Tuesday, 8 December 2015

The Upside and Downside of 2016

The same, only more of it. That’s the kind of year 2016 promises to be, according to Credit Suisse’s Global Markets annual outlook. Markets will obsess over if, when, and how much the Federal Reserve will raise interest rates. (Four times starting in December for a total of 1 percentage point, says Credit Suisse.) Credit Suisse’s Global Markets team believes global economic growth will pick up, driven by improvement in the U.S. and Europe, central bank policy will diverge further, and the dollar will continue appreciating.Of course, there are risks to every forecast. If things go too well in the developed world – particularly in the United States – inflation could accelerate faster than anticipated, leading to tighter monetary policy than currently expected. On the other hand, a collapse in Chinese investment could deliver a “devastating shock” to the world economy.

The Upside Surprise: Everything Comes Up Roses -Credit Suisse’s Global Markets team expects inflation in many countries to rebound from low levels as global growth accelerates slightly and crude oil prices begin to rise. Credit Suisse expects consumer price inflation in the U.S. to rise from 0.2 percent in 2015 to 1.4 percent in 2016, and from 0.1 percent to 0.9 percent in both Europe and the United Kingdom. As for Japan, it seems the island nation is once again in danger of being caught in the trap it has had so much trouble avoiding—disinflation. The bank’s analysts expect Japanese inflation to decline from 0.5 percent to 0.3 percent next year—still positive, but barely so.Of course, there’s always the possibility that inflation rises more quickly in developed economies, particularly the U.S. Quarterly GDP growth rates have averaged 2.5 percent since 2013, outstripping estimates of the economy’s potential. And allow us to put this simply: An economy that grows faster than its potential for a sustained period is due for a bump in inflation. At 5 percent unemployment, the U.S. is at or close to full employment, and if the labor market continues to improve, employers may have to start offering higher wages to attract workers, nudging inflation higher. American households are also starting to take on more debt, and Federal Reserve statistics show that banks have been increasing lending to businesses since 2010. Inflation tends to track the credit supply, so as credit grows, so too will prices.Markets aren’t prepared for a dramatic rise in inflation. Investors expect inflation to reach 1.89 percent in five years’ time, well below the 2.4 percent average over the last three years. If inflation accelerates, bond investors’ expectations about the Federal Reserve’s policy trajectory would turn more hawkish, leading to a selloff in longer-dated bonds. Faster-than-expected increases in interest rates could also curb consumers’ enthusiasm for purchasing big-ticket items that might require a loan.

The Downside Surprise: Everything Falls Apart - A more frightening scenario than the above: The possibility that the Chinese government and private businesses could reduce investment in infrastructure, machinery, and property by an unexpectedly large amount. Chinese investment is now larger in dollar terms than U.S. consumption, and the country plays a critical role in global manufacturing – both as an exporter of manufactured goods and as an importer of raw materials and equipment. An unexpected slowdown in Chinese investment could spark a global recession, and already-suffering commodity exporters would absorb a particularly hard blow.In that scenario, fiscal stimulus would be the best antidote, says Credit Suisse’s Global Markets team. Studies suggest that every percentage point of GDP spent on fiscal measures adds 1.5 percent to economic growth. Alas, major economies are unlikely to cut taxes or increase spending even in light of a profound growth shock. The United States will be in the middle of a presidential election, and it would be difficult to get individual European governments to coordinate on a broad, simultaneous fiscal stimulus, particularly given the region’s strict budget deficit rules.That leaves monetary policy. The European Central Bank and Bank of Japan could add to existing quantitative easing programs, while the United States and Bank of England could start new ones. Further quantitative easing would prop up risky assets, but at a cost. While quantitative easing improved liquidity conditions during times of market crisis by providing a source of demand to paralyzed fixed-income markets, massive asset purchases also have the effect of reducing liquidity in less troubled times by reducing the supply of available bonds.Policymakers seem more likely turn to negative deposit rates, charging commercial banks to deposit excess cash overnight at central banks. The European Central Bank and Swiss National Bank could push rates further into negative territory, while central banks such as the Bank of Japan and Bank of England could adopt them for the first time.While negative rates are good at devaluing currencies, they haven’t yet proved to be effective at stimulating domestic demand. The whole point of negative rates is to make it more attractive to spend or loan money than to keep it in the bank. Due to regulatory concerns, however, European commercial banks haven’t passed on their own deposit charges to their own customers, meaning that businesses and households have no incentive to spend rather than save.
 Devaluation boosts exports, but it’s a zero-sum game. The United States, which is very unlikely to adopt negative rates, would likely see the dollar appreciate faster and exports slow if more central banks adopt negative rates. “In aggregate, such a policy response is unlikely to deliver a broad-based stimulus to demand capable of reversing the downturn at the global level,” Credit Suisse’s Global Markets Team writes.Taken in turn, Credit Suisse says the risk of faster-than-expected inflation is far more likely than a contraction in Chinese investment. The bank’s economists expect the Chinese economy to begin stabilizing in the first half of 2016, and they foresee 6.5 percent GDP growth in 2016, down slightly from 6.8 percent in 2015. Still, given the potential global impact of trouble in China – and the likely lack of political will to respond appropriately – China risk is not something to ignore.

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