Three Themes that Will Rock Markets in 2016
Education - Greg McKenna | 04 Jan 2016
Looking back, looking forward
As a year of volatility ends, another seems set to begin
Traders inhabit a world of uncertainty. They must be comfortable making decisions to buy, to sell, to hold or to pyramid positions without knowing the exact outcome. Traders understand this and, for the most part, are comfortable with the world they inhabit.
But 2015 has been an uncommonly volatile year for traders and markets.
If they weren’t fretting about the chances of a Euro implosion and a Greek exit from the single currency, it was fears about the slowing global economy, the weakness in China, the crashing price of iron ore, crude oil’s continued meltdown, stocks red for the year, a Euro below 1.05, perhaps parity and now a Chinese Yuan devaluation and a Fed tightening in the United States.
Greece may have been resolved but, as we look forward to 2016, the year ahead could be just as volatile, or worse. Britain is contemplating an exit from the Euro; a Brexit. At the same time, markets will have to grapple with a US Federal Reserve which looks set to tighten as many as four times in 2016. Traders have to grapple with a crude oil market still heavily oversupplied, with prices falling and broad-based commodity weakness. Then, of course, 2016 looks set to be the year emerging markets may have to face their debt bomb, weaker economies and a clear signal China wants a weaker Yuan.
Elsewhere, a US dollar surge is expected. But could it already have been delivered with big falls across many Forex pairs in 2015? Most pundits say no, but positioning says much is priced in. Stocks look richly priced in the US and beyond, while bonds rallying as the Fed tightens could throw a spanner in many predictions.
2016 looks like another torrid year of volatility with three themes set to dominate the global market backdrop: The Fed, China and the Yuan, and Lowflation. Almost all the trades of 2016 will in some way flow from these three drivers.
With volatility comes opportunity, at least when it comes to trading.
Three big themes in the year ahead
The Fed, the Yuan and Lowflation
Sailing is a great analogy for markets and traders in the post-GFC environment. We’ve had plenty of perfect days broken by intermittent storms and rough weather, but 2015 felt like it was more foul than fair. And it seems there are so many cross currents in the year ahead that it’s a storm sail and battened hatches that will be de rigueur for 2016.
Amongst these many cross currents, three key themes stand out as being at the intersection of all the volatility.
1. The Fed tightening cycle
The Fed is about to embark on its first tightening cycle for nine years. Many argue the US economy is not ready for higher rates. Many argue that the junk bond selloff is the precursor of a US recession, and many argue that inflation in the US will struggle to get back to 2% anytime soon.
But what is clear is that the US jobs market is strong. Unemployment is heading back to pre-GFC levels and, for all of the above objections, the current strength of the US economy is simply incompatible with zero interest rates.
The question of how far and how fast the Fed moves rates is important because of the impact this tightening cycle, has on other markets.
The Fed’s move will impact the US dollar, Euro, Yen, Pound, commodities and commodity currencies. In other words, currencies in general.
The pace and aggressiveness – or not – of the Fed will also impact the US and global yield curves. That drives stock valuations in developed and emerging markets. It could put pressure on the Chinese Yuan, which could appreciate, or it could put more pressure on the Chinese to devalue. A stronger US dollar could pressure the emerging market debt load. It could hurt stocks used to not having to worry about interest costs.
My expectation is for the Fed to alternate between official hawkish talk of action and private talk of calm. I’d expect them to hike in December 2015 and then every quarter in 2016 to end the year at 1.25%.
That’s probably enough to be destabilizing, but not quite enough to crash global markets. But if the Fed discussion moves to shrinking its balance sheet, all bets are off. That would be destabilising.
2. Yuan devaluation and the Chinese slowdown
Markets feared China’s slowing growth rate at various times and in various degrees over the course of 2015. They feared the rate of 7% was nowhere near the real rate of growth. Australian billionaire fund manager Kerr Neilson even suggested the rate of growth, based on the indicators he watches, was closer to a paltry 4%.
