What to expect in 2016 – same, same, but worse

Trading on Fear

It is clear that markets so far this year are trading on sentiment, more specifically fear, with hard-data playing second fiddle. Or more accurately, price action suggests that markets are focusing on disappointing December numbers (e.g. US ISM) or even reasonably uneventful data (Chinese manufacturing PMI) and ignoring strong data such as U.S non-farm payrolls, Chinese services PMI and exports (see Figure 1).  The hit-and-miss approach of Chinese policy-makers to stabilise equity markets (and ultimately growth) have done little to restore confidence. I nevertheless flag in Figure 37 some of the key data and events to focus on this year.

Olivier desbarres 2016 guide fig 1&2

The key themes of 2015 are likely to remain at the forefront of markets’ mind and, if anything, become more acute. We will need to add to the mix US elections in November and a possible UK referendum on EU membership in H2 2016.

I summarise below my expectations for macro trends, monetary policy, currencies and politics in 2016, cognisant that a year is a very long time and that unknown-unknowns, particularly in the geopolitical arena of the Middle East and South China Sea, may catch policy-makers, markets and analysts off-guard. The bolded sections in the two tables are discussed in detail, other themes will be developed in forthcoming research notes.

Key expectations for 2016

  • Global growth will slow further, not collapse (see Figure 3). Headline inflation in developed economies is unlikely to rise much but core consumer prices will again avoid deflation (see Figure 7). The relationship between central banks and governments is likely to become increasingly tense.
  • US Fed may again have to tone down its hawkishness, but with little priced in by the market and risk aversion prevalent, US dollar appreciation should extend.
  • Eurozone will continue to contend with major cyclical and structural headwinds, including stubborn unemployment, tepid lending, nationalism and the immigration conundrum. Expect the ECB to ease monetary policy further and keep EUR/USD well anchored, with European policy-makers somehow succeeding in keeping the eurozone and European Union away from the abyss.
  • German story has quickly lost its lustre and I don’t discount Chancellor Merkel resigning.
  • UK consumer price inflation will remain tepid, as retail sales and GDP growth are struggling to gain velocity. This will keep the Bank of England on hold until very late in 2016 and sterling under pressure near-term. “Yes” vote will win the referendum on EU membership.
  • Falling commodity prices will keep exporting nations and their exchange rate regimes under pressure but I expect pegs to US dollar to hold.
  • Emerging economies’ growth model is clearly flawed and they will continue to experience capital outflows, keeping their currencies under pressure. But markets tend to under-estimate their fire-power, with EM central bank FX reserves still $2.5 trillion higher than pre-2008 (see Figure 31).
  • Non-Japan Asia currencies are likely to weaken further versus the US dollar but nominal effective exchange rates will hold up better. INR and THB look quite attractive.
  • Chinese growth will slow further but the key question is whether and how policy-makers deal with the elephant in the room – namely the large financial losses of corporate and local governments and banks’ bad loans.
  • CNY depreciation still more likely than shock-and-awe devaluation.


Global growth – slowing, not collapsing

Global GDP growth ticked up very slightly in Q4 to around 3.1% yoy, based on global manufacturing PMI data (see Figure 2), taking growth to a six-year low of around 3.1% in 2015, using IMF country weights (see The global growth collapse that never was but may still be, 18 December 2015). But global growth did not collapse, thanks partly to decent consumer demand buoyed by the improvement in labour markets in major economies, including the US, eurozone and UK (see Figure 3 and Figure 5), and ultra loose monetary policy.

International institutions on average forecast global growth to accelerate nearly 0.5 percentage points in 2016 (see Figure 4). It is difficult to see where this extra growth will come from and history suggests that these forecasts will be subject to downward revisions.

Major central banks’ interest rates are already near zero and in the case of a number of European central banks in negative territory, and the marginal benefits of ever-expanding central bank balance sheets are debatable. Meanwhile governments are showing little appetite for the kind of serious reform required for material productivity gains.

Olivier desbarres 2016 guide fig 3&4

Global – Crude oil prices approaching a cross-road

Crude oil prices have collapsed to below $30/barrel and while the outlook is opaque because of a complex supply picture the risk is still biased towards further price falls near-term. Global demand remains lacklustre, Iran oil production is coming back on line and OPEC has been unwilling to restrict the production of crude oil, with Saudi Arabia in particular prioritising market share over a higher oil price.

