The first day’s trading of 2016 opened with a resounding bang. The Chinese stock markets kicked off on a sharply downward tack, with disappointment in some quarters at the lack of a rate cut from the People’s Bank of China and concerns over the expiry of an emergency rule forbidding selling by large shareholders.
Disappointing manufacturing PMI data fuelled the sell-off and, as the drop in the Shanghai Index hit 7 per cent, trading was suspended by the new ‘circuit-breaker’ system, ironically designed to promote less volatile markets. Contagion spread to other Asian markets, swiftly followed by their European and US counterparts and investors dashed for their long preferred safe havens of US Treasuries, Japanese Government Bonds and gold.
The circuit-breaker fiasco could be viewed as yet another lesson learned by China’s authorities in their efforts raise the sophistication of their financial markets. The unforeseen consequence of the newly introduced system, however, was that freezing the market at its lowest point killed off any chance of an intra-day bounce, which typically follows a weak morning session, and global risk assets headed for the exit.
As we have said for some time, when uncertainty is at such unusually elevated levels the slightest alarm can turn into a panic. The reverse, of course, is also true. Indeed this degree of uncertainty is our greatest concern for 2016. None of the major themes for the year offers a clear or predictable picture. It would be just as easy to make a bull or a bear case for both of the world’s largest economies, namely the US and China.
If we believe the US Federal Reserve’s statements a few weeks ago, there is little to fear from US inflation reports near term. GDP growth continues at a moderate pace, labour markets are showing “considerable improvement” and Fed chair Janet Yellen remains “reasonably confident” that her preferred measure of PCE inflation, currently 1.28 per cent, will hit her stated target of 2 per cent over the medium term.
The US consumer is enjoying the benefits of lower fuel prices and consumer credit remains in a growth phase. However, rents are rising sharply due to a shortage of available property, a situation that may already have skewed the CPI figure upwards. Labour markets have been tight but are getting tighter. Upward pressure on wages is now starting to become evident.
So, despite a restrained headline PCE inflation reading, it appears that considerable inflationary pressures are building in the US economy and the Fed may already be as much as 75 or 100 bps behind the curve.
Indeed, the forecast ‘gradual’ hikes in the Fed funds rate could abruptly turn into a scramble upwards, chasing a sharply rising inflation figure. Add to this that Fed futures are currently pricing in only two interest rate hikes this year against the Fed’s current prediction of four hikes and the result could be more extreme swings in market sentiment.
The direction of the US dollar over 2016, though critical for global trade and markets, is also far from clear. In the last two interest rate hiking cycles, beginning in 1994 and 2004, the US Dollar fell on the initial upwards move in rates and then tracked sideways for three years.
So, after a seven year US Dollar bull-run, the widely anticipated further strength against other major currencies may not materialise. This would be good news for US exporters, which have long been battling currency headwinds and for the 40 per cent of global trade which is denominated in or linked to the US Dollar. This would of course be less positive for the remaining 60 per cent of global trade. It is hard to pick the winners at this point.
The oil price spiked in the final days of 2015, as hostile words were exchanged between Saudi Arabia and Iran. Only a few weeks previously, however, the price of Brent oil futures had taken another downward lurch. On a technical basis, there seems little to support the oil price, given supply side excesses in the US and the Middle East, coupled with oil inventories at historically high levels. Added to this, exceptionally mild weather in parts of the Northern Hemisphere has provided no seasonal boost from the demand side.
We had expected that steep falls in oil in the early part of 2015 would soon start to drop out of annualised comparisons, automatically adding a little ‘benign inflation’ to the major economies, where prices generally are struggling to gain traction. However, further volatility seems the only certainty near term, given the opposing forces at work here.
As we move further into 2016 there remains a considerable degree of uncertainty over the divergent trajectories of interest rates, currencies, commodities, bond and equity markets and the global economies.
With an overlay of heightened geopolitical concerns, market volatility higher than experienced in recent years seems the only predictable outcome. We have already witnessed the scale that markets can whipsaw on relatively little provocation. We continue to recommend a broad diversification of investments in order to deal with events as they unfold.
Caspar Rock is CIO at Architas.