Given this is the last Macro Weekly of 2015, it is a good time to think about the big themes that may shape financial markets in 2016. These are policy divergence, global growth, inflation, EM risks and a possible Brexit decision.
2015 ended with the world’s two key central banks moving in exactly the opposite directions.
Nick Kounis Head of Macro Research
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Have we seen peak central bank divergence?
No. 2015 ended with the world’s two key central banks moving in exactly the opposite directions. On Wednesday the Federal Reserve finally decided to lift interest rates from virtually zero, while earlier this month the ECB cut its key policy rate. This monetary policy divergence has further to run and is not completely priced in by financial markets.
We expect the ECB to cut interest rates again. The central bank projected an under-shoot of its inflation goal in December and was hoping that the stimulus package it announced would close the gap. However, downside risks to its inflation goal have instead increased since then. The EUR/USD rebounded following the ECB’s meeting, and has not come down much following the FOMC meeting. Oil prices have dropped sharply. 2016 looks likely to be the third year in a row that inflation is less than half the ECB’s price stability goal. Meanwhile, the Fed looks likely to raise interest rates again in 2016, when we expect to see another three 25bp steps. This is not fully priced into markets and US-eurozone interest rate spreads will likely rise further and the EUR/USD will eventually decline further.
However, there are also limits to divergence. US inflation is also relatively subdued. Together with the likely strengthening of the US dollar, this means that the Fed will raise interest rates rather slowly. Indeed, it will likely be the slowest rate hike cycle in history. At the same time, the eurozone economy is also recovering. This and limits to the scale of QE likely means that the ECB’s additional stimulus will be moderate.
Will global growth improve in 2016?
Yes, but moderately. We think that global economic growth will firm in 2016, but will still be sub-trend. The US and eurozone economies will likely continue to recover. Domestic fundamentals have turned more positive. US consumers are likely to benefit from ongoing strong job growth and a gradual upswing in wages. In the eurozone, bank lending conditions are easing and the labour market is firming. Meanwhile, emerging markets look to be stabilising and should benefit from weaker currencies and stronger DM demand. Although China’s economy should continue to gradually slow, its drag on the rest of the world economy should ease as last year’s collapse in imports abates.
Having said all that, the pace of growth will still be rather lacklustre. Trend growth in the US and eurozone is lower than in the past so even the above-trend growth rates we expect to see are really relatively low from a historical perspective. In addition, the growth in emerging market economies will be weak compared to recent years as they struggle with a range of problems from tighter financial conditions, to deleveraging and political instability in some countries.
Will global disinflation continue?
No, but the uptrend in inflation will be modest. One of the factors behind the disinflation of the last few years – energy prices – will likely abate. Our house view is that there will be a gradual rise in oil prices during the course of next year as the imbalance between supply and demand eases. In any case the impact of energy prices on annual changes in consumer prices will start to fade even if oil prices stabilise. This is because the year-over-year change in energy prices is currently deeply negative, so if it moves to zero, a significant negative on headline inflation will dissipate. That said, the recent sharp fall in oil prices means that the energy-related bounce in CPI inflation will be less than we anticipated a few weeks ago.
In addition, underlying inflation pressures are weak. In some economies like the eurozone and some emerging markets, this reflects that there is slack in the economy, though a renewed fall in the currencies should revive imported inflation. In the US, wage growth will rise, but the strong dollar will cap import prices. At a global scale, global manufactured goods price deflation looks set to continue given the current weakness in the industrial sector and world trade, and over-capacity in China. Overall, disinflation will likely end in 2016 but reflation will probably be moderate.
Are we set for a new EM crisis?
No, though emerging market risks are the ones we are most worried about. Emerging markets have high levels of private sector debts and many are also vulnerable to lower commodity prices. The worry is that higher US interest rates could trigger another bout of capital outflows, while the resulting tightening in financial conditions could lead to an abrupt deleveraging.
On the other hand, there are reasons to think that most EMs should be able to cope. The ratio of foreign currency reserves to short-term liabilities is high compared to where it was before the late 1990s crisis. In addition, the Fed rate hike cycle should be slow and EMs have already experienced quite some adjustment over recent years on the back of expectations of a Fed exit. Finally, the authorities in China have the tools and financial firepower necessary to achieve a gradual deleveraging in the economy.
Is Brexit a real risk?
Yes. There is a rising possibility that the UK will hold a referendum on its EU membership next year rather than waiting for 2017. If it does, it will be in contention to be the most significant global event of 2016 given the possible ramifications for the world's biggest economic block. Public opinion polls suggest that the gap between those that want to remain in the EU and those that want to leave is quite small and it could go either way. If the UK government achieves a credible renegotiation and recommends staying, the chances that the public will vote to remain in the EU rise. However, all that remains to be seen. The long-term impact on the UK and EU economies of Brexit would depend crucially on the new relationship defined by the agreements reached.
In any case, the uncertainty about the outcome of the referendum and how it will affect the UK’s access to the EU market, could make businesses cautious. It could lead to lower FDI as well weaker investment by UK firms that export to the EU. Sterling and UK assets could well build in a risk premium until there is more clarity.