The risk to this scenario stems from oil production cuts, rather than significantly stronger demand. First, there is mounting evidence that oil exporters economies in the Middle East, Latin America and Africa, are under severe strain and policy-makers under pressure to boost prices by restricting supply. There is seemingly disagreement within OPEC, with Nigeria pushing for production cuts. Saudi Arabia’ fiscal deficit has ballooned and large FX outflows are raising questions about the viability of the currency’s peg to the dollar. Second, US shale oil and gas companies are delaying or mothballing investments totalling $360bn and production is likely to have peaked.

Saudi Arabia would likely sacrifice its oil policy before it sacrifices its 30-year old fixed exchange rate regime but the world’s second largest oil producer is unlikely to have to sacrifice either. While the kingdom’s central bank FX reserves fell by over $100bn in the 12 months to November, they are still a sizeable $635bn or 56 months of merchandise imports. Put differently, Saudi Arabia still has the means to sit out the pain from lower oil prices. Only when its US competitors are largely out of the picture and oil prices stabilise – potentially the story for H2 2016 – is Saudi Arabia likely to start curbing production.

Global – Governments and central banks to continue enduring rocky marriage[1]

Lack of government leadership has left world economy vulnerable

Governments in the US, Europe and emerging markets have struggled to successfully address key structural issues. These include weak economic growth, stubborn eurozone unemployment, low productivity growth, aging populations, unfunded pensions and fiscal deficits, creaking infrastructures, private and public indebtedness and immigration.

A lack of clear and strong leadership in the major economies and governments’ unwillingness or inability to fiscally reflate their indebted economies are key to understanding why the global economy (and markets) remain vulnerable six years after the great financial crisis.

In the US President Obama is nearing the end of a sometimes impotent presidency, with policy-makers increasingly focussed on November’s elections and a bloated list of presidential candidates. European Union leaders, bogged down by the reputation-sapping Greece fiasco – which may once again rear its head – are now in disunity over how to deal with the mounting emigration and refugee crisis. The combination of large-scale migration, threat of terrorism and years of tepid economic growth, particularly in Southern and Eastern Europe, has contributed to the ascendancy of nationalist and populist parties and often fragmented parliaments (see European Union – Nationalism’s rise).

German Chancellor Merkel may well come under pressure to step down early, in my view – something unthinkable even a year ago (see European Union – the Merkel Factor). In Australia, the fifth prime minister in five years was appointed last year – hardly the pre-condition for sound long-term economic planning. Even in the UK, where the ruling Conservative Party convincingly won the May elections, Prime Minister Cameron is engaged in a bruising domestic and European battle to reform the EU ahead of a possible UK in-out referendum later this year.

Emerging markets no longer the all-in-one solution to world’s ills

The story is not much different in emerging markets. China’s transition from over-investment to higher value-added exports and consumption driven growth has stalled, with markets struggling to quantify the damage to Chinese corporates and banks. The collapse in oil prices and Russia’s annexation of Crimea have severely weakened both the economy and President Putin’s credibility. In Brazil and Malaysia, allegations of financial impropriety are rocking leaderships. The recent dismissal of the South African and Brazilian finance ministers, seemingly motivated by political considerations, has done little to shore up investor confidence.

In their defense, governments argue that after years of over-spending and spiralling deficits and debt they are left with very little fiscal headroom to spend their way out of trouble. In particular, a number of European Union countries, including France and Spain, are already likely to overshoot the 3% of GDP fiscal deficit ceiling this year and next. A sub-optimal deployment of these limited fiscal resources has compounded the challenge.

Passing the buck

Faced with seemingly intractable problems, governments have increasingly turned to their central banks for solutions. Central banks have responded, cutting policy rates to record lows. The Danish, Swiss and Swedish central banks have gone a step further by taking policy rates into (unchartered) negative territory, while the European Central Bank (ECB) cut its deposit rate to -0.2% in September 2014.

Financial innovation has of course not stopped there. The Bank of Japan (BoJ), US Federal Reserve, Bank of England (BoE) and more recently the ECB have engaged in Quantitative Easing (QE) – large-scale buying of government bonds – in a bid to improve export competitiveness and kick-start lending, borrowing and ultimately growth and employment.

For a while central bankers were the new rock stars of policy-making, with market participants shining the light firmly on monetary council members for guidance, analysing in ever greater detail the content and tone of even their most benign comments.

A flawed model and a strained relationship

But it has become clear that this model is flawed and cracks have started to appear in the relationship between central banks and their elected masters. Nowhere have these been more obvious than in the ongoing tensions between the ECB on the one hand and the German Bundesbank and Finance Ministry on the other.