Chart: Chinese GDP vs. US GDP
Certainly the economy is slowing. The OECD expects that Chinese growth “is projected to decline gradually to 6.2% by 2017." Manufacturing is slowing, industrial production has been in decline, and urban fixed investment is at its lowest level in 15 years.
As a result of the slowdown the central bank, the Peoples Bank of China (PBOC), has dropped interest rates and released cash into the economy by lowering the amount of reserves that banks need to hold.
On a positive note, however, there are signs in the reacceleration of retail sales growth to 11.2% in November (the fastest in a year) that these measures are gaining traction.
But as the government reforms the economy and tries to chase corruption out of business and the markets, there are risks to China’s economic performance. To mitigate these risks the PBOC is seeking the comfort of a more competitive currency. It shocked the market with a devaluation of the Yuan in August. That set markets across the globe afire with risk aversion and uncertainty and lead to August’s market rout in commodities, stocks, interest rates and currencies.
More recently, after a period of stabilization, the PBOC has been slowly weakening the Chinese Yuan against the US dollar. That’s taken the onshore rate, USDCNY, to the highest level (weakest Yuan) since 2011. That’s also pushed the offshore rate, USDCNH the one most traded by offshore market participants to its highest level since 2010.
This move to weaken the Yuan is critical to the global market outlook in 2016 because many argue that it was the move in the Chinese currency in the 1990’s which precipitated the Asian market crisis. That’s important in 2016 because of the level of emerging market debt being held at a corporate level and the potential, amid the current sell-off in junk bonds and high yield generally, that the weakening of the Chinese Yuan puts more pressure on its competitor countries and the companies within them. Of course, Chinese companies and local governments are carrying their own heavy debt load and is another source of potential instability in the year ahead.
In December the PBOC announced a “basket” peg including the US dollar, Euro, Yen and 10 other currencies as it tried to switch traders' focus away from the bilateral USDCNY and USDCNH rates. It’s clearly a strategy aimed at de-pegging the Yuan from any potential US dollar buying (Yuan strength) when the Fed tightening cycle begins.
It’s also a clear signal that as money flows out of China, or as the PBOC continues to ease, it will not be sterilized. That’s better for the efficacy of policy, the traction of monetary easing, in helping economic growth. It’s also better for the economy which can get a lift from a weaker currency.
But it's problematic for China’s competitors.
But where exactly is the PBOC aiming the Yuan?
This is the big question for traders, and a big theme for markets in 2016. Too much weakness, or too fast, and China risks both the ire of its neighbours and the international community which just voted to include the Yuan, along with the US dollar, Japanese Yen, Euro and Pound, in the International Monetary Fund’s central bank currency basket known as Special Drawing Rights (SDR).
In the lead-up to this decision China promised to keep it currency stable, a strategy it might appear to abandon if USDCNY slips too far.
Chart: Yuan onshore vs. offshore
The question is what is too far and what is a material move?
At approximately 6.47, USDCNY is only 2.4% weaker than the post-devaluation lows. Even against the pre-devaluation level of 6.20/22 USDCNY is only around 4.3% weaker than it was before the move. USDCNH has moved further as traders bet on a bigger devaluation but the PBOC has sort to keep this spread under 10 points recently.
But whether it’s the onshore or offshore Yuan rate when contrasted with the moves we have seen in the Australian dollar, Euro, Sterling and even Yen over the past couple of years and the Chinese are on solid ground, and have a strong argument that the currency is the epitome of stability. Certainly during the GFC and in the post-GFC era they have been an outstanding global citizen when it comes to the management of China’s foreign exchange rate.
So, I’m looking for China to maneuver the USDCNY rate into the 6.8 to 7.0 region we saw before its appreciation began in 2010. That’s a not too hot, not too cold zone.
