inverse correlation between the Nikkei and the yen points to the need for complex risk management approaches.

Europe returns to modest growth
Europe was stagnant from 2012 through 2014 due to its sovereign debt crisis, tight fiscal policies, and the ECB allowing its balance sheet to shrink. The ECB is expanding its balance sheet in 2015 and is likely to continue to do so in 2016. Sovereign bond yields suggest the debt crisis has been resolved – at least for now. A better performing credit system should help support modest growth, in the 1.5% to 2.5% range for real GDP for 2016. The euro is likely to experience range-bound volatility as Europe’s return to growth is a positive which must be weighed against any probability of a US short-term rate rise.

EM political and economic risks
Emerging-market stocks and currencies have suffered significant declines since May 2013. At first, many analysts blamed former Fed Chairman Ben Bernanke for his talk about ending quantitative easing as the main problem for emerging market countries. We argued then and we argue now that this was a spurious correlation. Brazil’s President Dilma Rousseff is embroiled in scandal, Turkey faces uncertain elections, as does Argentina, and violence in Thailand suggests even more risks, just to name a few. Moreover, many emerging market countries are tied in one way or another to commodity prices, and sustained low prices have hit their growth prospects and currencies very hard.

At currently depressed currency values and stock prices, we see considerable long-term opportunities in emerging markets, but the short-term political and commodity risks are stopping many market participants from bringing money back to these markets. With the exception of China, the younger demographics of most emerging market countries offer the possibility, subject to political risks and realities, of an eventual return to 4% to 7% real GDP growth, which stands in sharp contrast to the 1.5% to 2.5% real GDP potential for most mature industrial economies. Indeed, we see emerging market FX pairs associatedwith carry trades (that is, long high-rate currency, short low-rate currency) could develop into an active trading strategy once global equity markets settle down and risk appetites rise.

Persistently low commodity prices, but upside/downside risks now approximately balanced and range trading is the order of the day
When commodity prices fell in 2008, it was mostly related to a sharp drop-off in demand from the mature industrial countries which were experiencing a financial panic. This time around, the challenge for commodities is excess supply complicated by weakening demand from China and many emerging market countries. In the long-run, low commodity prices generally provide a good foundation for getting growth going again, which then leads to higher commodity prices – well down the road. As John Maynard Keynes famously said, “we are all dead in the long run.”

Oil market dynamics may shift gears in 2016, however, as some new themes develop and older ones fade in importance because they are fully discounted into market prices. For example, the China deceleration and increased oil supply from the Middle East, including Iran, seem well priced into market expectations. The new development in 2016 may be, at long last, evidence of a supply response in North America to lower oil prices. During 2015, many new investment projects in the energy sector were cancelled or dramatically delayed. At the same time, the need to maintain cash flow to pay debts and expenses meant that while rig count was cut an emphasis on keeping the oil flowing rapidly from efficient wells prevented a supply response. A year later, though, the lagged impact of the decline in investment in energy projects could start to be reflected in oil production in 2016 and beyond.

While there is certainly a possibility of revisiting previous market lows for oil prices, or oil going to $20/barrel as some analysts have suggested, the probability is declining sharply. Slowing demand and more Middle East supply are fully incorporated into prices, so the next news would involve less supply.

By the same token, the probability of sharply higher prices – a return to $100/barrel oil – is also very low. To get back to $100, either China or other emerging market countries have to start growing rapidly again (not likely) or a major supply disruption occurs in the Middle East (possible, not likely).

Within the energy sector, however, there are some important nuances. WTI is now favored over Brent in terms of its potential to reassert itself as the global benchmark for oil prices. Brent has declining production and has been hit harder by lower prices since the North Sea is a high maintenance region for oil production. Also, European natural gas long-term contracts were once priced off Brent, but that is happening less and less. We expect more volatility in the basis risk between Brent and other oil types, which will make Brent less useful for hedging and risk management.

There is also likely to be movement in the price for natural gas in different regions of the world over the next few years. The United States, as a low-cost producer, has the potential to export LNG to Asia, especially Japan. While it takes years and billions of dollars to build the liquefaction plants and port facilities, it is all in progress and over time this will put upward pressure on US natural gas prices and downward pressure on natural gas prices in Europe and Asia.

El Niño and agricultural markets
A strong warming of the Pacific Ocean near the equator approaching South America represents an El Niño weather pattern which built steadily from March 2015 through July 2015, weakened a little in August, and returned tofull strength in September. Warmer waters lead to more evaporation, and that means more precipitation depending on where the winds blow. El Niños, however, also shift wind patterns. The US storm track moves a little further south, for example, and raises the potential for wet weather and possibly a little warmer-than-average winter. And there are offsets. Warmer waters in the equatorial Pacific often occur in parallel with cooler waters in the southern Pacific off Australia and Indonesia which can heighten drought prospects.

Every El Niño is a little different, but with a lag of say a year or so, we typically see disruptions to agricultural prices – usually higher, depending on where the droughts occur and their severity. Even an “average” El Niño usually causes enough disruptive weather patterns to lift affected agriculture prices about one year after the El Niño forms.

Non-traditional risk factors
We also want to highlight the rise of non-traditional risk factors in terms of potential impact on global growth and market activity. Specifically, we are talking about earthquakes, volcanoes, hurricanes, and disease epidemics. The earth’s geology, weather patterns, and health environment have always been dynamic. What is different now is that the population is so much larger and concentrated in very large cities while the global economy is so much more integrated compared to previous centuries. This means that natural disasters and disease epidemics can cause much more economic damage than in the past, and that the indirect impacts on trading-partner countries and global markets can be huge. We are not in the business of forecasting these non-traditional risk factors; however, when they occur, our view is that they will be associated with higher than usual market volatility as risk managers seek to limit the damage.

Cleveland Volcano, situated on the western half of Chuginadak Island, is one of the most active of the volcanoes in the Aleutian Islands, which extend west-southwest from the Alaska mainland. It is a stratovolcano, composed of alternating layers of hardened lava, compacted volcanic ash, and volcanic rocks. At 3:00 p.m. Alaska Daylight Time on May 23, 2006, Flight Engineer Jeff Williams from International Space Station (ISS) Expedition 13 contacted the Alaska Volcano Observatory (AVO) to report that the Cleveland Volcano had produced a plume of ash. The ash plume is moving west-southwest from the volcano’s summit. A bank of fog is a common feature around the Aleutian Islands. The event proved to be short-lived; two hours later, the plume had completely detached from the volcano. The AVO reported that the ash cloud height could have been as high as 6,000 meters (20,000 feet) above sea level.