by Andrew Hunt
The FOMC has of course already decided to raise the Fed Funds Rate and while we would not expect the move to have a significant impact on the demand for credit within the US real economy – and it may even improve the supply of credit to the economy by improving the functioning of the credit system, we are concerned that a higher cost of funds for those entities that ‘mine’ liquidity in the USD credit markets for use elsewhere within the global economy may add to the deflationary forces that are already established within parts of the global capital flows system.
Moreover, we are also concerned that while the total size of the FRB’s balance sheet is unlikely to change over the coming year despite the shift in interest rate policy, the need to hold the Fed Funds Rate up may result in the Fed withdrawing significant quantities of liquidity from the financial system through reverse repos, and will likely imply a significant reduction in the effective size of the Fed’s balance sheet from an overall monetary stance point of view. In this context, what has been a small price move may prove to be a large quantity move.
We are also concerned that if the FRB does conduct large scale RRPs in order to hold the Fed Funds up, then it will implicitly be supplying hundreds of billions of dollars of collateral to the system. While this might be helpful from the point of view of aggregate credit supply (particularly within the financial system), the release of high quality collateral (i.e. Treasuries) and the expansion of high quality collateral will presumably lower the demand for the corporate and other private sector instruments that the banks had hitherto been obliged to use as collateral during the ‘famine’. This may have implications for the corporate debt markets. Indeed, we do wonder if the hike in the Fed Funds may turn out to be positive for mortgage lending and the housing market, while negative for the corporate debt markets.
The corporate credit markets represent another of our key themes for 2016. The level of US corporate debt is now back up to an ‘all-time’ high relative to GDP and corporate borrowing is now growing at a faster rate (in dollar terms) than GDP, a rare and usually worrying event. We suspect that this situation has occurred as a result of a particular confluence of factors, namely the impact of QE and the collateral famine on the demand for corporate paper; the over-reliance of corporate management remuneration on relatively short duration employee stock options; and the (regulatory enforced) relatively rapid employment turnover of senior management. At present, much of the debt that is being issued has a duration of >15 years while the average tenure of a board member is less than half that and the timespan of a stock option scheme is a fifth of the duration of the bond..... Clearly, this situation creates an incentive for management to gear up / de-equitise the employers’ balance sheets. In addition, most of their employers (i.e. shareholders) also possess a relatively short time horizon and so there has been a tendency for the corporate sector to become over-geared over recent decades.
This high level of debt has been built up against a background in which corporate profits are weak according to the NIPA data, corporate guidance is far from upbeat, and the corporate sector is running its first material financial deficit since the GFC. There is also considerable adverse news and sentiment over the corporate debt markets at present, with the result that there seem to be few inflows. We therefore fear that the early part of 2016 may not be a particularly happy period for the corporate debt markets.
In terms of defining just what may make an unhappy year for the corporate debt markets, we should be aware that this unhappiness may take two forms, namely weaker pricing and a rationing of new issuance. If the latter ‘quantity of issuance weakening’ occurs (and we suspect that this will be how much of the weakness is manifested – the sponsoring brokers will likely ration new issuance), then we would expect many real world companies to become financially constrained with regard to not only the amount of capital spending they can do but also the amount of equity buy-backs, M&A activity and even share option schemes that they can attempt. Hence, problems within the corporate debt markets could adversely affect both the corporate earnings outlook and the valuation of those earnings.
Our fourth ‘key’ forecast is also linked to the subject of corporate cash flow. With the US – and many other – corporate sectors apparently short of cash flow and at the same time potentially less able to borrow, there will presumably be even more pressure on companies to reduce what now seem to be extremely elevated levels of inventories. We can therefore expect further price discounting, more pressure on the currencies of the ‘manufacturing-heavy’ economies, and of course further cuts in production and employment in the manufacturing sectors. Each of these factors will be either implicitly or explicitly deflationary for the global economy and we therefore expect CPI inflation rates to remain low in most countries.
Interestingly, we would note in this context that Europe seems to be the one region within the global economy that is not currently carrying a particularly high level of inventories relative to sales and this may allow Europe to appear to outperform many of its peers in headline growth terms over the next few months. This may provide some near-term support to the EUR.
In particular, the weakness in the outlook for production (as confirmed by many of the world’s PMIs / ISM indices at present) will continue to weigh on the commodity markets and hence the export receipts and terms of trade of the commodity producers. We therefore fear that there will be no ‘let off’ for the likes of Brazil or South Africa in the near term, while in the rest of the world weak commodity prices will continue to help to depress global CPI inflation rates.
