Macro Outlook – 2016

Summary:

• Stronger USD: Expect to see the USD rally continue – driven by policy divergence (the Fed
  raising rates), relative economic strength (most other economies are looking weak) and
  reinforced by the debt feedback loop (a higher USD puts pressure on USD borrowers to cover
  exposure). The rally is likely, in my view, to end only when international growth picks up, when
  there is a massive increase in fiscal spend by some of the larger economies (such as China) or
  with a reversal of policy (with US rates declining and a return of more QE).
  
• Weaker than consensus US GDP growth: the stronger USD is disinflationary and negatively
  impacts the export segment. Also, underlying global demand remains weak.
  
• Lower than consensus inflation, for many of the developed markets: Limited wage pressure
  and weak demand in the US and EU are likely to keep inflation very subdued.
  
• Fed policy flip flop: While the Fed is currently hawkish, they are stuck in a feedback loop. The
  stronger USD and eventual rate increase will slow the economy, which will in turn likely cause the
  Fed to weaken further out – potentially mid-2016.
  
• An increase in fiscal spending and a shift away from austerity by the major economies: A
  key risk to my views is that, rather than the expected modest increase, governments go all in with
  a significantly large increase to impact demand – this though would likely only coincide with lower
  markets and economic weakness. Also, while positive short term, the higher debt/GDP will raise
  solvency issues further out.
  
• End of Debt super cycle: Debt levels have, in aggregate, increased since ‘07 and it’s likely we
  are at or close to the peak of the cycle. Certainly US consumers show no appetite to re-leverage
  at this juncture. A continued nationalisation of the debt (seen in the developed markets since ‘09)
  will likely drive the eventual need to monetise, write-off or devalue the debt.
  
• More QE from ECB and BoJ: both economies are weak and policy makers are convinced of the
  benefits of easy monetary policy and QE.
  
• Continued weakness in the Emerging Markets: A few factors here: 1) China data remains
  weak (see electricity production, retail sales and commodity demand), impacting demand from
  EM; 2) commodity prices remain weak and there is little to indicate an improvement here, 3) the
  stronger USD puts many borrowers under pressure, potentially ending in a deleveraging process.
  
• Geopolitical tensions to mount: The refugee crisis, in conjunction with the ongoing debt crisis
  in the periphery, is likely to lead to shifts in the fabric of EU market policy, which may result in a
  more fiscally liberal but protectionist leadership – not conducive to labour movements and greater
  productivity.

Macro by country:

US:
Most economists are relatively bullish on the US economy and expect it to be the driver of
global economic growth. While, with zero rate policies and ample credit available, there is little to
indicate any severe slowdown in the works, I don’t expect that the underlying economy will be as
strong as many economists believe. Indeed, unless there is an increase in fiscal spending and a
weaker USD, I would not expect growth to exceed c.2.5%.

Headwinds to growth:

• Retail sales are not strong (particularly in the small business segment).
  
• Underemployment remains high and the participation rate is at 30 year lows. The underlying
  labour market is still not great even after 7 yrs of stimulus. While this may act as a tailwind to
  keep inflation in check, it dampens outright demand.
  
• The stronger USD impacts the export sector and weakens demand from the emerging
  economies. The stronger USD serves to tighten liquidity in dollarized economies, essentially
  driving deleveraging – impacting external demand.
  
• While the US has less exposure than EU or Japan to the emerging markets, stagnation in these
  markets impacts the US as well.
  
• Lack of re-leveraging: While US consumers have done a better job at deleveraging than their
  european counterparts and this headwind is waning, there are no signs yet of a re-leveraging,
  which would be accretive to growth.
  
• Capital expenditure remains subdued (as companies carry on doing share buybacks).

Tailwinds to growth are waning:

• A number of growth tailwinds have started to fade:
  • Light vehicles sales being back at 2006 peaks
  • Housing has come out of its ‘09 slump but unlikely to drive growth like it did prior to the GFC.
  Investment currently stands at around 3.5% of GDP and while it may increase marginally
  further, it is unlikely to reach the levels of 2006 of 6%.
• Easy credit has been in place for years and consumer and small business confidence are both
  back at pre GFC highs.

The market’s performance also gives some support to this view of weak growth, with cyclicals
(energy and mining) significantly underperforming defensive areas of the market – hardly reflective
of a market expecting stronger growth. Sales data from the cyclical sectors is also weak.

The key risk to my view is that the government may significantly increase its fiscal spending to
support growth. This policy would be stimulative short term but a rising debt/GDP will impact the
ability to run deficits further out (it’s simply a case of borrowing from the future).

In terms of inflation and rates, while the Fed may tighten, I would expect them to be very slow to
initially raise rates and any rate hike cycle to be relatively short. While there is some wage growth
there is little inflation pressure at this point and the money multiplier continues to trend south
(although recently this indicator has indeed started to show signs of improvement). This is not to
say, however, that they shouldn’t have raised rates a few years back as cheap credit has a habit of
driving up mal-investment, the results of which we will likely see over the course of the next few
years.

US inflation is thus expected to remain very benign into 2016 and deflationary forces from a
stronger USD and lower commodity prices are likely to remain in play, through the early part of the
year. Should wage pressures indeed flare up, the participation rate is likely to increase, offsetting
some of this pressure.