Fundamentally, central banks simply do not have the policy magic-wand to hit multiple and sometimes conflicting targets which include low and stable inflation, strong growth and financial stability. Looser interest and exchange rate policies can have a positive impact on economic variables in a cyclical downturn. But their initial positive impact tends to fade over time and they can also distort incentive structures and asset markets.

In particular, the one-off boost to exports from a currency devaluation typically tapers off as relative price is only one of many desirable attributes for exports of goods and services. The positive impact will also be negated if other competitor currencies benefit from currency-weakening policies – currency wars, whether explicit or not, tend to leave few long-term winners (see Economist)

Furthermore, monetary policy is typically ill-suited to deal with problems of a more structural nature. Japan and the eurozone are cases in hand. The Japanese economy has struggled despite multiple rounds of BoJ QE and this should have been a warning to other central banks going down this path. While the ECB’s QE has successfully made the euro and exports more competitive and lowered borrowing costs, bank lending and private sector borrowing have risen only very slowly and unemployment remains above 10% for the fifth consecutive year (see Figure 5). ECB governor Mario Draghi has left the door wide open for a further expansion and/or extension of its current QE program but expect diminishing returns in the absence of serious structural reforms.

QE in the US has arguably proved more successful, with GDP growth reasonably stable around 2.5% year-on-year in the eight quarters to Q3 2015 (see Figure 6), labour productivity ticking up and the headline unemployment rate at multi-year lows (see Figure 5). But it has done little to paper over the economy’s structural cracks, including a worrying erosion in labour participation rates and an ageing power and transport infrastructure in dire need of investment.

Olivier desbarres 2016 guide fig 5&6

Central banks bear part of the responsibility for disinflation threat

The expectations which governments and economic actors have heaped onto central banks are clearly unrealistic and ultimately counter-productive. But that does not mean the central banks are totally off the hook.

Central banks’ spheres of responsibility have broadened exponentially since 2009 and they have so far kept at bay another global financial crisis, but for most monetary institutions securing moderate and stable inflation remains a key goal (often enshrined in legislation).

On this front, central banks have so far only done just enough to avoid deflation. But with global growth likely to slow further this year, deflated energy prices and the diminishing efficiency of monetary policy, the threat of falling prices remains alive. While fears of global deflation in 2015 were overhyped, a GDP-weighted measure of global consumer price inflation for the world’s largest economies dropped to around 1.6% year-on-year in November from 2.2% in 2014 and nearly 4% in 2011 (see Figure 7). For developed economies – namely the US, UK, eurozone, Japan, Australia and Canada – the picture is even more gloomy with headline inflation only just hovering above zero (see Figure 8).

Admittedly this partly reflects the fall in energy prices, which central banks would argue they have little or no control over. Global core inflation has been remarkably stable around 2% since mid-2011, but for developed economies and China that figure is closer to 1.5%. At the other end of the scale, the central banks of Russia and Brazil are likely to continue grappling this year with an acute inflation problem.

Olivier desbarres 2016 guide fig 7&8

Policy flip-flopping and erroneous forecasts

Central banks’ flip-flopping on key policy decisions has arguably been a contributing factor. Despite years of morose eurozone economic activity, the ECB only announced its QE program in January 2015 – by which time the UK and US bond buying programs had already run their course. In the US, FOMC members have repeatedly revised down their expectations for appropriate interest rate hikes and failed to provide a clear and consistent message (see Figure 9). In the space of a year, they have revised down their end-2016 forecast by 125bps – a full five hikes – to about 1.3%. In the UK, BoE Governor Mark Carney was forced into a number of u-turns in 2015 following unexpectedly strong labour market data alongside near-zero inflation.

At the heart of the problem is major central banks’ repeated failure to accurately forecast domestic and international economic trends (let alone financial markets). No econometric model can capture all “unknown unknowns” but the margins of error are difficult to justify. In particular the Fed has systematically failed to accurately forecast inflation. In September 2014, the FOMC was forecasting PCE inflation at 1.6-1.9% yoy in Q4 2015 – 1.5 percentage points above actual inflation or 1.5 times the standard deviation of PCE inflation using 20 years worth of monthly data.

Olivier desbarres 2016 guide fig 9

Finally, central bankers have at times been emboldened to embrace a far broader-than-traditional mandate, encroaching on issues normally the preserve of government officials – such as global warning. This has in turn strained relations with elected leaders and perhaps of more concern potentially diluted their focus on variables which they can actually influence. Some, including Bernie Sanders who is currently polling second in the US Democratic Party primaries, have also publicly criticised the inner workings of the Fed and its relationship with Wall Street.

