2016 will be another year of living dangerously for investors

2016 promises to be a tough year for investors. They will have to contend with an array of dangerous cross-currents that will test nerves to the extreme. There will be few places where investors will feel secure as slower global growth, conflicting policy signals and increased market volatility make rewarding investment opportunities even harder to pick.

Financial market confidence will be running the gauntlet. Asset allocation looks extremely overstretched right now and, with fading fundamental appeal, investor confidence in over-cooked equity markets could end up in sharp retreat next year. Anything that upsets expectations about access to cheap and easy money in 2016 will take its toll.

The global economic outlook carries lots of health warnings right now. While there has been a lot of positive carryover on growth expectations for the US, UK and Europe, thanks to QE’s legacy, the outlook still remains clouded in doubt. Risks are mounting that world growth could slip back into the doldrums in 2016.

The dramatic drop in global commodity prices this year and the 15 per cent collapse in world trade flows over the last 12 months are symptomatic of deep cracks in global demand. Certainly, the International Monetary Fund’s projection for world growth to pick up to 3.6 per cent next year from 3.1 per cent in 2015 looks highly questionable. There is a strong probability that world GDP growth will drop back below 3.0 per cent again in 2016.

The global economy is not rushing into a deep stall just yet, but the pace of economic activity definitely looks under threat, a key bearing on whether the six year old global equity rally sinks or swims in 2016. Hopes for faster growth are absolutely crucial for stock markets sustaining good forward momentum next year.

US Federal Reserve policy intentions are critical for market morale staying upbeat. Rising US interest rates are already underway, but this is only the first step back to normality. There is a bigger shock waiting in the wings from the likely changeover from quantitative easing to quantitative tightening at some future stage.

Ominously, Fed Chair Janet Yellen has already warned markets that the US central bank’s balance sheet will shrink ‘considerably’ once the US economy has reached maximum employment. We are not too far of that point right now.

As the US’s QE-driven liquidity boom was the catalyst for the post-2009 global asset rally, the market’s dread of the Fed down-sizing its balance sheet will mark a major turning point. In spite of all the continuing monetary pump-priming from other economies, any hint of a future Fed switch from US QE to QT will be cathartic.

The Fed’s 4-1/2 trillion dollar stockpile of QE assets, already accounts for about 27 per cent of US GDP, far above its historic 6 per cent holdings. When the garage-sale of QE assets starts for real, the market impact will be significant, setting off a chain reaction of rising bond yields and higher borrowing costs.

Despite all the Fed’s bravado about US economic prospects, consumers, businesses and investors are bound to feel the pinch. And there will be wider consequences too, as the world weighs up the Fed’s return to tighter policy as an iconic first retreat from global cheap money.

This is not good news for global investors who are overweight equities and banking on faster global growth and continuing cheap leverage to keep the rally extended. If risks remain tilted to the downside and investor confidence dives, then flight-to-quality flows back into safe haven government debt and a dash-into-cash could slam global stock and credit markets hard in 2016.

One thing is clear, safe haven bolt holes will stay in high demand. In a risk-off environment, investors will seek safety in the US dollar and Swiss francs. The yen is bound to get a lift as Japanese investors seek sanctuary in their home market.  Slower global growth and heightened financial market tensions will be bad news for commodity currencies like the Canadian and Australian dollars and the higher-risk emerging markets.

The return of risk aversion will be very bad news for investors generally. There will be little comfort in traditional safe haven bond markets like German government debt, where a large part of the curve is already steeped in negative yields.

2016 could mark a year for investors to hunker down and wait for better times. Unfortunately it could be a long wait before the good times roll again.

No quick fixes left as global economy battens down for the Fed’s first rate hike

 

Global policymakers might like to think they walked on water with quantitative easing, but, as Japan has shown over recent decades, once deflation gets embedded, economic miracle cures are no easy solution. The latest downturn in energy and commodity markets is another unsettling sign that the major economies and global financial markets are heading for another deflation wave and tougher times ahead.

Two decades on from Japan’s first foray into QE, the nation’s leaders are still battling to wrestle the economy from the grip of chronic recession risks and deflation dangers - and they remain a long way off from normalising policy. It has been a long hard battle and it is not over yet.

There must be many central bankers from leading industrial countries suffering acute night terrors, wondering how to retreat from zero interest rates and the explosion of QE-led bond buying since 2008 that has left them with an unfathomable puzzle. That is, how to reduce the dependency on super easy monetary accommodation without damaging growth?

This week, the US Federal Reserve will attempt to do just that when it finally lifts interest rates after seven long years at zero per cent. The Fed has decided the time is ripe to begin the return journey to neutral interest rates somewhere around the 3 to 4 per cent mark.
 
The second leg of ‘mission impossible’ comes later on when the Fed starts disposing of its huge 4-1/2 trillion dollar stockpile of QE assets. There is no date fixed for that yet, but the Fed probably wants to put it off for as long as possible. It could wreak a terrible toll on the global economy and world financial markets.

The world can do without more turmoil. Since 2008, the global financial crisis has already been through three disastrous phases. The credit crunch in the US and UK, Europe’s sovereign debt crisis and more recent emerging market mayhem have all left global confidence in a precarious state. There may be no easy way back from a ‘fourth wave’.

