The voracity of market moves at the start of 2016 belies the underlying deterioration of the major economies. Vulnerabilities have been exposed by the start of US rate tightening, and China slowing down. But according to the latest Economic Outlook by Neil Williams, Group Chief Economist at Hermes Investment Management, the real danger is that financial markets overreact to the original economic triggers.
With rates close to – or through – the floor, policy cannot be accused of being ‘toxic’
Sharp equity declines are traditionally associated with key macro shocks and/or a toxic policy mix. Current policy can hardly be accused of being toxic, suggesting China and the US Fed are the main culprits for the markets’ fear. Yet, their main macro risks should still be contained. Even with ‘true’ real growth of just 3%, China in 2015 will have generated over two years nominal growth equivalent to the entire GDP of Spain. Expecting it to carry on doing more was unrealistic.
US: The Fed’s expectation of raising the funds rate to 3½% is no longer feasible
The Fed’s expectation of raising the funds target rate to 3½% sometime after 2018 looks unrealistic, but we doubt it will be dissuaded from hiking again in this cycle. We expect two further 25bp US rate hikes by this Christmas, taking us to a still low 1% ‘peak’ rate.
This suggests another two years of negative real rates in the US and UK, on top of the six years we’ve had.
Eurozone: ECB QE provides cash to lend, but it cannot force consumers & firms to borrow
The ECB and the Bank of Japan, meanwhile, are still in the advanced economies’ growth ‘slow-lane’. They will have to accelerate their QE and make their rates more negative, aiming to keep long yields down.
Negative rates have been tried before, evidenced in the early 1980s by Switzerland’s tax on deposits to weaken the franc. It had only limited benefit. Their effectiveness now (aimed at discouraging cash hoarding) hinges on keeping long yields down rather than directly boosting loan demand, given the ECB’s commitment to buy government bonds down to a yield as low as the negative deposit rate.
UK: Brexit – if it occurs – would be a ‘long drawn-out can of worms’
A complication for the UK, of course, is its EU referendum. Brexit is the ‘known unknown’ for UK assets in 2016. Our base case is that Brexit is avoided. But uncertainty will build, and should Brexit occur, the Bank of England may again have to become the biggest sponsor of gilts, via QE.
The only real precedent we have is Greenland, whose ‘soft’ exit in 1985 left it an associate member still subject to EU treaties. Its negotiating process between referendum (sparked by home rule and fishing rights) and departure took three years. So, a risk with the UK, a much larger economy and, after 43 years, far more entwined in the European project, is that it would need even longer than this.
China: Given half the economy is fixed investment, the de facto real rate is even higher
China looks like it has the wherewithal still to soften its landing - with a ‘dashboard’ of policy buttons still to press. Rates and banks’ reserve requirements can be cut, along with further renminbi devaluation, direct lending, and a range of fiscal stimuli. For firms, real lending rates are as high as 10%. The second-round effects need watching, such as the impact on China’s real estate.
Now China must avoid a policy ‘face-off’ with the US. Renminbi devaluations are an extra incentive for the US Fed to take only ‘baby steps’ in raising rates. Fortunately, China should itself prefer only ‘drip-feed’ devaluations to help its balance sheets.
Yet when market sentiment wanes and risk aversion builds, markets often lose sight of the original triggers – taking policy expectations to extremes. We may presently be close to that point, with money markets of late inferring no respective US and UK rate hikes before 2017 and summer 2018.
If we’re right, this seems complacent.
How grizzly is this bear market?