In the same way that curbing central banks’ authority and independence is regarded as potentially damaging to a country’s economic prospects and credibility, the current trend of relying on central banks to do most of the heavy lifting is proving problematic. The solution may not be simple given the depth and breadth of challenges which economies face today, but a more focussed and realistic mandate for central banks would likely be a step in the right direction in addressing the deep-seated problems affecting today’s major economies.

US – Fed policy path still the elephant in the room

The idea that the Fed finally hiking rates after nearly a decade would somehow quash market uncertainty was always wishful thinking. What the Fed does next remains the elephant in the room (see The first hike is the hardest…and so is the second and third, 15 December 2015).

FOMC members’ median expectation is four 25bp hikes this year, which would take the policy rate to 1.375% (see Figure 10). The weighted average is for a slightly less hawkish 91bp of hikes. The Fed expects a stronger US economy will gradually push inflation to 2%, but recent history shows that FOMC members have a tendency to be overly-hawkish (see Figure 9). Analysts and finance experts have a more dovish view, forecasting respectively 75bp and 30bp of hikes. The market is only pricing in 40bp of hikes – or one full hike and a 60% probability of a second hike.

By definition someone will be proven wrong and I would argue that it will again be the FOMC. US GDP growth likely slowed in Q4 2015 to around 1.2-1.3% quarter-on-quarter annualised from 2.0% in Q3, dragged down by an uncompetitive and weak manufacturing sector (see Figure 1). Headline non-farm payrolls numbers have been strong but job creation has been concentrated in the low-paid sector and the labour participation rate is still below the long-term average. At the same time forecasts for an imminent US recession (two successive quarters of negative GDP growth), which seem to have recently gained traction, probably ignore the resilience of US consumption.

Olivier desbarres 2016 guide fig 10&11

US dollar hat-trick

For the second year running in 2015 long dollars was one of the most profitable currency trades, propelled by the resilience of the US economy and the Fed going against the global trend of easier monetary policy (see Figure 11). I expect dollar appreciation to extend to a third consecutive year even its gains are likely to be more modest.

Market pricing of Fed rate hikes is very slim so FOMC members could halve their expected number of rate hikes without conceivably having a material impact on the dollar. There is a risk, however, that even if the Fed hikes broadly in line with market pricing – say in March and then again only in H2 2016 – the market will interpret this long time gap as the Fed’s tacit admission that it pulled the trigger too soon in December 2015, in turn pressuring the dollar. Furthermore, while the Fed has seemingly been largely immune to the dollar’s appreciation (and its negative impact on manufacturing), there may be a level at which the Fed can simply no longer ignore dollar strength.

I still think that it would take a cataclysmic US and/or global event for the Fed to reverse its recent hike. While such a policy u-turn would undoubtedly destroy the Fed’s already soft credibility, history (i.e. 2008) tells us that in this scenario of extreme risk aversion the dollar tends to outperform.

European Union – Nationalism’s rise

Nationalist parties are on the rise in the majority of EU states (see Figure 12). They are already in power in Greece, Hungary and Poland and have strong parliamentary footholds in Spain, Lithuania and Finland. While they still only have a small number of parliamentary seats, they currently lead national opinion polls in the Netherlands and Sweden and performed strongly in recent local and regional elections in Austria and France, respectively. A notable exception is Norway where the Progress Party fared poorly in recent municipal elections.

Olivier desbarres 2016 guide fig 12

This reflects national electorates’ legitimate concerns and may not have a direct or immediate impact on financial markets, particularly as nationalist parties in the larger economies still have few seats in power. UKIP only won a single seat in the British lower house of parliament. In France, the FN failed to win a single region in the second and final round of voting. This suggests that the French electorate is not yet willing to give power to a party that it still views as too right wing and lacking coherent economic policies despite Marine Le Pen having distanced herself from her father’s more extremist views.[3]

But this rising nationalism is fragmenting parliaments and is partly responsible for derailing governments’ urgent structural reform agendas at a time when monetary policies are losing their potency.

European Union – the Merkel Factor

German Chancellor Merkel has for many years been rightly regarded as the eurozone’s safe pair of hands. But her star has been fading and she is facing falling popular support and splits within her coalition government.

