Alan Howard BH Macro Global 2015 Letter – Volatility Ahead
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 was agreed in a last minute deal, the implementation of reforms and debt-relief discussions are likely to remain difficult. Moreover, political tensions are rising. The consequences of the immigration crisis, which has hit even the otherwise rock solid leadership of Chancellor Merkel, has seen increasing support for nationalist and populist parties in various countries of the common area. Looking forward, the prospects for the Eurozone in 2016 look more challenging than in 2015. Indeed, on the one hand, the above mentioned tightening of financial conditions induced by the December ECB policy decision, albeit moderate, came at a moment when renewed easing was needed so as to provide fresh impulse to the quantitative easing manoeuvre, amid the challenges posed by the risks of deflation, a slower and riskier global environment and a still challenging and far from complete process of de-leveraging. Risks that the December ECB macroeconomic projections of accelerating recovery and convergence to price stability will be greatly disappointed look particularly elevated. Should that be the case, pressure on the ECB to ease monetary conditions again, making use of all its available instruments, will increase.
Entering the seventh year of its expansion, the UK economy has lately been marked by a dichotomy between developments on the real and nominal sides: while indicators in real, or volume, terms have proved resilient – although not completely immune to the global slowdown – indicators in nominal, or price, terms have remained sluggish. For instance, while real GDP likely expanded by about 2.2% in 2015, both headline and core inflation remained low, at 0.0% and 1.2% y/y, respectively. Similarly, while on-going strong job growth led to a further drop in the unemployment rate, the tightening of the labour market failed to translate into meaningful upward pressure on nominal wages. As inflation keeps undershooting the Bank of England’s 2% inflation target, the Bank remains in no hurry to hike rates in the near future, especially as the economic outlook in the short term has become more clouded. First, the past appreciation of Sterling still poses a headwind to the economy, weighing on exports. Second, fiscal policy should become slightly more contractionary this year, compared to the last couple of years. Thirdly, the uncertainty surrounding the EU referendum may result in companies putting investments on hold until the uncertainty over the UK’s future in the EU has been removed. Thus, even in a scenario where the UK remains a member of the EU, confidence may be adversely affected in the run-up to the referendum.
In the alternative scenario, where the UK votes to leave the EU, the economy would likely suffer more, at least in the short term. Moreover, such a scenario would rekindle fears over a break-up of the UK, as the question of Scotland’s independence could come back on the table. In our base case, the UK economy will continue its expansion and make up for any pre-referendum slowdown in the data once the referendum has been held, driven by robust gains in incomes in real terms – due to inflation rates even lower than nominal wages growth – over the past couple of years and an on-going need for housing and infrastructure investment. The gradual erosion of spare capacity and the further tightening in the labour market should eventually set the scene for the first rate hike, but only once wages growth have shown clearer signs of acceleration. However, the risks remain skewed towards a later rate hike, due to a weak global backdrop, the sensitivity of the currency, uncertainty about the new level of the non-accelerating inflation rate of unemployment (NAIRU) and an elastic supply of labour to the UK from the EU. Lastly, the Bank of England may well decide to implement macroprudential measures to tackle any signs of overheating, which could weigh on economic activity and act as a substitute to monetary tightening.
While 2014 was marked by a large swing in activity due to the introduction of the consumption tax hike, 2015 saw steadier, modest gains for the most part. The output gap stepped down 1 percentage point at the start of the year and was flat thereafter. The unemployment rate maintained its downward trend seen over the previous five years and looks to end 2015 at its lowest level since 1997. For the most part, survey measures like the Tankan and Shoko-Chukin survey of small and medium-sized businesses moved sideways over the year, and industrial production was flat on balance.
Looking to 2016, Japanese growth is likely to be tepid, averaging fairly close to the slow rate of potential output growth. Solid momentum in private domestic demand, supported by ongoing income gains, should be partially offset by a difficult external outlook due to the recent strength in the yen, as well as ongoing weakness in major Asian export markets. Government spending could be a slight drag on the economy, and we see no reason to suppose that the upcoming corporate tax rate cut will materially boost aggregate demand in the near term.
