Asset Allocation: The big picture
Global economic growth stuttered badly during 2015, as China and other emerging markets struggled to keep going. While European growth has surprised to the upside during 2015, particularly in Germany, the US economy has been disappointing, despite maintaining a rate just above trend. And while China’s economy will always be important in the medium to longer term, US growth arguably holds the key to shorter term market prospects in 2016, especially given the Fed’s stated ‘data dependent’ policy path.
Despite a consensus last year on an impending first rate hike, the course of future moves is much less clear, particularly following the US economy’s significant autumn weakness. Economic optimists point to some early indicators of a better Q4 for the US and to strength in the jobs market, but the housing market has been a drag on the economy for a while and remains so. Consumer spending, an important contributor to US growth, has also slackened in recent months
Indeed, while the Fed might be failing on the inflation side of its dual mandate, employment trends have been positive. Over the last few years, unemployment trends have rather confounded forecasters. Despite exhibiting lacklustre economic growth generally, with several significant downward lurches, the falls in average unemployment rates across the G7 have been the sharpest of any (global) recovery for decades.
The decision by the IMF to include the Chinese currency in the basket of currencies in the special drawing rights basket from October 2016 is a symbolic but important step for China, and will probably be accompanied by more moves to liberalise the currency, although it is likely to be a cautious process.
Emerging market economies, although a disparate group, mostly struggled in 2015 as they adjusted to the many strong headwinds, from the Fed raising rates to declining commodity prices and the painful after-effects of huge private sector leveraging.
With inflation falling and economic growth disappointing, most developed market bond markets have outperformed against the indications of forward rates at the end of 2014. The 10-year US Treasuries traded within a 50bps range for much of 2015 but European government bonds had a more volatile year.
By the middle of the second quarter, the 10-year Bund yield was down to 0.08% from its new year 2015 level of around 0.5%, and then nine weeks later was back up over 0.9%.
Peripheral spreads, too, had a volatile year, buffeted by politics as well as the ECB’s momentous venture into quantitative easing. Many argue that this high degree of volatility could continue into 2016, due to uncertainties in macro fundamentals and a worrying tendency for market liquidity to fall rapidly at certain times.
While there may be a propensity for broker research to apportion much of the blame to the balance sheet constraints applied to their trading floors, and hence to argue that the situation may possibly be worse than it appears, there is no denying that market pricing has been difficult in times of stress, even in developed market government bonds, the most liquid markets in the world.
With the caveat that there will no doubt be sporadic episodes, probably unpredictable, of high volatility and potentially difficult market conditions, the overall outlook for developed market sovereigns is reasonably healthy. The central forecast is a gentle upward trajectory for policy rates, with the US curve flattening somewhat and European curves steepening, led by Bunds.
That said, it has been nearly 10 years since markets were last in a proper tightening phase, and the wiser, possibly more experienced investors will be justifiably cautious.
Last year was one of dollar strength and emerging currency weakness. Although rates markets may have been downgrading the magnitude and speed of policy rate hikes from the Fed, widely diverging central bank policies combined with China’s poor growth outlook, seem set to support the dollar’s move to highs not seen since the turn of this century.
For many years, the Swiss and Japanese currencies moved in reasonably close tandem but in early 2010 the two currencies started to diverge. The Swiss franc has been the more ‘predictable’, continuing to appreciate throughout the financial crisis and during the euro-zone’s more troubled recent times.
The yen’s real effective exchange rate has instead languished for several years, and it is now cheap on several metrics. Indeed, according to the Bank of Japan’s calculations, the currency’s real effective exchange rate is at its lowest since the early 1970s – when the dollar/yen rate was set at 360. The currency suffered as global trade collapsed from 2011, hitting Japan hard, and dragging its current account into a 10.4% of GDP deficit by the end of 2014. Japan’s state pension fund portfolios have also been big sellers of yen, as they increased their foreign allocations over 2015.
However, what was interesting through 2015 was that the currency did not weaken materially further despite two-year interest rate differentials widening significantly in favour of the dollar versus the yen, suggesting other strong forces were at work supporting the Japanese currency. Also supportive of the yen in 2015 was that the trade balance moved into significant surplus, and that the BoJ surprised markets by not easing monetary policy even further, with government policy shifting instead to the fiscal side.
Focus: a perspective on bond liquidity
Market liquidity will always be topical. Since the financial crisis, regulatory changes have sparked a huge debate, particularly over the last couple of years. Liberty Street Economics, the economists’ blog of the Federal Reserve Bank of New York, has been running a series of studies* into liquidity in various bond (and equity) markets.
For on-the-run Treasury securities, the economists surmise that current liquidity is reasonable in historical terms. While there is no doubt that dealer balance sheets have shrunk, Liberty Street Economics proposes, perhaps not too surprisingly, that this should not be largely ‘blamed’ on tighter regulation but say it is also a function of secular trends – such as technological – as well as changes in dealer risk-taking behaviour before and after the crisis.
Rather than worries about average liquidity levels across markets, the authors suggest concerns are more about liquidity risk, or rather the risk of sudden withdrawals of liquidity provision, particularly in tail events – such as the extreme Bund volatility experienced in early May 2015 – where liquidity appears to suddenly evaporate. Interestingly, their findings suggest that liquidity risk has not increased significantly in the US corporate bond market.
And so the Fed economists argue these tail events may have more to do with the changing structure of trading, rather than regulation altering dealer behaviour. They point to the fact that trading of on-the-run Treasuries is largely electronic, with much of it occurring at very high speeds and frequencies across multiple platforms, and includes a growing share by hedge funds and other non-dealers.
They conclude that the modern market “implicitly involves a trade-off between price efficiency and heightened uncertainty about the overall available liquidity”.
*Introduction to a Series on Market Liquidity, Liberty Street Economics, Federal Reserve Bank of New York, August 2015.