Germany’s handling of last year’s Greece crisis divided its European partners and exposed the EU’s cumbersome decision-making process. The recent events in Cologne and strong opposition from many EU leaders to Merkel’s open-borders-immigration stance have forced her to dilute a cornerstone policy. At a macro level, export and GDP growth has been soft in recent quarters, casting doubts on Germany’s export-driven model and intensifying calls for Germany to loosen fiscal policy. Volkswagen’s demise in one of Europe’s worst ever corporate scandals has severally tarnished Germany’s corporate image of efficiency and transparency and arguably its credibility on the global stage. The yet-to-be opened €6bn Berlin airport fiasco has dented a once-invincible aura of fiscal discipline.

Whilst still a low probability event, I would not rule out Merkel resigning before the autumn 2017 elections, with Finance Minister Schäuble taking over. Schäuble is an experienced and respected politician but political instability in the EU’s largest economy (and world’s fourth largest) would reinforce the view of a somewhat rudderless European Union. Other major EU powers are seemingly unable or unwilling to step up to the mark, with France led by an unpopular president dealing with the aftershocks of terrorist attacks in 2015. Italian Prime Minister Renzi has been a vocal critique of Germany but is young and untested on the bigger stage and Spain’s economy is showing promise but from a very low base.

UK – Inflation still nowhere to be seen

While core CPI-inflation has edged up above 1% yoy, headline inflation is stuck around 0% (see Figure 13).  Modest retail sales growth and falling energy prices are likely to keep core in check and headline inflation well below the BoE’s 2% target. There is also some evidence that retailers under pressure from on-line sales are squeezing profit margins, rather than increasing prices, in order to maintain market share. I look in turn at the drivers of inflation, which I summarise in Figure 14.

Olivier desbarres 2016 guide fig 13&14

Total employment growth has picked up, the employment rate[4] has edged up above 60% for the first time since July 2008 (see Figure 15) and the unemployment rate has fallen to a seven and a half year-low of 5.2% (see Figure 5). The labour market has clearly got tighter, with some industries such as construction, reporting severe labour shortages. But the UK labour market is still short of being tight, in my view. The share of full-time employment is still quite low by historical standards (see Figure 15) and net immigration shows few signs of abating.

Olivier desbarres 2016 guide fig 15&16

This may explain in part why wage growth, while finally in positive territory, remains modest and weekly earnings are still nearly 10% below their early 2008 peak (see Figure 16). The UK has at least for now seemingly made an implicit decision to prioritise jobs, even if part-time, over pay. Wages are also likely being anchored by modest inflation expectations, in turn held back by flat-lining inflation headline CPI prices (see Figure 17).

Rising consumer credit is potentially a more potent driver of consumer demand. Net unsecured lending to individuals hit a near 10-year high of £14bn in the 12 months to November, although it remains 40% below its peak (see Figure 18).

Olivier desbarres 2016 guide fig 17&18

Despite positive wage and employment growth and rising consumer borrowing, retail sales growth remains modest around 2% yoy and has lagged US growth (see Figure 19). This may be in part due to cash being saved rather than spent (see Figure 20).

Olivier desbarres 2016 guide fig 19&20

UK – Rate hike still a distant mirage

The slowdown in UK GDP growth, muted prospects for inflation and planned fiscal tightening this year point to the Bank of England keeping its policy rate on hold at 0.50% for at least the next 6-9 months. This would imply the spread between the UK and US central bank policy rates, which narrowed to 12.5bp in December, turning negative in coming months for the first time since end-2006 (see Figure 21).

This is justified by the two countries’ relative macro fundamentals, as I argued in US slow sizzle, UK slow boil (3 December 2015) and would be broadly in line with market pricing of rate hikes for 2016 of 40bp for the Fed and 11bp for the BoE (see Figure 22). By contrast, in a survey I conducted in on 15 December (i.e. before the December Fed hike) respondents on average forecast both the Fed and BoE to hike their policy rates about 30bp in 2016. Market pricing – effectively only a 45% probability of a 25bp BoE hike – may be tested later in the year if decent UK labour markets, a weaker sterling and higher energy prices are putting a bit of pressure on inflation and the referendum on EU accession goes in favour of the “yes” vote.

Olivier desbarres 2016 guide fig 21&22

UK – Sterling recovery likely to come late in the game

Sterling has weakened sharply since end-November (see Figure 23) and I expect it to weaken further in coming months. But I see scope for sterling to regain some ground later in the second half, premised on three key drivers: (i) The Bank of England hiking its policy rate or at least preparing the ground for a hike; (ii) a “yes” vote at the EU referendum pencilled in for H2 2016 (see below UK in-out EU referendum: “Yes” vote to edge it); and (iii) the positive impact on manufacturing and the economy from a more competitive currency.