Lowflation is what the world is suffering from in 2015 and what it looks set to suffer under for at least another year. That is, the inflation rate most of the developed world and parts of the developing is experiencing in terms of consumer and producer price inflation are under the central banks targets. Thus, we have lowflation as opposed to the outright deflation we’ve seen in Chinese PPI for close to four years.
Chart: Inflation - Quarterly 2011 – 2015 (Source: OECD)
Lowflation is important for markets because central bankers worry about a lack of inflation, and ultimately deflation, for two primary reasons.
First, low or falling prices mean consumers don’t lose anything by not spending today. They assume prices will be around the same level in the future and so can delay purchasing. That hurts economic growth as low inflation can lead to a negative feedback loop with growth.
The second reason central banks worry about low inflation or deflation is this economic growth aspect. A lack of inflation, and pricing power, could signal a weak economy and a lack of aggregate demand. Much of the developed world, and China, is in this very situation right now.
Almost universally, inflation across the world is below central bankers target rates or comfort measures.
As central bankers are fond of telling traders, this is because the crash in the price of crude oil, and commodities more broadly, has depressed prices at the moment. They argue that these forces are “transitory” and that inflation will soon be back above 2%.
They may be right. But the trouble with this thesis is the Japanese experience. Through a cycle of depressed energy prices and the boom that took oil well north of $100 a barrel, Japan has steadfastly remained well below the OECD average inflation rate except for a period in 2014.
If Japan is a benchmark worth noting for central banks, something former Bank of Japan Governor Shirakawa asked and answered in the affirmative at the BIS in 2013 when delivering a speech asking whether Milton Friedman was right about inflation being an “always and everywhere” monetary phenomenon. Then the notion that inflation will swiftly, and sustainably, revert above 2% around the world is questionable.
Shirakawa also argued, there is a technological element to lowflation’s persistence around the globe. Shirakawa said the relationship between money and prices “was broken in many economies due to subsequent deregulation and technological change.”
The basic premise of the technological argument for lowflation is that technological advances drive prices down. That can be either through a lower cost of production, and hence cheaper prices, or because technological advancements mean you get more for the same price. Think Smart TV for the price of your old dumb TV. That’s lowflationary.
Technology, Google, Baidu, E-bay, Amazon, smart phones. They are all lowflationary because they are turning commerce, at a retail and business level, into almost perfectly competitive markets. How do they do that? Because all this technology drives transparency, gives pricing power to the buyer and makes business more efficient.
That’s important in understanding what’s going on right here and now in economies and in markets because it might mitigate the Fed tightening in 2016. It could certainly stop the Bank of England from easing and it could even see the RBA ease rates. Crucially though, if lowflation does not stay or slow the Fed, the divergence in policy between US interest rates and the rest of the global central banking elite can drive some potentially huge moves in markets.
Higher rates in the US could drive the US dollar higher. That can depress profits for US companies and will continue to weigh on commodity markets, most of which are denominated in US dollars. It may also accelerate the PBOC’s push toward a weaker Yuan. That will not be easily dealt with in emerging markets and, as we saw in August, whatever the PBOC’s protestations that it is not pursuing a weaker currency, actions speak louder than words and market ructions are almost guaranteed.
Crucially, what lowflation has done over the past few years is undermine faith in central bankers. Like the child brave enough to call the emperor naked, lowflation has exposed central bankers as mere mortals and not the prescient gods of markets many observers thought them. As Bank of Canada governor Poloz said in December, "2015 was another year in the series of serial disappointments".
The Trades of 2016
These three themes intersect across so many markets that even though 2016 looks set to be another volatile year, a number of macro trade opportunities become obvious.
Whether in Forex, precious metals, oil or stock market indices, opportunities abound.
In my next report I will outline my top six macro trades for 2016. Existing AxiTrader clients will receive a copy it as soon as it’s available.
If you’re not trading with AxiTrader, open a live account or subscribe to the AxiTrader blog now for access.
Chief Market Strategist
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