The inflation performance was mixed over the year. Abstracting from the effects of the consumption tax increase, the year-on-year change in core prices was relatively flat in 2015, remaining within a thin band straddling 0% throughout the year, as falling energy prices, which are included in Japan’s definition of core inflation, held down the aggregate. On the other hand, the 12-month change in consumer goods excluding food and energy steadily moved up. Stable 0.1% seasonally adjusted month-on-month gains were added to the 12-month change, while essentially flat readings in 2014 dropped out. After significantly boosting its bond buying in October 2014, monetary policy was essentially on hold throughout the year.
The Bank of Japan (“BoJ”) tweaked its policy at the December meeting by extending the maturity of the bonds it will buy from ten to twelve years, and introducing a new program to buy exchange-traded funds of stocks issued by companies actively investing in physical and human capital. Markets initially rallied, thinking that it represented a true increase in policy accommodation, but then they pulled back once they realised their extremely limited nature. The Bank went on to describe its actions as a technical adjustment. All told, it served to raise questions as to whether the BoJ will revert back to incremental policy changes, without actually moving the needle on accommodation. Governor Kuroda had said a month earlier that the BoJ needs to lead markets in pushing up inflation expectations; it cannot simply rely on wages to pick up on their own. With Governor Kuroda’s aide recently saying that the conditions are in place, more accommodation looks to be under serious consideration. Indeed, the need for further accommodation has increased of late as the reinflationary backdrop has deteriorated. In the second half of December, the yen appreciated over 2% against the dollar and then opened the year strengthening another 2%.
Oil took another step down, and while the BoJ is capable of separating the direct effects of oil on its definition of core inflation from changes in the underlying trend, there are still some spillover effects to non-energy prices. Consumer inflation expectations appear to have stumbled in the last few months with a weighted average of household inflation expectations falling 0.6% from its first-quarter average. Spring wage negotiations appear to be disappointing. All told, while the 12-month change in core prices should move up due to base effects as the previous sharp declines in energy prices fall out of the calculation, in this environment further inflation gains excluding food and energy are not in the offing.
2015 was a most challenging year for China, gripped by an extremely challenging combination of high and still rising leverage, and slowing underlying growth, both in real and nominal terms, as large overcapacity in a number of sectors induced deflationary pressures. Attempts by policy makers to ease monetary conditions in the form of cuts to the reserve requirement ratio (“RRR”) and official interest rates, showed diminishing returns in terms of their ability to generate credit and boost economic activity. This is perhaps unsurprising as the transmission mechanism tends to lose its effectiveness in a high leverage environment. As a result, in 2015 GDP growth slowed from 7.7% to 6.9%, the lowest in 30 years, although broadly in line with the government “about 7%” target. Speculation on the accuracy of the China growth data has risen, as many analysts believe that the actual growth rate is lower than the published figure. Moreover, China’s stock and foreign exchange markets witnessed great turbulence. Indeed, on the one hand the Shanghai composite index after nearly doubling from November 2014 to mid-June 2015, subsequently collapsed returning to its January 2015 level. On the other hand, the Yuan depreciated by approximately 3% from mid-August 2015 to year-end, despite massive intervention by the People’s Bank of China (“PBoC”) aimed at stabilising the exchange rate until it joined the IMF SDR basket on 30 November. Importantly, capital outflow pressures persisted thereafter. Throughout the whole of 2015 foreign exchange reserves contracted by more than US$500bn, to US$3.3tn.
Looking forward, 2016 looks as if it could be another turbulent year for China. In particular, capital outflow pressures are likely to persist despite tightened capital controls and a large current account surplus, along with the rising demand from onshore corporates and households aimed at diversifying their assets from RMB into USD. The on-going anti-corruption campaign could also exacerbate capital flight. As such, the PBoC will likely encounter increasing difficulties in smoothing out the pace of the depreciation, as the costs in terms of reserves’ depletion are likely to rise. The official GDP growth target for 2016 is likely to be lowered to about 6.5%, a result which may be a challenge to achieve given the increasing ineffectiveness of the monetary transmission channel and the limited room to ease monetary policy conditions amid rising outflows. Fiscal policy is likely to be expanded, but not to an extent which can stabilise the economy, as only small-scale fiscal easing measures are poised to be introduced after the March National People’s Congress. Last, but not least, elevated volatility in financial markets is likely to persist, at least until such a time as the exchange rate is let freer to adjust to market forces, thus damaging growth prospects