Rights,Wrongs &Returns:2016-Year of living dangerously

Policy cross-currents. The key concern facing investors as we approach ’16 is the possibility of sudden and significant shifts in currency, bond and commodity markets caused by a combination of shortage of US$ and cross-current of misaligned monetary policies. Whilst the Fed and BoE might feel that potency of monetary policies is coming to an end, the position is likely to be different for ECB, BoJ and PBoC, leaving smaller CBs struggling to control volatile flows.

As discussed (here) we maintain that the global economy essentially resides on the US$ standard and hence global reflation is not possible without Fed. Unless velocity of money recovers and/or Fed embarks on QE4, global liquidity is likely to continue to erode; US$ is likely to appreciate, further compressing aggregate demand, trade and liquidity. Indeed, the more aggressive other CBs become (against tightening Fed), the greater would be the ultimate demand compression and stronger deflationary pressures. Over the last five years, consensus has always started the year expecting improving trajectory of GDP growth, trade recovery, steady FX, flat-to-increasing commodities and erosion of deflationary pressures, only to see most of these assumptions derailed. Is ’16 going to be different? The consensus estimates remain in the ‘goldilocks’ range, with no expectation of dislocation in bond, currency or commodity markets and assumption of steadily improving macro backdrop. Whilst possible, this is a low probability outcome in the year of policy cross-currents & eroding US$ liquidity.

Our base case scenario for ’16 is that it will be another year without global growth engines. Although the US is growing above the trend line, the pace remains too slow to inject sufficient demand and US$ into global economy whilst neither Eurozone nor Japan or China are capable of adding much towards global momentum. The same applies to EMs. The only economies that are capable of significant stimulus and leveraging are low income economies; but alas they only contribute ~10% of global demand. Hence, we believe that it will be another year of no trade, volatile but mostly declining US$ liquidity and significant asset class volatilities. In our view, it is likely to be a poor environment for global traders, commodity producers and anyone with US$ borrowing mismatch.

The key signal to watch would be a surge in US$, potentially forcing China to embark on a much more aggressive Rmb devaluation. This would significantly aggravate global disinflation. Given that the Fed is the only CB capable of reflating global economy, its domestic tightening bias against the background of looser ECB and BoJ is likely to be the main trigger. Only by joining other CBs in a stimulatory action can the Fed strengthen global demand. However, this could result in domestic overheating, which in many ways what the world really needs.

In this world of rapid policy and liquidity cross-currents, we continue to emphasize “return of the money rather than on the money” and hence we prefer countries with lower degree of external vulnerability, trapped domestic liquidity, political stability and prospect for structural reform; finally, it is not yet the yr for commodity producers. This continues to point us towards China, India, Phil and/or Taiwan & Korea, and away from Indo, Mal & Thailand. Given that investment decisions are now almost entirely flow driven and hence every trade is overcrowded, the danger is that the slightest liquidity shift could cause an investor stampede. Being negative EM equities and positive US$ has for some time been the most overcrowded of trades. Whilst this does not necessarily make it wrong (consensus is always right, until it isn’t), it highlights a risk of potentially violent reversal, particularly in view of non-US monetary stimulation.