When the Fed eventually pares back its over-bloated balance sheet, global liquidity will feel the pinch. So too will global asset markets which have been kept afloat by vigorous QE pump-priming for the last seven years. Investors who have indulged in cheap, easy leverage will suffer severe withdrawal pains as rates go up and liquidity is squeezed.

There will be no easy fix. Markets are already bracing for the dawn of tighter money this week, while the global economy is showing worrying signs of fatigue. The US and UK economies are losing vital momentum, the euro zone is mostly struggling, China is slowing down and Japan has just avoided another technical recession. Emerging economies remain at risk.

The continuing collapse in global commodity and oil prices reveal disturbing cracks in the world economic outlook. The drop in crude oil prices to the lowest levels since 2008 is symptomatic of a growing shortfall in global demand as economic activity slows up.

The aftermath of the global financial crisis is still being felt. Balance sheet restructuring, debt-deflation and austerity cutbacks are casting dark shadows over world economic confidence. Consumer, business and investor optimism remains skittish and the spectre of rising US interest rates could be the tipping point for another major market meltdown.

The Fed is clearly being blinded by glowing US employment numbers, with the US jobless rate back to pre-crisis levels. But it is important to remember unemployment is a lagging not leading indicator. There are still weak links in the US economy and the global backdrop remains deeply unsettled.
 
World trade has already shrunk 15 per cent from levels a year ago. Global growth projections continue to be downgraded by leading forecasters like the IMF and OECD. World economic sentiment remains balanced on a knife edge.
 
If the Fed miscues and global confidence goes into knee jerk reverse, there is little to stand in the way. The world’s policymakers have run out of easy options. The global economy is building resistance to new QE initiatives and there is precious little fiscal slack left while governments continue to cut budget deficits and slash debt.

Global equity, credit and bond markets could easily be swept up into the mother of all ‘taper tantrums’ if the risk-off mentality gets a firmer grip. The danger is global policymakers will end up hapless bystanders without a cure.

Global investors losing patience and faith in the euro

There was once a time when the euro was one of the world’s most favoured currencies, the must-have foreign exchange asset sought by traders, investors and currency reserve managers. It is no longer the case. In recent years the currency has fallen from grace and become more of a pariah with international investors.

Last week’s news that China’s yuan will be included for the first time in the International Monetary Fund’s basket of reserve currencies is likely to deal another blow to the euro’s waning appeal. It will lead to a re-jigging of global investment preferences away from the euro’s failing fundamentals towards the yuan’s growing allure, backed up by much mightier economic and financial resources.

The euro is plagued by deep rooted problems. The European Central Bank is struggling to jump-start faster recovery in the euro area and trying to prevent a slide into deeper deflation crisis. There are mounting credibility issues too with signs of growing internal dissent evident within the ECB’s ranks over its stimulus strategy. And the euro could be hit hard next week when the US Federal Reserve finally hikes rates for the first time in a decade.

It is not looking encouraging. Investors could be deserting the euro in droves, putting a test of parity versus the resurgent US dollar squarely in the frame in the coming weeks.

Nobody wants a currency that fails to protect intrinsic value and loses investor confidence. The euro might have enjoyed a sharp 3 per cent rebound in the wake of the last week’s ECB policy decision, but it was nothing more than a short-covering rally, sparked by investors being wrong-footed by misleading official hints in the lead up to the meeting.

For weeks, the central bank had stoked up expectations that it would deliver a much more effective stimulus package, comprising lower rates with an accelerated quantitative easing programme, releasing much-needed extra cheap cash into the economy.

But last week’s ECB measures fell well short of expectations. The market had hoped for more than the meagre 10 basis point ECB deposit rate cut to -0.3 per cent and the bare-minimum six month extension of the 60bn euro monthly bond buying programme. The disappointment has triggered concerns about a fierce internal row raging inside the ECB.

Germany’s Bundesbank has openly criticised the risks of QE overkill and warned that further monetary accommodation is unnecessary. It is a dangerous rift that casts serious doubts about future strategy and not good news for the currency if policymaking stays divided.

There is a very real danger the ECB will never fully get on top of the crisis, if Germany blocks future policy initiatives. With the ECB’s asset purchase programme already extended to March 2017, the euro will in any case stay chronically depressed for a long while yet.

The inclusion of China’s yuan into the IMF’s basket of reserve currencies, due to take place in October 2016, will be another factor working against the euro in the long run. The euro’s current weighting in the IMF’s Special Drawing Rights basket will be cut to 30.93 per cent from 37.4 per cent. The yuan’s weighting will enter the SDR basket with a 10.92 per cent share.

This is bound to affect relative asset allocation preferences among the world’s central banks as currency reserve managers begin to rebalance investments in favour of the yuan to reflect the new SDR weightings. The yuan looks set to enjoy a honeymoon period in the next few years and mainly at the euro’s expense.

From a standing start in 1999, when the euro was first introduced, the single currency enjoyed a surge in demand with its share of world foreign exchange reserves rising to a 28 per cent peak in 2009. But, in recent years, its popularity with reserve managers has been badly blighted by the euro zone crisis and unsettling market volatility. The euro’s share of world reserves has since fallen back to 2002 levels around 20 per cent and the decline looks set to continue.

With the euro losing investor confidence and its currency fundamentals on the slide, central bank reserve managers will continue to diversify away. The US dollar will prosper thanks to its rising interest rate appeal. So too will the yuan, reflecting its economic and financial strengths.

There seems little the ECB can do to stop the rot. Global investors have lost patience and faith in the euro.