Macroeconomic Forces That Will Control Markets in 2016
By Stephen Vita
Several macroeconomic trends remain under the microscope in 2016 as investors try to understand why stock markets are plunging and bond yields are imploding around the world. Key trends concern monetary policy, issues with economic growth, and the threat of deflation.
Monetary Policy
Central banks continue to worry about the global economy, and loose monetary policies still dominate in the United States, Europe and Japan. In early February 2016, the Federal Reserve told banks to stress test the possibility of short-term rates staying negative for a prolonged period if the economy moves into recession. The three-month Treasury bill rate is already at -0.5%, and there are growing doubts that the Fed will raise the federal funds rate in March. Futures markets forecast a 65% probability that the Fed will not tighten, while European Central Bank (ECB) President Mario Draghi is expected to cut rates at the ECB’s March meeting. The Bank of Japan is already in the negative interest rate club, a move that temporarily sent global stocks into an explosive rally.
Negative interest rates are the new norm as 11 eurozone members show two-year sovereign bond yields below zero. Low rates are nominally bullish for equities, but most worldwide stock indices are stuck in bear markets in 2016. The business cycle created too much inflation until the Fed tightened and often drove the economy into recession. Inflation was controlled, and a loosening cycle ensued, pulling the economy and stock market upward, though that paradigm does not exist anymore. Central banks have no leverage to elevate risk markets by cutting rates to the bone. With few other options, Ray Dalio of Bridgewater Associates believes that Federal Reserve Board Chair Janet Yellen will be forced to bring back quantitative easing. Risk markets, which are now dependent on easy money, would applaud that move and also favor an indication that the Fed is done raising rates.
Economic Growth
The January non-farms payroll report sent the unemployment rate under 5%, but the number of jobs created was well under estimates as economic growth continues to limp along. The cognoscenti at the recent Davos conference in Switzerland were focused on the growth issue, and for good reason. In the fourth quarter of 2015, for example, the world economy expanded at its slowest pace in over two years, led by the decline in China, which accounts for 15% of global output. Most other emerging market economies also steeply declined, while developed economies in the United States, Europe and Japan lost traction. The global economy expanded 2.4% annually in the fourth quarter, less than the 2.6% expansion in the third quarter.
Countries in both developed and emerging markets are handicapped by inept fiscal policy, slow productivity growth and staggering debt levels. The United States’ total public debt has increased by $8 trillion to a total of $19 trillion under President Barack Obama. Many companies are also still engaged in deleveraging from the debt accumulated during the lead up to the 2008 financial implosion, and emerging markets have much further to go in this process than developed economies. There is also a harbinger of trouble in the supply managers’ survey for manufacturing and services. The manufacturing survey issued last week stayed at a level under 50, which is significant because this is a leading indicator of economic growth. Slow growth is clearly better than contraction, and financial markets have a chance to recover in 2016 if central banks remain compliant and avoid damaging policy mistakes.
Deflation
Inflation expectations continue to undershoot forecasts, and the scent of deflation is now a worldwide issue. Prices are cooling in China, Japan and other countries in the Far East. The Eurozone is in particular trouble with 15 of 19 members in deflation. The current U.S. trend is disinflation, not outright deflation. The Fed targets an inflation rate above 2%, but it remains uncomfortably low. In this environment, it is surprising that the Fed decided to tighten monetary policy in December.
Deflation is a pernicious economic phenomenon. It increases inflation-adjusted interest rates, which suffocate investments, slow economic growth and push countries to weaken their currencies. A currency weakening strategy is clearly evident in China, Japan and Europe, which simply exports deflation to other countries that are still experiencing moderate levels of inflation, like the U.S. Trade tensions rise because the stronger U.S. dollar reduces the competitiveness of American products, a theme pushed hard by candidates in the 2016 presidential election. Stock markets don’t perform well in a deflationary climate, but long-maturity government bonds may outperform as interest rates descend.
Reading the Tea Leaves
The macroeconomic tea leaves point to structural problems that are not easily solved. One of the most shocking manifestations of the economic rot underneath is the performance of major banks. Stock prices for Credit Suisse and Deutsche Bank, for example, have fallen below 2009 crisis lows, and the vicious commodity bear market is yet another embodiment of this rot. These trends will likely continue going forward, creating another challenging year for investors.
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