As the global economy limps into 2016, the prospects for a sustained pickup in worldwide trade and/or a return to robust growth are decidedly grim.
Global trade growth has lagged the already tepid pace of global output expansion for three years running, averaging just 3% per year. That’s half of the rate witnessed from 1983 to 2008.
Meanwhile, inflation expectations in developed economies have not rebounded, despite the best efforts of DM central bankers. And yet housing costs have soared in tandem with round after round of policy rate cuts and the global proliferation of QE, reflecting two things, i) central banks have learned nothing from the US housing bubble (that is, when you artificially suppress borrowing costs, housing prices soar), and ii) when you intentionally inflate bubbles in the assets most likely to be concentrated in the hands of the wealthy (i.e. financial assets), those bubbles spill over into other asset classes like real estate and high end art.
What should be apparent from the above is that all the Mario Draghis and Haruhiko Kurodas of the world are doing at this point is blowing bubbles on the way to creating more inequality and embedding ever greater amounts of risk into capital markets not only by driving up prices, but by sucking out liquidity.
As for Main Street, there’s no “wealth effect” (where “wealth effect” refers to a kind of neo-trickle down economics catalyzed by QE). There’s only persistently slow growth, a jobs market that churns out more waiters and bartenders than it does breadwinner jobs, and a noticeably wider gap between the rich and the poor as exemplified by the fact that the billionaires of the world are paying $170 million for Modiglianis [26].
But the game is almost up. Central banks have monetized everything that isn’t tied down. Hell, Kuroda owns half of the entire Japanese ETF market. Rates are below zero and there’s only so much more NIRP banks are going to be able to stand before negative rates get passed on to depositors. Put simply: we’re approaching the Keynesian endgame and there’s still no growth, and no inflation (well, unless you count housing) and trade is collapsing.
Against this backdrop, RBS is out with 10 key points for 2016 and as you’ll see below, the overarching message is that the entire world is about to discover that the emperor(s) have no clothes.
Note the last point (#10) as it, i) goes along with a previous note from Alberto Gallo in which RBS takes a close look at support for "radical" political parties in Europe (more on this here [27]), and ii) makes a connection between recent economic outcomes in Europe, the ECB's evolving experience with ZIRP, NIRP, and QE, and Japan's lost decade.
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From RBS
These are our key views for 2016:
1. There are limits to monetary policy. Central bankers will be tested in 2016. The economic equilibrium based on monetary stimulus, but lack of other measures is circular and fragile. Central bank balance sheets cannot grow indefinitely and forward guidance cannot target asset prices, without damaging credibility. Investors are growing increasingly wary of central bankers’ credibility, and worried about the effectiveness of further stimulus (ECB, BoJ) and their ability to reverse policy (Fed, BoE).
2. Fiscal stimulus, reforms and investment remain scarce. The result is more QE in Europe and Japan, and a very shallow reversal of policy in the US and UK. We expect the ECB to deploy more QE in December, extending the length of the programme and the list of eligible assets. We think the BoJ will continue expanding its balance sheet as well. Conversely, exiting QE will be difficult even in the regions where it is deemed most successful – the US and UK – given lack of balance sheet deleveraging, or re-leveraging. Our economists expect the Fed to start hiking in December and to end at 1.5% at the end of 2016, with risks skewed to the dovish side, and the Bank of England to start hiking in August 2016. We think the impact of ECB QE2 will be temporary, as for QE1, due to persistent structural issues in the Eurozone economy. Despite convergence in periphery-core financial spreads, investment and loan volumes continue to decline, according to ECB data. The opportunity for US and European governments to build on the recovery is infrastructure investment and reforms, respectively. But what we are seeing is still too little, too late.
3. More QE means central banks will own an increasing share of assets markets. The ECB has already bought much of the free-float in European covered bonds, and the BoJ owns half of some stock ETFs in Japan. Without sovereign bond issuance, ECB QE demand will outpace bond supply by 2:1. This means the ECB will have to look for more assets (regional bonds, corporates), or that investors will be squeezed with lower yields or into other assets. However, given investment regulation, not every investor can move from asset to asset: some will have to learn to live with lower yields.
4. Market liquidity will decline further, also due to central bank buying of assets. This reduces both the free-float available, and the number of factors driving prices. Regulation will also continue to reduce dealers’ ability to make markets.
5. China’s top priority is reform, not stimulus: the slowdown will continue. A largescale stimulus is unlikely – instead, a long-series of reforms aimed at restructuring local governments, the financial sector, state-owned firms and at reducing corruption is what we are likely to see. If needed, Chinese policymakers have dry powder to smooth the landing, with cuts to the policy rate, bank reserve requirements or by using reserves. But the dry powder is not as much as it looks, compared to the length of the multi-year readjustment period for the Chinese economy.
6. China-dependent economies will get hurt: Brazil and Australia in particular. Brazil is the most vulnerable EM, on a combination of China exposure, dependence on $ debt, and political risk. Australia, still trading as a safe haven, is instead sitting on a very levered housing market and an export sector completely geared to China.
7. Banks will need to live with low interest rates. More disruption and consolidation is coming. This will challenge investment bank focused business models, and generally low-profitable banks. We see some opportunities from consolidation, e.g. in the Italian popolari. We are long, but avoid investment banks and EM-exposed banks.
8. Asset managers: liquidity optimisation and bye bye to passive investing. We see disruption in the asset management industry also. Passive strategies, IG in particular, will be replaced by ETFs. Active strategies will be increasingly detached from benchmarks. We look at liquidity optimisation as a way to build more efficient portfolios.
9. Deeper capital markets are part of the solution, but the solution is far away. A more flexible financial system, where debt restructuring is quicker and more efficient, could help economies to get out more quickly from a balance sheet recession. Despite the United Nations’ call for a common framework for sovereign restructuring, Greek restructuring will continue to be a purely political decision and to be procrastinated.
10. The equilibrium, for now, is QE infinity – but political risk could be the breaking point. Political risk could be the breaking point for the QE infinity equilibrium. Europe, unlike Japan, will not be able to go through a “lost decade” intact, given its political dynamics, elevated youth unemployment and rising radical parties.