Olivier desbarres 2016 guide fig 23&24

UK in-out EU referendum: “Yes” vote to edge it

Prime Minister Cameron has committed to holding a referendum in the second half of the year on whether the UK should remain a member of the European Union. It may be pushed back into 2017 if Cameron’s negotiations with his EU counterparts over the UK’s terms and conditions of EU membership stall. Along with the house prices, Corbyn (and the weather), few other topics are getting as much air time.

Opinion polls put the yes and no votes broadly neck and neck, but the UK general elections in May cast a serious shadow on the reliability of UK opinion polls. In a Survey which I conducted in July, 83% of portfolio managers, analysts and finance specialists with a view forecast that the UK would still be in the EU by the end of the decade.

My core scenario is that Cameron will secure the “yes” vote, premised on his ability to secure a better deal for the UK and the electorate’s conservative nature. I acknowledge, however, that intra EU negotiations can be protracted, emotional and unpredictable. Furthermore, the immigration issue has given weight to the campaign to take the UK out of the EU. Whether the UK is better off in or out of the EU is an immensely complex topic – partly because there is no precedent – which I will leave aside for now.

Germany and France, and more broadly the European project, cannot afford to lose the EU’s second largest economy. Indeed, Cameron’s initial discussions with key trading partners to reform the EU and ultimately give the UK a greater degree of autonomy in decision-making, including on immigration and benefits, suggest there is some scope for negotiation. The UK economy has performed well and the government committed to further fiscal tightening, which has resonated with Chancellor Merkel. The governments of Hungary and Poland have also agreed in principle to some of Cameron’s demands.

Finally, last year’s “yes” vote in Scotland’s referendum on UK membership suggests the collective desire to be part of a union should not be under-estimated, while the incumbent Conservative Party’s convincing win in the May elections underlines the electorate’s affinity for continuity, rather than the unknown

UK – Buy-to-let market under pressure, house prices less so

House prices in the UK may not stabilise, let alone fall materially, any time soon as new housing builds struggle to keep up with demand propped up by cash buyers, cheap and plentiful credit and rising wages. The rise in prices may however slow given forthcoming changes to non-resident domicile status and recent curbs placed on the UK buy-to-let market.

Since early 2009, UK house prices have surged 23% and 33%, respectively, according to the Land Registry and Nationwide, to 4.5% above their previous high in October 2007. In contrast, US house prices are still 5% below their all-time high in July 2006 (see Figure 25). The Bank of England’s governor, Mark Carney, has repeatedly highlighted the risks associated with asset price inflation in terms of the country’s financial stability. Moreover, Nationwide’s affordability index, which measures mortgage payments as a ratio of mean take home pay, rose to a 7-year high of 66% in Q3 in London (see Figure 26), pricing out low-income first-time buyers and exacerbating wealth inequality. This is politically problematic for a government that campaigned in favour of more affordable housing in the May elections and its recent measures aim to tackle the supply of and demand for housing, as well as access to capital.

Olivier desbarres 2016 guide fig 25&26

The recently introduced starter home program, through which 200,000 first-time buyers will be able to purchase new houses or flats at a 20% discount, is a step in the right direction but comes after years of lacklustre supply of affordable housing under both Conservative and Labour governments. It is also debatable whether these properties will be truly affordable, particularly in big cities, with builders reluctant to flood the market with new supply.

Policy-makers have therefore been turning their attention to housing demand, adopting a two-pronged approach. First, they have improved access to cheap capital for those trying to get onto the housing market, by introducing the help-to-buy scheme – effectively an interest-free loan to borrowers with a 5% deposit. Second, the reform of the resident non-domiciled tax status due to come into effect next April may curb demand for housing, particularly at the high end.

The real headline-grabber, however, is the Chancellor’s recent decision to cut tax relief on buy-to-let properties and increase the stamp duty on second properties. Moreover, the government recently announced the possibility of giving the Bank of England the power to place tighter limits on buy-to-let mortgages. While it is too early to judge these policies’ effectiveness, a less lucrative buy-to-rent market may in turn cool the demand for, and prices of, housing assuming the government can close any loopholes.

