Strategy & economics
That was the year that was
In their quarterly market commentary, Richard Jeffrey and Kieron Launder review 2015 and share their outlook for 2016.
Was it hopes disappointed or simply more of the same? Or both? The year 2015 continued to be characterised by what is widely perceived as dull world growth. The implications of that dullness became perhaps more obvious during the year, and possibly a little better understood. For Western economies, still in rebalancing mode six years after the great recession, dull growth is much safer, although it is now beginning to demand more active management by central banks. For emerging manufacturers and commodity producers, dull growth in the West is much more of a challenge. They are structured to supply stronger demand momentum in the mature economies of Europe and the US. The consequence is that there remains significant overcapacity amongst both Asian manufacturers and the suppliers of raw materials and energy. This, in turn, has obvious implications for pricing power – to the benefit of Western consumers, who are enjoying lowerpriced imports of many manufactured goods and appreciably cheaper energy and food.
The US economy is likely to have grown fractionally faster in 2015 than in 2014 (2.5% versus 2.4%), but by less than expected at the start of both years. Although slow-ish by historical standards, 2.5% is consistent with what we believe to be the economy’s sustainable growth rate. This contrasts slightly with the eurozone. While its growth rate has improved, and is likely to have been around 1.5% in 2015 compared to 0.9% in 2014, it is still falling short of what should be achievable in the longer term. For the UK, published numbers imply a deceleration in growth to around 2.5% in 2015 from 2.9% in 2014. However, we expect the 2015 estimates to be revised higher by the Office for National Statistics, probably to around 2.75%.
GDP growth (actual and consensus forecasts)
So why, against the relatively subdued backdrop, did the US Federal Reserve (the Fed) decide to raise interest rates in December – the first increase since the relentless and eventually massively debilitating tightening that began in mid-2004 and culminated two years later? The answer to this is twofold. Most obviously, with the US economy growing at more or less its new-normal rate, it was no longer considered appropriate to leave interest rates at crisis levels. What began to put even more pressure on the Fed was the tightening in the US labour market. It has been a feature of the recovery phase on both sides of the Atlantic that relatively unexciting growth rates have translated into very strong job creation – the corollary being only weak gains in productivity. In the US, the unemployment rate has fallen much faster than the Fed had been anticipating, and is now at a level judged consistent with full employment. Simultaneously, it is evident that job openings remain very high and the rate of increase in labour costs is picking up. Whilst headline inflation measures have been held down by falling food and energy costs, there is evidence that domestically generated inflation is beginning to pick up.
This is a situation which we expect to persist for a while – that the US labour market continues to tighten, despite seemingly modest growth. Eventually, we expect companies to take action to improve productivity by raising investment spending. Until this happens, labour costs are likely to rise faster and the Fed will be under continued pressure to raise rates. This raises a number of questions with regard to the Fed’s reaction function – most obviously, how inflation-tolerant it might prove. This is important since it will determine how quickly interest rates may rise over the period ahead. Our assumption is that the Fed will want to ensure inflation expectations remain well anchored, but will not want to risk undermining growth. It is reasonable to assume that this combination will limit the pace of the tightening to no more than one 0.25% rate increase each quarter.
At the other end of the spectrum, the European Central Bank (ECB) remains under pressure to take further action to stimulate growth. Even so, it was evident that the ECB itself has become more equivocal about the requirement for additional action. While growth in the eurozone may be considered sub-standard by historical standards, it is improving. Hence, at the end of 2015, the ECB disappointed markets by announcing only a marginal further easing. Looking ahead, if the gradual improvement in the economic outlook continues, and if core inflation picks up, it seems probable that the ECB will judge the scope and necessity for further action as being limited.
This leaves the Monetary Policy Committee of the Bank of England (BoE) with contrasting external influences. But the characteristics of the UK economy are most similar to those of the US. While growth was by no means spectacular in 2015, there was a continued tightening in labour market conditions, which has been reflected in an increase in the employment rate for people of working age (that is, aged 16 to 64 years) to its highestever level. More importantly, wage inflation clearly increased during the year. Forward guidance on interest rates from the BoE has been less than helpful (if not highly misleading) over the past few years. Consequently, we place little weight on Governor Mark Carney’s
seemingly benign comments and the markets’ interpretation that rates may not start rising until 2017. Indeed, we would not rule out a first increase in bank rate in mid-2016.
