Questions for 2016

Despite the fact that major asset classes have had a returns near zero this year, there are a number of interesting disconnects. Here are a few that I’m watching, and some of my conjectures. I think many of these are likely to be resolved next year, but there is a clear risk that some of them continue for longer. As usual, readers are welcome to comment.

Will the disconnect between corporate credit spreads and the broader economy continue?

This is something I’ve highlighted before. In fact, I think the biggest general surprise for market participants globally in 2015 was the massive widening in credit spreads in the fact of fairly benign economic conditions. The chart below illustrates – the ISM composite index, a proxy for growth, is in blue and inverted on the LHS, and long dated BBB credit spreads is in red. The current disconnect is about as wide as levels prevailing in early 2000, and a major reason some bears are calling for a recession next year. (To be clear, I do not expect one)

There are a number of reasons for the disconnect, IMO, so I do not expect the gap to fully close. The strengthening of bank balance sheets has allowed consumer credit conditions to substantially disconnect corporate credit conditions. Supply / Demand mismatches in corporate credit space, especially at the long end, is likely another reason.

As the chart above shows, credit spreads are currently at levels we’ve only seen historically ahead of recessions. Having said that, I do not think it is likely that spreads will be able to tighten substantially from here, even in a best case scenario. With the economy at full employment and the Fed hiking, recession risks will be on the minds of credit investors until we actually get one.

Will the disconnect between credit prices and equity prices be resolved?

Even though credit spreads have widened dramatically this year, equity prices were broadly unaffected. Part of this is due to different weightings in the respective indices, part of it is due to the fact that the broader economy has done OK, as noted earlier. But the fact is that these two markets are currently pricing in fairly different outcomes in the year or two ahead. Credit markets are discounting a recession, while equity valuations are quite full and nowhere close to that. Historically, these disconnects have resolved themselves via either a robust increase in earnings or a recession. Neither seems especially likely at the moment. Another possibility is that the disconnect resolves itself through time. A full blown equity bubble seem unlikely at this stage – IMO, we would’ve seen one developing by now if that was in the cards. The fact is that the tightening in corporate credit conditions has already been felt across the corporate landscape in varying degrees. Valuations of start ups and high end real estate, for example, have already been impacted this year.

Currency moves seem to have a smaller impact on domestic conditions in many countries. Will this mean higher currency volatility in the future, especially with monetary policy in many countries at ZIRP?

This is a topic that has been getting increasing attention:

http://www.wsj.com/articles/why-weak-currencies-have-a-smaller-effect-on-exports-1451243289

This is also something that we’ve seen in the data. In general, the weakening of the EUR and the JPY have had only modest effects on domestic conditions.

This is the case for the EU, according to Coeure, who noted that “For the euro area, ECB staff research recently found that an increase in the share of the euro as an invoicing currency can lower exchange rate pass-through considerably.”

https://www.ecb.europa.eu/press/key/date/2015/html/sp151121.en.html

On the other hand, Fischer noted in a November speech (h/t CP) that the effect of an appreciation of the dollar is both substantial and gradual, with more than half the effect occurring after a year: http://www.federalreserve.gov/newsevents/speech/fischer20151112a.htm

A weaker immediate but longer lasting effect on growth from changes in FX seems a reasonable result of a longer and more global supply chain. If that’s true, how will central banks react in the future – especially the central banks of small, open countries? Will they try to do more, knowing that the immediate effects are more limited? Does that mean greater currency volatility than in times past? How will they do it, with policy rates already at zero and balance sheets enlarged?

Japan’s current account balance has been improving substantially, even as the BoJ maintains easy policy. How will the Yen react? In general, will currencies be more responsive going forward to current account balances in a world where monetary policy faces larger constraints?

The Japanese Current Account balance has improved very significantly since year, and much faster than consensus expectations. The chart below illustrates the consensus forecast for the Japanese current account this year. It has been revised up by 2% of GDP!

Part of the improvement has been oil, part the currency, but other factors apply as well. For example, a Japanese court has authorized 2 nuclear reactors to restart, which means 4 of Japan’s 43 reactors will be back online soon, and the central government is behind the effort. http://www.nytimes.com/aponline/2015/12/24/world/asia/ap-as-japan-nuclear.html

To put the improvement into context, the last time Japanese current account was at 3% of GDP was in 2011 and USDJPY was below 80. In addition, the surplus is expected to persist for the foreseeable future.

I’ve already noted that being long Yen (vs CHF) seems attractive, and this is just one reason. As usual, how things play out in Japan will provide valuable lessons for other countries in the future.

Will the Phillips Curve reassert itself?

The Fed thinks so – but the market seems more skeptical. As a reminder, the Phillips curve is a historical inverse relationship between Unemployment and inflation.

This is a pretty big deal, because central bank orthodoxy makes many of the same assumptions. The widely cited Laubach-Williams ‘Natural Rate of Interest’ embeds an output gap estimates that is informed by an estimated Phillips curve, for example. Recent central bank commentary suggests that the strong consensus remains affirmative. The last time short term unemployment rates coincided with such weak inflation figures was in the late 90’s:

As we now know, the recovery in core PCE figures then allowed the Fed to accelerate its hiking cycle.

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8 thoughts on “Questions for 2016

  1. As usual, great content combined with comprehensive anlysis :-) Are there any books related to global macro investing which would you recommend to read ?

    Thank you for insightful posts in 2015 and I hope to see more of them in following year.

    1. Thanks for your kind words. Inside the house of Money is a pretty good book that came out not too long ago. Books written by central bankers tend to be pretty good as well – I’d definitely recommend those!

    2. Depending on the level, I think these two books are worth having a look at:

      Global Macro Trading (Greg Gliner): very basic but a good overview

      Global Macro: Theory and Practice (Andrew Rotaniv): covering various topics

  2. Thanks for the latest comment. I very much like your blog and follow it regularly. Re Credit Spreads/ISM: you should break it down into Service/Manufact components and compare it to the performance of the relevant BBB spreads. Around 20% of BBB (Investment Grade) is made up by Energy and Basic Industry related companies.

    Happy new year

  3. Thanks Alex. You’re right, it would be clearer if I split it up – I’ll try to get the data for that. But having said that, I don’t think the differential is large enough to substantively change the conclusion… Looks like in US equities space, the Energy + Materials sector weight is around 10%… Seems like a rough ballpark estimate for that sector in IG credit space is about 150bps wider than average according to Bloomberg. (feel free to correct me if I’m wrong there) so if we double that for BBB on a 10% weight differential, that’s worth 30bps. Certainly a decent chunk but not enough to change the conclusion, IMO. I’ll try to get more accurate numbers.

    1. Yes, agree. It should look less dramatic but not challenge your basic point. Happy to share some charts/data on BBB Energy/Basic Industry spread data if of interest. Looking forward to reading your next blog entry

      Best
      Alex

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