In fact, we would argue that, if there is growth within the global economy, it will by necessity have to be centred within the service sectors of the US, UK and those other countries that do succeed in growing. Elsewhere, we have noted that the US will probably need to achieve inflation rates of 4% or more within its service sector simply in order to keep headline CPI inflation in positive territory and this argues for more property price and service sector wage inflation occurring. Unfortunately, this form of unbalanced growth will likely create ever more distorted economies, with lower rates of average productivity growth (since service sector productivity growth tends to be lower than manufacturing sector productivity growth), and higher rates of income and wealth inequality. The latter will likely have implications for the political climate – there may be more Donald Trump / Farage types creating waves.
This probable bifurcation of the real economy between the weak but closely-watched / data-rich manufacturing sectors and the notoriously hard to measure / opaque service sectors will make it all the harder for policymakers to both set policy and communicate their thoughts and expectations to markets. We may therefore have less policy predictability in 2016 than we were perhaps used to a few years ago.
Along with the deflationary consequences of the inventory overhang that we described above, and the outlook for China (see on), one of our other biggest themes for 2016 revolves around the outlook for global capital flows. We have of course been tracking the deflation in global capital movements for all of this year (it was the topic of our first report of the year) and is clear that the process is continuing.
It is clear that, although there may be some signs of some modestly faster domestic credit growth in some DM economies (US, UK and Germany), there are at the very same time clear signs of a virtual credit implosion within international capital movements. The only possible exception to this negative message would seem to be Japan but even here the amounts involved seem quite modest by global standards. Moreover, this implosion in international credit flows has led to a sharp slowdown in credit growth within the majority of the EM, at least excluding China.
We believe that this slowdown in international credit flows is the result of increased uncertainty over the direction of DM central bank policies, the increase in currency volatility that has been associated with the weak world trade / high inventory situation and most of all by a tightening of regulatory standards, the effects of which will have far out-weighed the impact of the FRB’s recent policy tightening. Unfortunately, since we do not expect the regulators to ‘back off’ or currency volatility to decline, we expect a further contraction in global credit flows in 2016 which will likely help to spread the weakness in global manufacturing that we described earlier into weakness in the service sectors of all but a few economies. In particular, we expect that the service sectors of many of the EM – and their specific property markets – to suffer as a result of the contraction in global liquidity.
In such a seemingly ‘tight’ global monetary environment, we suspect that an increased degree of financial stress will emerge amongst either the weakest or most extended borrowers or lenders. Therefore, we along with some policymakers fear that there could be some form of financial crisis during the course of the year in a financial centre and our personal feeling is that such a crisis is most likely to occur in one of the ‘newly expanded’ EM financial centres. A potential candidate for such an event would appear to be Singapore given the recent rapid growth in its banking system, the high level of domestic property prices and mortgage debt, and the Singaporean banks’ high levels of both foreign assets and liabilities.
Our final (and key) theme for 2016 revolves around China. China has embarked on a monetary experiment on a scale not witnessed since perhaps John Law and as a result the central authorities may no longer even have control over credit and liquidity growth. That this unfettered monetary expansion combined with a significant easing of fiscal policy has done little other than to stabilise the domestic economy is interesting in its own right but the outcome of this policy has been an unprecedented outflow of flight capital from the RMB.
For us, it is no longer of whether China will suffer a hard landing, since it is clear and increasingly accepted by the world’s policymakers that China has suffered such a fate. We also know that China’s policymakers have conspired to create a very lax monetary and fiscal regime that while it has not provided much of an obvious boost to the economy, has created a massive capital account deficit, a weak balance of payments and significant pressure on the country’s FX reserves. These are all verifiable statements of fact, even if they tend to be under-reported in many places for particular ‘micro’ reasons. What seems to be more important at this stage is whether China will now endeavor to support the RMB through a re-enforcing of its capital controls, or whether it will let the RMB decline.
Our sense is that it will be difficult to re-impose capital controls effectively even through the most draconian of means and that, if China did succeed in doing so, then it would likely cause a sharp increase in stress in the Hong Kong, Singapore, French and perhaps even Japanese banking systems.
Alternatively, China may simply decide that it is easier to allow the RMB to depreciate by enough to choke off its capital outflows but were this to happen, we could expect a further race for the bottom in EM currencies and also a sharp rise in global deflationary pressures. At present, we feel that this is the most likely outcome in 2016H1.
In summary....
Clearly, our outlook for global growth and inflation is well below that of the consensus and we are certainly not expecting an imminent rebound in the EM markets or economies in the foreseeable future. In fact, we fear that there may be some form of financial event within parts of the EM (or even Europe) that will require some form of a coordinated global response (such as more swap lines from the FRB) to resolve. Finally, we suspect that the best hope of a global recovery in 2016H2 will lie with a (global) easing of fiscal policy that is potentially funded by the central banks in a QE x+1 regime.
Andrew Hunt International Economist London
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