Alan Howard BH Macro Global 2015 Letter – Volatility Ahead

Market Commentary


The year ended much as it began, with healthy gains in employment contrasting with anaemic growth. The economy appears to have expanded by approximately 1.75% in 2015, paced by consumption spending and held back by the drags from international trade and inventory destocking. The fundamentals in the household sector are solid. Real income is expanding at a moderate pace, wealth as a share of income is relatively high, balance sheets are in good shape on average, and credit is readily available for most borrowers. As a consequence, there is renewed vibrancy in the housing sector and brisk demand for consumer durables like motor vehicles. The inventory destocking appears to be a largely one-time adjustment that weighed on growth in the second half of the year, just as the sharp decline in capital expenditures in the energy sector subtracted from growth in the first half. Meanwhile, the headwinds from international trade are likely to persist in 2016, both because such adjustments tend to take longer and because the US dollar continues to appreciate. We anticipate 2016 mostly reflecting a repeat of the trends seen in 2015 without the drags from inventories and energy-related investment. In terms of risks, consumption could surprise to the upside if households spend more of the wealth accumulated over the last few years; however, global growth could disappoint further and lead to worse net exports, or the energy sector could suffer another round of cutbacks if low prices persist. The labour market was the highlight of the macro story in 2015. The US added 2.65 million jobs over the year and the unemployment rate fell from 5.7% to 5.0%, which is close to most estimates of full employment. If forecasts are correct and growth is above 2% in 2016, then the unemployment rate should continue to fall. The performance of the labour market is even more remarkable given lacklustre real GDP growth. The data suggest that potential growth is considerably slower than most estimates. If potential growth were 2%, then the unemployment rate should have increased during a year of sub-2% growth. In fact, since the unemployment rate dropped so much, the likelihood is potential growth is closer to 1% than 2%, a sobering fact with negative long-term consequences for economic performance and policymaking. To help appreciation of that difference, the economy would double in size every 35 years at 2% growth and only every 70 years at 1% growth. In other words, productivity growth looks stagnant, which means that there’s little room for real wage gains. In addition, lower potential growth means the economy will flirt with the zero lower bound on nominal interest rates whenever there’s a downturn. All of these implications—slow potential growth, weak productivity growth, and monetary policy that’s constrained by the zero lower bound—are negatives that will probably continue in 2016. If the labour market was the highlight of the macro story in 2015, then inflation was the worst. For most of the year, total consumer price inflation bounced around a little above zero and core inflation was stuck at 1.3%.

The reasons for low inflation are no mystery. Total inflation is being held down primarily by the huge decline in consumer energy prices and core inflation is weak because of the pass-through of lower prices for energy and imports. These are shocks to the price level so inflation should eventually pick up, but this is taking longer than expected because energy prices continue to fall and the US dollar keeps appreciating, thereby lowering import prices. The outlook for inflation in 2016 resembles the outlook for inflation at the beginning of 2015, calling for a slow pick up in headline and core. However, that’s contingent on energy prices and the USD finding some equilibrium. In terms of policy, the Federal Reserve raised rates in December, ending months of speculation about the timing of lift-off. The debate immediately turned to the pace of monetary policy normalisation, with the policymakers promising “gradual increases” in rates while the market is sceptical that the economy can withstand any further removal of accommodation. The gulf between a dovish Fed and an even more dovish market will play out over the course of the year. Fiscal policy has merited almost no attention in the last few years, apart from the periodic scares about the debt ceiling and government shutdown. However, at the end of the year Congress agreed on a budget that should add a few tenths to real GDP over the next two years. Looking forward, the Presidential election looms in November. Although the market’s attention is focused elsewhere at the moment, there will be a keen interest in the election by the summer when a more liberal Democratic party faces off against a more conservative Republican party. The country is deeply divided and there will be volatility no matter the outcome of the election.


2015 started with the ECB announcement in January of a new €1.1 trillion bond purchasing programme, known as “APP” (Asset Purchase Programme), a new monetary policy instrument that had been partly anticipated by financial markets at the end of 2014. The programme, consisting of both sovereign and sub-national debt purchases, came as a complement to the private assets bought since the end of 2014, with a total volume of €60bn per month. Although the ECB Quantitative Easing (“QE”) programme was implemented successfully and real GDP growth climbed to approximately 1.5% in 2015 from 0.9% in 2014, the economic recovery continued to be fragile, as the impulse from QE diminished during the year, resulting in inadequate stimulus to withstand the intensifying headwinds stemming especially from the slowdown in global demand. Indeed, activity growth slowed from an annualised rate of 2.2% q/q in Q1, to 1.6% q/q in Q2 and 1.2% q/q in Q3.

Although the labour market recovered further over the year, with the unemployment rate declining by one percentage point to 10.5% at the end of 2015, the adjustment remains slow, very heterogeneous across countries and far from enough to fill the still large output gap, as shown by the still very subdued wage dynamics. At the same time, price developments continued to undershoot both the ECB and market expectations, with HICP inflation averaging a very low 0.0% in 2015, much lower than the ECB predicted at the beginning of the year. This disappointing outcome, which risks structurally de-anchoring inflation expectations, stemmed especially from lower commodity prices, although core inflation also remained extremely tame, lower than 1%. As a result, the ECB objective of returning to its target of “below but close to 2%” in the medium term remains in jeopardy and the risks of fully-fledged deflation have not gone. As such, the ECB policy decision to ease monetary conditions only slightly in December and disappoint greatly financial markets expectations which they had previously raised could prove very detrimental for the economic prospects of the Eurozone. Indeed, following the decision, financial conditions tightened, inflation and inflation expectations fell, and the economic data disappointed. Politically, the summer months proved highly volatile with Greece’s anti-austerity Prime Minister Alexis Tsipras calling a referendum as the highly-indebted country came very close to exiting the Eurozone.

While a third bailout programme of €85bn

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