Michael Pagliari, partner in investment management at Smith & Williamson, the accountancy, investment management and tax group explores 2015 and outlines his expectations for 2016
2015 was marked by a few major events. At the beginning of the year, the Greek crisis was cauterised as the troika (the EU, ECB and IMF) released funds conditional on reform, while ECB bond buying ‘resolved’ the Eurozone crisis. Over the summer, China’s desired orderly transition from an investment-based economy to a consumption-based one was interrupted, as markets feared a collapse in GDP. Equity markets were ambushed and sold off between 10% and 15%. Commodities, in particular oils and metals, were hammered, because of a combination of waning Chinese demand and global oversupply. In the background, the US economy continued to chug along at a respectable pace and in the UK, for the first time since the Great Financial Crisis, nominal wages started to inch higher which, together with lower imported inflation, translated into higher real incomes and promise of increased consumption. Equity markets have pegged back a good part of their earlier losses.
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Any increase in interest rates by the Fed is likely to be modest and restrained, by historical standards. This is because the stronger dollar is biting into corporate profits and the Fed will be wary of overly tightening financial conditions. This rate cycle has been flagged, and the market should be ready for it. Historically, after rates start to move higher equity markets have a wobble and then move higher. On average, over the past four tightening cycles, equities have gained around 10% in the 12 months following the first rate hike.
As mentioned above, the ECB has underwritten Eurozone stability through bond buying. A consequentially weak euro and low oil prices provide favourable tailwinds. For the first time in many years, governments are even finding some room to loosen austerity. The design of the Eurozone remains deeply flawed but the immediate future looks less bleak than just a few months ago. However, there is a growing divergence between USD and Euro interest rates and it will be interesting to see what effect this will have on currencies.
Commodities should stabilise in 2016, as high-cost supply is taken out and demand from China resumes. Although it is true that commodity imports into China will fall as a percentage of GDP, the still fast growing absolute size of the Chinese economy is likely to cushion the blow. Oil is a good example of what might come to pass. Saudi Arabia is running a fiscal deficit of 20% of GDP with oil at $40 and so may come under pressure to cut production. An oil price of $60 would ease a lot of the stress in the credit markets and it is probable that metals would also recover their poise.
Inflation should gently start to move higher in 2016, closer to the levels desired by the central banks. There are plenty of risks out there; the debt problems in China could come to a head and spiral out of control, and overall global debt levels are still frighteningly high. Unless productivity, which has been very poor, moves to more normal levels it is not clear how this long-term problem will be resolved. In the meantime, financial repression will continue. Finally, the UK’s EU referendum looms and opinion is split as to what the consequences may be. Perhaps sterling will be the safety valve should the ‘Outs’ win the day.
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By GlobalData
Michael Pagliari, partner in investment management at Smith & Williamson
