Steen's Chronicle: Excuses change nothing, but everyone feels better
- Two years' gains wiped out in three weeks!
- People are worrying too much about China
- Focus should be on central bank divergence
- Recovery requires a weaker US dollar
What a start to the year! In the space of three weeks we have lost all of the gains in the stock market from 2014 and 2015.
The chart below is MSCI World, MSCI Emerging markets and MSCI Europe – the picture is the same for the US, Japan and China. A wasted two years of “lower for longer?”…. .absolutely!
Congratulations! Three weeks into 2016 and we have lost ALL the gains of 2014 and 2015!
Meanwhile, Italy is on the brink of a new banking crisis, Portugal's new government is about to reverse all of the gains made over last five years and UK is getting pushed towards the EU exit door. Add to this the major political issue of refugees, a US election which anyone with an iota of sanity can see is going from bad to terrible, and a Middle East imploding from low oil prices.
To explain the mechanics of the present correction, which is now entering a bear phase, I made this illustration: The three drivers of markets (Main market focus)
There are three major drivers of markets:
(i) The Fed rate cycle: being the dominant central bank of the world it dictates absolute direction of global rates. The hike in December came after a big increase in funding costs for the corporate and private sectors, but now policy rates (central banks) and market rates are aligned and projected to rise.
The price of money is always the most important input to any economy and right now the market is pricing 1.7 hikes in 2016 (42.5 bps) and the Fed is promising 3-4 hikes (75/100 bps).
When focus again returns to the Fed and its rate cycle it will be a game of "who blinks first". The Fed backing down or the market moving up? For now, clearly, the market continues to fade and mistrust the Fed’s intentions.
(ii) Oil prices: everything you have done today and everything you will do for the rest of the day will have electricity consumption in it. Oil is a main generator of car fuel and electricity so the input cost of energy is a key determinant for real wages and real consumption.
Oil has negatively affected both the price of money and growth globally. The price of money is affected by the fact that there's less “slush money” – the Middle East and all the commodity producers no longer run current account surpluses and hence they have less money to invest in US and European fixed income markets. This drives up the price of money and academic studies have shown that the net reduction in yield when "slush money" is flowing freely has been roughly 100 basis points. (I.e.: Long-term bond yields would have been 100bps higher in this cycle were it not for these investors.)
Likewise, growth impulses from commodity market countries has been net negative due to less money available for importing capital goods and services.
Oil and energy prices, however, also add upward drive to growth. Europe will in 2016 feel the full impact of lower energy prices. As a net energy importer it stands to make considerable gains in disposable income at consumer and business level. This will make it difficult for the European Central Bank to be keep printing money throughout 2016.
The ECB, however, is always lagging the real world. (Don't forget in early 2014 ECB chief Mario Draghi dispelled any notion of deflation!) The lag means that the ECB will move aggressively, but doing so it will have ignored the fundamental net positive impact from energy and the overall healing of the consumer and business sector in Europe. Conclusion: the ECB will be on pause by this summer and central banks will again be facing in the same direction…
(iii) China: that GDP growth is coming down is hardly any surprise!
The “devaluation” is more of a test drive of free capital movements and a support for the economy through raising liquidity to finance debt servicing. That China is finally again moving forwards with more free capital movement and facilitating credit for finance hungry emerging markets countries is hard for me to interpret as a net negative and major focus point!
What is interesting is how aggressively the market is using China as an excuse – it is best shown by this customer survey by BAML:
Get this! Since the last survey (November 2015) the Fed has hiked policy rates, but the market has moved its focus from the Fed rate cycle to China in a big way:
In November, 59% of those surveyed saw the Fed as the biggest macro theme, now less than 23% feels it is important!. China, meanwhile, has moved from 27% to 66%!
The market continues to only be able to focus on one risk at a time. 2016 so far has been all about China but the “only” real concern should be the disparity between where the Fed sees the rate cycle in 2016 (3-4 hikes) and what the market predicts (1.7 hikes). How that evolves is the next directional move in macro.
The weak data start will not get the Fed to step off the pedal in January, but as data starts to come in for January I fully expect the Fed to back to down to first 2-3 hikes, then 1-2, and even ultimately 0-1 but for now, we are involved in a Mexican standoff.
We came very negative into Q1 as our “Mind the gap” Q1 Outlook also projected, but we are getting to levels where “value” again is materialising, especially in the tiered credit spectrum (investment grade and above) and energy/materials.
My model is 100% risk-off, but I am now hedging with CALL options on equity upside and my strategy is more and more….short on the day and closed by the end of the day, awaiting new information. (Rotation back to the Fed being the main focus.)
My USD call – weaker in 2016 - is close to being initiated. The long-term momentum is turning slowly. (I will keep you posted on when it turns).
That is still the main conclusion: The US dollar direction is still the king, the gasoline of the market. The higher the trade weighted USD goes the less risk assets will return. The path of least resistance for investors, policy makers and world growth remains the same: We need a weaker US dollar.
– Edited by Clare MacCarthy
Steen Jakobsen is chief economist and CIO at Saxo Bank