UK employment rate (aged 16-64)
Central banks have clearly been worried about two risks: deflation and the wider impact of a slowdown in China. In our view, the risks of outright deflation (characterised not just by falling prices but also an implosion in demand) in the West have been hugely overstated. Indeed, falling food and energy prices have resulted in a demand stimulus in Europe and the US. That Japan is still struggling to raise its growth is more to do with having a rapidly ageing population than a lack of policy stimulus. Similarly, while slower growth in China undoubtedly represents a problem for commodity-producing countries, it is unlikely to have a significantly negative impact on growth in the West, since most Western industrial countries (including Germany) export relatively little to China. For the UK, stronger growth in the eurozone is potentially much more significant than weakness in China. Unsurprisingly, the Chinese authorities themselves are worried about growth prospects and are likely to take further action to stimulate their economy. Undoubtedly, this would be welcomed in South America and by other commodity producers. Even so, we doubt that we will see a major rebound in commodity prices over the year ahead. This means the costs of oil, industrial raw materials and food products will remain subdued.
So, looking ahead, what are likely to be the key characteristics of the world economy in 2016? Overall, we expect world growth to be modestly stronger than in 2015. However, this improvement is unlikely to be sufficient to instigate a significant turnaround in emerging economies. While Asian manufacturers are likely to find the environment remains very price-competitive, demand for raw materials and energy is expected to remain sluggish. If pressure builds up on policy makers in the West, this is expected to be the result of rising domestic inflationary pressure coming through as a result of tightening labour markets and the consequences for wage inflation. It may also be that monetary authorities in the UK and US begin to worry more about the pace of credit creation. One thing will very definitely remain the same in 2016: all eyes will remain firmly focused on the Fed.
Selected commodity-related indices
From an asset class perspective, capital market behaviour reflected investors’ concerns regarding the themes outlined above and their slow acclimatisation to the return to normal growth (trend-like rates).
Risk assets have been supported by very accommodative policy measures over the last few years, thus higher valuations were likely to be challenging (particularly for the US), with investors also showing greater focus and differentiation between sectors – energy and industrial commodities unsurprisingly suffering the most. As initial hopes of stabilisation and rebounds in commodity prices faded, investor concerns moved from temporary cashflow impact and corporate adaptation to structural challenges and survival of the fittest. The UK equity market was most adversely impacted, having the greatest sectoral weighting of major developed markets to these areas. Stock markets that did well over the year were generally those where monetary policy was still being eased, such as Europe and Japan, while emerging market companies were still struggling to adapt to lower external demand, excess capacity amongst competitors and low commodity prices. China has continued to march to its own beat, such that while we have seen incredible highs, collapses and mass stock suspensions, domestic stock markets have still shown double-digit gains for the year. Within main equity markets dispersion was significant, with the aforementioned sectors lagging while investors were paying an increasing premium for companies evidencing growth.
Corporate concerns also impacted the credit markets, with spreads* continuing to widen – led by, but not isolated to, energy companies in the high yield sector. Reduced liquidity in bond markets ensured increased volatility, but overall government bond yields were more stable through the last quarter. While we saw significant volatility in the early part of the year, the reduced impact of falling energy prices on core inflation has been picking up in the UK and US, leading to yields being increasingly underpinned.
Volatility is likely to be something that remains with us into 2016 across a number of markets. The ongoing divergence in monetary policy between the global currency of the US dollar, and almost everyone else who isn’t pegged to it, is likely to lead to currency and earnings volatility. Lower for longer commodity prices may cause meaningful changes across the geopolitical spectrum, causing challenges for commodity producers and exporters, as well as a significant boost for many consumers around the world, boosting disposable income and expenditure. While volatility should be welcomed from an investor’s perspective (as it can offer greater opportunities), we should also positively acknowledge that this is partly due to less synchronised global economies as some have largely recovered from the great financial crisis with normalising monetary policy; technological advances have also played a part (for example fracking) in bringing about lower goods prices around the world.
1 The difference in yield between that offered by a corporate bond and a comparable government bond.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.