But underlying demand for housing is likely to remain well underpinned:

  • Cash buyers: The share of housing bought entirely in cash has risen to close to 40% from 35% in 2013 and 15% before 2008, with foreigners accounting for a decent chunk of this buying. Figure 24 indeed shows that UK house price inflation, which pre-2008 closely tracked mortgage lending, has since far exceeded the rise in mortgage lending.
  • Lending: Those buying their first property or up-scaling still have access to reasonably cheap and plentiful credit. In January-November 2015, gross secured lending to individuals rose 6.5% yoy to £200bn. Net lending[5] was up a dramatic 38% yoy to £30bn with plenty of upside before lending even gets close to 2007 levels (see Figure 18).
  • Wages and employment: Employment and wage growth has picked up, albeit from low levels (see Figure 15). As a result national affordability ratios have slowly improved since mid-2014 to near the long-term average of 33% (see Figure 26).

Hiking the policy rate to cool the property market is a blunt instrument given large intra-regional differences in housing prices and affordability and the BoE will be conscious of wiping out a material share of people’s wealth. So for the time being UK policy-makers are likely to stick to a more surgical approach of trying to control credit growth, reducing the attraction of buy-to-let and increasing the supply of new housing – enough to stall the buy-to-let market but probably insufficient to materially reverse the rise in UK house prices.

Emerging Markets – Another tough year ahead

2015 was a very tough year for EM economies, particularly for the commodity exporters – Brazil (oil, metals, iron ore, food), Russia (oil, gas, metals), South Africa (metals, iron ore, coal) and to a lesser extent Malaysia (gas, palm oil) and Indonesia (oil, gas, coal). Commodity prices at end-2015 were 8% lower than at the peak of the financial crisis in late 2008 (see Figure 27), with the largest price drops recorded in natural gas and iron ore (see Figure 28).

Olivier desbarres 2016 guide fig 27&28

The prospects for 2016 are not rosy, with perhaps a few exceptions including India. Weak prices for hydrocarbons, metals, food and agricultural raw materials will continue to weigh on the current account and fiscal balances of commodity exporters, in turn keeping their currencies under pressure and exacerbating double-digit inflation in Brazil and Russia. This will make it much harder for these countries’ central banks to support economic growth by cutting rates.

Government policies have so far compounded the dilemma. The embargo on Russia is cutting into much-needed foreign exchange revenues, changes of key personnel in South Africa and Brazil have undermined market confidence and damaging scandals have rocked governments in Brazil and Malaysia. Without structural reforms, these countries will remain in a tight bind.

Non-Japan Asia (NJA) – Positive glimmers amongst the gloom

The outlook for NJA is arguably not as morose, but its two power-houses – India and in particular China – have their own battles to win (or lose).

For starters, the economies of India, Thailand, Korea, Taiwan and in particular Singapore benefit significantly from lower oil and gas prices (see Figure 29). The net benefits to China and Philippines are more modest. Indonesia and in particular Malaysia are net losers due their significant oil, gas and coal exports (see Crude Expectations, 16 January 2015).

Olivier desbarres 2016 guide fig 29

But we should not over-inflate these benefits as low oil prices partly reflect weak global demand, a concern for Asian exporting nations. Furthermore, the recent fall in oil prices is impressive in percentage terms, less so in dollar-terms, and the dollar fall in oil prices is likely to be less dramatic going forward – after all there is a hard floor at zero[6].

Olivier desbarres 2016 guide fig 30&31

Emerging Market currencies running into walls

In any case the gains to net commodity importers from lower prices prices are unlikely to compensate for likely large capital outflows in the face of general risk aversion and weak exports (see Figure 30) and EM, including NJA, currencies will remain under pressure (see Figure 32). The question is which central banks have the willingness and scope to support to their currencies. Much was made of the $540bn fall in the US-dollar value of EM central banks’ FX reserves last year to a 3-year low of $6.5 trn – and by implication of their ability to support their currencies (see Figure 31). But this was partly due to valuation effects – namely a strong US dollar – and the USD-value of FX reserves is still $2.5trn higher than before the 2008 crisis.

I would expect NJA central banks to favour continued modest weakening of their nominal effective exchange rates (NEERs), to support export competitiveness, but to resist large devaluations which would then become hard to control (see Figure 34). Higher imported inflation from weaker currencies is unlikely to be an issue given soft core and headline inflation.

Therefore, NJA central banks are likely to intervene in the FX market to slow and smooth, but not stop let alone reverse, currency depreciation versus the US dollar. Central bank FX reserves in India, Korea, Philippines, Thailand and Taiwan are sufficiently large, in terms of months of imports, to mount credible defences of these economies’ currencies if the outflows are modest rather than substantial as in 2008. FX reserves are more modest in Malaysia. The risk nevertheless remains tilted towards higher currency volatility and pronounced depreciation of NJA currencies.

