Global Macro Themes of Interest for 2016

I was reading an article on Bloomberg the other day that 2015 is the year that nothing worked.

According to the article and I do believe them, it was the worst year for asset allocation funds since 1937. A 2.2% gain in the SP500 is roughly the best anyone could do.

You might have heard the old saying: “don’t put all your eggs in one basket” and this applies to asset allocation too, if one market is not performing well, probably another one does and we can move our assets there. That didn’t happen in 2015.According to a survey it was the worst annual performance for hedge funds since2011.

For 2016, as an investor, you should begin with a top down approach asking yourself two important questions: why did this happen in 2015 and is this likely to continue?

The main reason for this “unprecedented uncertainty” was mainly monetary policies set by central banks and in particular monetary policy decisions by the US FED.

In the Bible it says, “the Lord gives and the Lord takes away”, in our case the FED created a strong bullish environment for many assets by the introduction of their accommodative QE program and in 2015 in anticipation of the end of QE and a return back to normalizing rates and a more hawkish environment, resulted in the conditions we currently experience.

There were of course over reasons, like the QE in Eurozone, the slower growth in China,the drop in global growth, the impact in commodities and the effect of very low energy prices, fighting deflation, all that resulted in a year that the uncertainty regarding the future and what happens next, caused choppy market conditions, with no distinctive trends, broken correlations and the whole world hanging from the lips of Janet Yellen the president of the FED.

The potential impact from the FED’s decision was huge, for all markets, from Bonds,equities, to emerging markets and EM currencies and basically everyone was on a“wait and see” mode before pulling the trigger.

So more or less these developments shaped the conditions in 2015.

But this is old history now! The next question is whether these conditions are likely to continue in 2016 or if we are expecting something to change that will result in different conditions, a different regime.

Our first macro them for 2016 is that the US markets will outperform other developed markets.

The US is doing much better compared to other developed market economies. Even if projections regarding GDP growth are revised lower for at least the short term, the US economy is creating jobs and we can see a small but obvious rebound in manufacturing and housing.

So how is this affecting markets and the man on the street?

Let’s start with the bond market.

If conditions continue improving and if this scenario proves correct then let me tell you that we will have some important portfolio restructuring.

As short term yields move higher because of the monetary policy and an expected hiking cycle, compressing the difference between short and longer term yields that results in a flattened curve in USD Treasuries.

That worked very well for 2015 but please remember that in the last meeting of the year the FED changed their policy and moved to a hiking cycle.

Now, if the economy keeps going as it is now and the FED doesn’t change their policy dramatically then we can have a hiking cycle that happens at a slow, gradual pace or conditions are far better than we thing and we have a fast, hiking cycle.

Neither of these supports the case for a flattener so please be warned!

Investors and economists do recognize the improved conditions in US but what causes uncertainty is inflation and international conditions. If the economy is improving then why inflation is still moving around the zero level, where is the pickup in inflation?

That brings us to the second macro theme, which is fighting global deflation.

With the exception of US, the effectiveness of QE’s and other accommodative measures on global scale is doubtful.

A structural economic weakness in emerging markets, lower commodity prices, lower growth and weakness in China’s economy and the prospect of a currency war (also known as currency depreciation) make central bankers think twice about a return back to normalizing rates.

Our second macro theme, global deflation, is also the biggest threat for FED’s policy, as international markets nowadays are well connected and a slowdown and a return of deflationary forces on a global scale can seriously affect conditions inside US as well.

Our third macro theme is emerging market currency weakness.

Improved conditions in U Seconomy and the prospect of higher interest rates cause will most likely put downward pressure in EM currencies. Countries like Turkey, Brazil, South Africa or certain South East Asian economies that have an important deficit and depend on foreign portfolio flows will suffer the most. If that scenario materializes will most likely affect commodities too, as deteriorating conditions in EM anda potential drop in demand will cause commodities to drop further. Therefore even currencies from commodity producing economies like the Australia, New Zealand and Canada.

Our fourth macro theme has to do with crude oil as this seriously impacts headline inflation and is a serious catalyst for global deflation. 

In 2015 a drop in demand from EM countries but especially China, caused the price of oil to sink. But I am afraid there were other more complicated reasons as well. The Saudi government the largest producer of oil among OPEC members decided to keep production at high levels, therefore keeping prices lower for two main reasons: they wanted to keep their market share and not lose it to shell oil producers from the States or Iran. There was also a geopolitical reason that also satisfied the geopolitical plans of the US, by keeping oil prices low, they were placing financial pressure in a country that oil is a large portion of their GDP and that’s Russia.

The question is, how much pain the Saudi’s can take in their budget before deciding that enough is enough. The latest budget was better than expected but nevertheless it showed that revenues are falling and they do have a deficit to finance. They have announced important changes in 2016 to promote economic growth and reduce expenses but there are also other economies inside OPEC that feel the pain of low oil prices and the impact in their economy is important.

Let’s now turn to our fifth macro theme which is China itself and the future of global trade. 

We have been witnesses of the fact that central banks and governments around the world have been trying to survive the financial crisis that started in 2008 by introducing accommodative monetary and tighten fiscal policies and lower their exchange rates in order to boost their exports and stay competitive in the global arena.

Was this enough? If we take a look at Eurozone and Japan the answer is probably not and in the case of Eurozone we have important social unrest that can affect the unity of Europe. Growth in the US is there but is anemic. Deflationary forces have not gone away, constantly reminding us how fragile the global economy is at the moment.

How will China respond to these conditions and the rising rates by the US FED? Global trade is expected to remain weak over the next five years and I am certain that China will be looking to stimulate domestic demand and boost exports. Their actions will be closely monitored as they will impact the relations with US and can impact global trade and EM economies.

Of course someone can argue that there are other catalysts as well that can affect the outlook of 2016 but our goal is to apply a top down approach, understand the major macro themes and then start looking at more detailed specific factors that will allow us to highlight the highest probability trades for the year ahead.

As we understand the global financial landscape and what is driving prices on a macro level, then the high probability trades will be revealed, like for example, the Canadian dollar, the USD, commodity currencies, emerging market currencies, European equities, and other opportunities but that is the scope of another presentation.

Thank you!

Fotis Papatheofanous, MBA.