A multi-speed world (Archived)
In a year marked by a series of record highs followed by major sell-offs across asset classes, investors in 2015 could be forgiven for thinking uncertainty was the new normal. Here Mellon Capital’s1 Vassilis Dagioglu considers some of the possible causes of volatility in 2016.
Accommodative monetary policy and moderate growth will make 2016 a year of lower volatility “albeit with spikes of uncertainty along the way”, argues Vassilis Dagioglu, portfolio manager, Mellon Capital.
In particular, Dagioglu highlights central bank action as one of the most significant factors driving markets, noting that any outsized movement in major economy interest rates could trigger a ripple effect across asset prices.
“Divergence in monetary policies is expected to drive up the US dollar and sterling versus the euro and the yen and consequently boost shares of eurozone and Japanese companies relative to US shares,” he says. “Meanwhile, in commodities, a strong US dollar could encourage producers to maintain increased output to service their dollar-denominated debt and government deficits, which in turn would push up supply and drive down pricing.”
At the same time, however, Dagioglu says there has been “an over obsession” with the timing of policy interventions by the Fed and Bank of England. Any upticks in US or UK rates are likely to be small and incremental and easily absorbed by the market, he says. Moreover, any rate rises are likely to be the exception in a world still dealing with low growth, subdued inflation and the hangover from the global financial crisis. The reality for 2016, he says, is more likely a divergent world with different rates of growth and hence a variety of approaches to interest-rate policy (See Figures 1 and 2).
Calculation is based on a number of high- and medium-frequency measures of the macro economy and financial markets that are likely to be highly effective at estimating subsequent economic growth. A level slightly above 100 would indicate a significant probability of a mild economic recovery. The further the Leading Economic Indicators measure is above 100, the faster the pace of economic growth. Conversely, a level approaching 99, and certainly below 99, would indicate a significant probability of a mild economic contraction.
“We believe developed economies will continue to expand into 2016 although at different and, on average, moderate rates,” he says. “We view growth as being on a moderate trajectory, certainly not an environment in which we expect growth to pick up to a point where major central banks across the globe will drastically withdraw from their accommodative monetary policy regimes.”
For Dagioglu, this easy monetary paradigm is also true for countries exposed to falling commodity prices and to the decline in the oil price in particular. In his view, countries with heavy commodity exposure will continue to lose momentum on the back of oversupply and slack demand and so, far from raising rates, will continue to seek to reduce the cost of borrowing.
“More than a year on from the collapse in commodity prices we can see how quickly the global growth prospects of energy exporting countries have been affected,” he says. “In 2015, oil majors scaled back pretty quickly on their exploration and development projects and this is now having a severe impact on the earnings of energy-related companies. We’re not witnessing any restriction in oil and gas supply or any sustained pick-up in demand or pricing – and, given the US’s newfound status as a global non-OPEC producer, nor do we expect to see any concerted action on tackling chronic levels of oversupply.”
He adds: “Typically with commodities you see significant overinvestment followed by swift declines in pricing due to overcapacity. It’s a cycle that can last several years to play out and we’re really only at the start.”
The China question
China has been flagged as another potential source of volatility in 2016 as it continues its transition to consumer-led growth. Here though Dagioglu takes a nuanced view, noting how the Chinese authorities have focused on a smooth transition and have intervened when necessary to make that happen. This means the chance of a hard landing for the Chinese economy “is now low”, he says, adding that, in any case, the impact of the country’s slowing growth on the world’s developed markets “has been overstated”. “The exposure of the corporate sector in the US or Europe or Japan to China is limited. Generally speaking, China accounts for less than 20% of exports for corporates in those countries.”2
On the question of emerging markets (EMs), Dagioglu’s view is that stalling growth could be a source of uncertainty in 2016 but not of sustained volatility. On the one hand, he says, low borrowing costs have boosted the amount of outstanding dollar-denominated emerging market debt and this could potentially fuel periods of increased volatility. On the other hand, reserves – particularly for sovereign issuers – remain high, and this reduces the potential for defaults. Likewise, a lot of adjustment on exchange rates has happened, he says, while in many cases the prospect of further EM asset class weakness is already priced in.
Meanwhile, although China has started to repatriate some of its fixed income exposure by selling down Treasuries, this is unlikely to have a broader impact. Says Dagioglu: “Large reserve allocation decisions tend to take time to play out. Even if China were to try to rebalance even more quickly out of Treasuries, the global demand for US debt would still persist in our view.”
The winds of change?
Elsewhere, Dagioglu points to political change as one probable cause of volatility through to the end of 2017. The electorates of the US and South Korea are among those expected to head to the polls in the coming year, but for Dagioglu, Europe is likely to be key. In the UK, for example, a referendum on continued membership of the European Union could be a watershed moment, while elections in Ireland and Austria could see the rise of parties with an anti-Europe agenda. Greece could also be problematic. Despite having two elections and one referendum in 2015, the country is still no closer to resolving the issue of its long-term debt, says Dagioglu, “all that’s happened is the risk of a Grexit has been pushed further along the road”.
“For the rest of Europe the danger is we’ll see something similar: the rise of voices opposed to the current status quo but also the inability to create clear majorities with a clear pro- or anti-Euro mandate,” he says.
He concludes: “In this environment, we believe it’s important for investors to actively monitor and manage portfolio volatility. For us, the coming year will be one for very selective regional exposures.”
What to watch
- Any outsized movement in major market interest rates could trigger a ripple effect across asset prices.
- Unexpected election results and the rise of anti-European sentiment could drive volatility
- A further collapse in commodity prices could add to uncertainty
1. BNY Mellon Investment Management EMEA Limited is the distributor of the capabilities of its investment managers in Europe, Middle East, Africa and Latin America. Investment managers are appointed by BNY Mellon Investment Management EMEA Limited or affiliated fund operating companies to undertake portfolio management services in respect of the products and services provided by BNY Mellon Investment Management EMEA Limited or the fund operating companies. These products and services are governed by bilateral contracts entered into by BNY Mellon Investment Management EMEA Limited and its clients or by the Prospectus and associated documents related to the funds.
2.BACI International Trade Database, European Central Bank as of November, 2015