Europe:
While European manufacturing will get some boost from the weaker Euro and from lower wage
costs in parts of the periphery, underlying economic health continues to look weak. Saying that, it is
showing gradual improvement, though again I expect reality to fall south of consensus.

Tailwinds to growth:

• Easy monetary policy and a very active central bank: In addition to buying bonds and reducing
  yields, the ECB has imposed negative rates to drive cash out of savings accounts and into
  consumption.
• Lower wage costs across most parts of the periphery have and will continue to increase
  competitiveness and aid the export sector.
• The weaker Euro also increases the price competitiveness of exports.
• Lower oil and commodity prices: as a net consumer of commodities lower prices are a positive.
• Pent up demand: like the US a few years back, we are seeing demand in various segments
  picking up. The housing markets are also strong in the core and picking up in parts of the
  periphery.

Headwinds to growth:

• Europe has greater exposure to the emerging markets than the US.
• EU banks remain excessively leveraged (unlike the US, EU banks have been slow to cut
  leverage).
• Debt levels remain excessive across the periphery. The debt crisis will be back.
• Recent unfortunate events in Paris may impact trade flows and ease of access.

It’s been 7 years since GFC and Europe still has a long way to go to recover. While the ‘debt crisis
has been continually pushed out, yields have risen across parts of the periphery and we are seeing
political change that could potentially destabilise the status quo (see Portugal).

In terms of inflation, it will remain very benign and there is little pressure for the ECB to alter policy
at this point. Expectations are for the Euro to weaken further against the USD.

Japan:

With the BoJ still adamant over its benefits and with the economy back in recession, due in part to
weaker demand from China and emerging markets, we are likely to see more QE in Japan. High
debt levels and weak demographics aside, QE has driven inflation expectations up and the
deflationary factors such as falling property prices and corporate deleveraging have reversed, at
least for the moment.

Tailwinds to growth:

• The lower yen has supported GDP growth as well as inflation expectations. The BoJ is likely
  launch further QE to reinforce the mentality that inflation is here to stay.
• Employment has increased and is now higher for prime age workers than the US.
• The corporate segment is in relatively good health with lower leverage levels than other
  developed market peers.

Headwinds to growth:

• Emerging market exposure: like Europe, Japan also has exposure to the emerging markets as
  well as to China.
• High government debt: Japan’s debt/GDP is already over 240%, so the ability to raise fiscal
  spending would usually be limited. I say usually as, with 10yr sov yields below 50bps, it implies the government has unlimited ability to continue issuing yen debt….as the BoJ just buys all
  issuance.
• Terrible demographics: Japan has one of the oldest populations and unless immigration
  increases significantly (which is unlikely), the working population will continue to decline. Furthermore, retirees tend to reduce spending dramatically so local consumption will come under
  pressure.

While we may see continued economic improvement in 2016, of all the developed nations, Japan
is one that could potentially enter a ‘weimar’ like hyper inflationary blow up – driven by ever more
QE. The government is already a significant holder of debt and equity assets and will likely have to
continue doing more. Now that they are on the QE path it will be very difficult for them to exit.

Emerging markets:

Many emerging economies are going through a very rough patch, with the USD and commodity
demand being perhaps the two key factors to watch here.

Countries such as Turkey, South Africa, Malaysia and a number of others, have significant
exposure to USD denominated debt, which has impacted their ratings and ability to raise debt.
Also, a weaker China and lower oil and other commodity prices have also significantly impacted
the commodity exporters, most notable perhaps Brazil.

We have already seen a number of economies and currencies come under pressure. The
Malaysian ringgit and South African rand have both fallen c.25% to the USD YTD. It’s even worse
in the case of Brazil. Unlike prior EM crises, most have allowed their FX to float but this inevitably
hurts those with USD debt exposure. Tightening potentially hurts even more.

Headwinds to growth:

• A stronger USD will impact liquidity. I expect it will continue to strengthen until we see a blowout
  in default risks in the emerging markets or a return of more QE in the US.
• Weak commodity price and demand: many commodities are facing an oversupply issue and
  demand from China remains weak.
• Slowing China: while services may be showing growth, industry remains weak.
• Deleveraging: This may be in its early stages following significant increases in debt since ‘04.
  Non-financial private debt has grown exponentially – now over 70% in Turkey, Brazil and Russia
  and over 100% in China, Malaysia and Thailand.

Potential Tailwinds:

• The flip flop of Fed policy and a weaker USD
• Massive fiscal stimulus from China

Of the major emerging markets, China looks to be the most resilient. Net consumer leverage and
mortgage borrowing remains relatively low as is external debt (c.15% compared to Turkey at over
40%).

The linchpin of the views expressed above are that the USD will strengthen in 2016. With an
over-leveraged world and much of this debt being USD denominated, it’s a significant call –
one which offers up many opportunities from which to profit should one be prepared.

Contributed by Rob Aspin, CFA
20/11/15

Rob is an investment professional and CFA Charterholder with extensive experience in discretionary portfolio management, portfolio construction, hedge funds, global stock selection and investment advisory. His views can be followed on https://sg.linkedin.com/in/robertaspin