Olivier desbarres 2016 guide fig 32&33

India remains one of the brighter beacons in Asia, with the economy likely to benefit further from the fall in the oil price and reasonably modest levels of FX debt. Moreover the INR has a reasonably low correlation with the CNY (see Figure 35). But exports have shrunk and the challenge for Prime Minister Modi remains clear – to push through parliament the structural reforms welcomed by investors and necessary to push India’s GDP growth towards double-digits. Weak global growth is likely, if anything, to compound this challenge.

The Thai baht, one of the weakest NJA currencies in the past 12 months, may also prove attractive, particularly if the timetable for general elections crystallises. Thailand’s exports have held up better than in most other Asian economies, the country is a net beneficiary from the fall in energy prices and short-term external debt levels are modest.

Chinese growth & currency – a riddle wrapped in a mystery inside an enigma

Talk of a Chinese “hard-landing” is largely meaningless given the failure to define what a hard landing actually entails, either quantitatively or qualitatively. It is the change in the growth rate which is relevant and on that metric the picture remains bleak.

From a cyclical perspective Chinese investment, export and GDP growth is likely to slow further despite probable central bank rate cuts and other policies to shore up lending and financial markets (see More EM central banks to join rate cutting party, 30 September 2015).

From a structural perspective, the key question is whether and how the government will finally deal with bad bank loans, the by-product of rapid borrowing by corporates and local governments to fund increasingly less profitable infrastructural and property investments. Policy-makers may well have to deploy some of their vast financial resources to shore up lenders and/or borrowers and avoid a bigger correction in growth. The experience of other countries shows that how China deals with these bad loans will be key.

The exchange rate’s path is likely to remain integral to the China story and again the current terminology is of little help. The focus on a possible renminbi “devaluation” to boost export competitiveness and shore up growth typically fails to define exactly what is meant by a devaluation. The renminbi’s 2% “devaluation” versus a strong US dollar on 15th August was arguably a devaluation only in name, albeit one which rattled markets.

Indeed the renminbi NEER has only weakened gradually since last summer. It is still trading within the range in place since early 2015 (see Figure 34) and its pace of monthly change is still within its historical ranges (see Figure 35). This would tend to confirm that Chinese policy-makers pay close attention not only how the renminbi trades against the dollar but how it trades against the currencies of its main trading partners – which the PBoC recently confirmed officially.

Olivier desbarres 2016 guide fig 34&35

The PBoC ultimately faces a difficult task should it want to deliver a significant boost to China’s export competitiveness as the renminbi is highly correlated with other emerging and developing currencies (see Figure 36). Put differently, a large one-off devaluation versus the US dollar would likely see other currencies also weakening versus the dollar, in turn blunting the move in the renminbi NEER. Furthermore, it would slow China’s transition from growth driven by low value-added exports and fixed investment to growth driven by high-valued exports of goods and services and consumption.

Olivier desbarres 2016 guide fig 36

But with Chinese growth slowing and the central bank’s foreign exchange reserve still seeing large outflows, the path of least resistance may be for the central bank to allow a modicum of currency depreciation, as experienced in the past month. This would imply the CNY NEER continuing to depreciate on a month-on-month basis – the bottom end of the range in Figure 35. Not shock-and-awe but a clear tweak to policy nevertheless.

Olivier desbarres 2016 guide fig 37



[1] This is an updated write-up of an article first published in Intercontinental Finance on 11 January 2016

[2] FN leader Marine Le Pen won 42% of the vote in the Nord-Pas-de-Calais-Picardie region while the up-coming Marion Marechal Le Pen – the niece of Marine Le Pen and grand-daughter of Jean-Marie Le Pen – won 45% of the votes in the Provence-Alpes-Cote-d’Azur region.

[3] The incumbent Socialist Party led by President Hollande won five regions while former President Sarkozy’s centre-right party won seven. This is a not too dissimilar outcome to previous presidential elections when the FN did well in the first round but either failed to make it to the second and final round or as in the 2002 elections was comprehensively beaten in the second round (incumbent President Chirac won 82% of the votes to FN leader Le Pen’s 18%).

[4] Employment rate defined as total employed as a percentage of population aged 16 and over

[5] Gross lending minus capital repayments

[6] Since early 2015, the price of Brent crude is down 46% but “only” $26/barrel. In 2014, it was down a similar 47% but that equated to $50/barrel


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