Let’s take a deep breath and apply a tactical and strategic lens to try and answer some of the key questions behind this year’s bad start.
There are a lot of trading days left in 2016, and plenty of questions that need answers. How bad is the global economy? Is oil the driver of markets or a convenient excuse? How much bad news is really in the price? What could realistically improve things, tactically or strategically?
Let's start with what we know. Global growth is weak, and our 2016 GDP forecasts remain around 0.2 percentage point below consensus in both developed and emerging markets. But, it is important to distinguish between below-trend growth (our forecast) and the recession fears gripping markets.
While recent data have been poor, and financial conditions have tightened, a wide variety of indicators still lead us to believe that a US or global recession is not the base case. We will be closely watching the report on US fourth-quarter GDP, due to be released this Friday, Jan 29, 2016.
If the growth outlook has moved less than the market, maybe the blame lies with oil? Brent was down 25% for the year through Wednesday, Jan 20, 2016, and the high correlation between oil and equity prices in this sell-off has implied a level of causation.
We are more skeptical. Falling oil isn't the economic positive that many (including ourselves) assumed a year ago, but its decline looks more like a symptom of other issues (growth concerns, a lack of risk appetite, a stronger dollar) than the cause. The details of the equity decline also challenge the idea of oil driving markets; year-to-date, European healthcare is down almost as much as European energy. Japan equities, which have little energy exposure, have been a global underperformer.
So what is holding back risk appetite? A major overhang remains the question of how China will manage its currency. China’s yuan is near the lower end of a range that has existed since August, a range our economists expect to hold through midyear. But keeping the currency stable is being challenged by dollar strength, making it more difficult for China to ease policy to support growth. We think this issue, above all others, is the main macro dilemma facing markets in 2016.
Could anything help? Look out for the Federal Open Market Committee meeting. Markets are concerned about both continued tightening and a potential US recession. They likely only need to worry about one. Were the Fed to remind the market that it remains data-dependent, it could temporarily alleviate some of the pressure on the dollar (and the yuan) and address concerns regarding a policy mistake. We note that the rate market is already pricing in fewer than two Fed rate hikes for all of this year. After a relatively dovish European Central Bank meeting on Jan 21, 2016, and with a Bank of Japan meeting up next, this could shape up as a big week for the world’s major central banks.
Central banks won't be the only things to watch. January has experienced the largest monthly gap between stock and bond returns since October, 2008 (around 11%). Any stock/bond allocation that was set at the start of 2016 is now off-benchmark as a result, raising the question of portfolio-rebalancing flows. Given the around US$36 trillion that sits in global pension mandates, even small adjustments could be meaningful.
Finally, some brief notes on valuations, especially in light of rising growth concerns. Global equities now trade on 13.5x forward earnings, near the 10-year median. Over the past 25 years, US equities have traded at a higher forward price-to-earnings ratio 63% of the time, while EU equities have been more expensive 53% of the time. Longer-dated US triple-B-rated credit trades at +255 basis points, or hundredths of a percentage point.
The average spread during a recession, going back to 1925, is +246 basis points. US high-yield spreads averaged around 800 basis points during the 2001-02 US recession. They are already near these levels today. While valuations have improved across many assets, credit may be discounting the greatest risk of recession.