Strategy Outlook Fourth Quarter 2015

Our Global Investment Strategy service recently published their Strategy Outlook for Q4 2015.

The quarterly report highlights the following key points:

• Tactically, investors should maintain a cautious stance on risk assets for now. The turmoil in emerging markets is not yet over. A weaker yuan will add to the fire.

• As one looks toward 2016, the effects of China’s fiscal and monetary stimulus should begin to feed through to the global economy, giving EM and cyclical stocks a boost.

• Despite stronger global growth next year, deflationary pressures will persist. Treasury yields could fall, even if U.S. growth does not falter.

• The dollar will remain broadly range-bound against the euro and the yen. The greenback has more upside against sterling, and in the near term, against EM and commodity currencies.

• Investors should underweight U.S. stocks relative to Japanese and euro area equities. Over the long haul, owning Chinese H-shares is our single best trade idea.

Clients interested in reading the full report can access it here.

Chinese Growth: A Reality Check

After a turbulent summer, macro data releases in the past week offer a reality check on China’s economic situation. Overall growth numbers suggest that the economy has continued to decelerate, but that the deterioration has so far remained mild and gradual.

  • The main drag on the economy remains capital spending, particularly among private enterprises. Real estate, mining and manufacturing sectors have all experienced continued stress. The bright spots are spending on infrastructure and investment by state-owned enterprises. However, they have not been strong enough to arrest the slowing trend in overall investment.
  • The industrial sector is still very sluggish but appears to have stabilized at depressed levels. Both industrial production and electricity supply have accelerated from previous months, albeit very modestly.
  • The consumer sector remains reasonably buoyant. Retail sales growth accelerated slightly to 10.8% year-over-year in August, from 10.5 and 10.6% in the previous two months. The strength in retail sales suggests that the negative wealth effect from the collapse in the domestic stock prices has been marginal, with no visible impact on consumer spending.

Taken together, our model based on the monthly macro data suggests that economic growth in the third quarter is set to drop below the 7% official target, but there is no sign of an economic crash as widely feared by the market.


Going forward, the performance of the Chinese economy critically depends on several major “swing factors”, please see the next Insight, Chinese Economy: What To Watch For

Quantitative Tightening?

Fear mongering that equates Chinese reserve sales to an unwinding of central bank QE misses the broader point.


Our global fixed income strategists have no doubt that global yields would spike if the Fed, ECB or Bank of Japan were to begin liquidating their stocks of government bonds. It is a clear case of bond repricing due to the increase in the net supply that must be absorbed by the private sector. Fortunately, this is certainly not a near-term risk.

FX reserve adjustment is a more complicated story. As pointed out in last week’s Insight, there has been no consistent relationship between Chinese flows into Treasurys and the level of Treasury yields over the past 15 years.

More important for global bond yields will be the evolution of ex-ante savings and investment flows. The so-called “Global Savings Glut” (GSG) was evident before Lehman, but the Great Financial Crisis reinforced the reflex to save. Household savings rates jumped across the major countries, while the corporate sector built up cash as its financial balance shifted up. Meanwhile, government deficits exploded after 2007, but austerity is now well entrenched in many countries (i.e. the drain on the global pool of savings from the government sector is now waning). When all three sectors of the economy (households, corporates and governments) are simultaneously trying to save more or dissave less, interest rates fall.

A key part of the GSG story is China’s fixed exchange rate policy. China’s history of rapid export-led industrialization is well known. This involved a managed undervalued exchange rate, the encouragement of large amounts of FDI into the export sector, the accumulation of large amounts of official reserves, and the export of net Chinese savings through official intervention. An undervalued exchange rate discouraged domestic consumption, lifting the pool of saving available to the rest of the world. The fear for some time is that China will abandon this policy. Please see the next Insight, (Part II) Quantitative Tightening?

August Payroll Report Doesn’t Change A Thing

The August payroll report hardly differs from any previous report this year. But given the financial market backdrop, we doubt the Fed will deliver a rate hike that the bond market is unprepared for.


At 173,000, plus positive revisions to previous months, U.S. non-farm payrolls are cruising along at a remarkably steady pace this year. The U.S. economy has consistently delivered monthly payroll gains of between 173,000 and 266,000 since January, 2015 (March was the only outlier). Given the Fed’s self-mandated thresholds for liftoff that they have been articulating all year, the August payroll report would have given policymakers enough ammunition to hike rates in September, if financial markets hadn’t recently revolted.

However, the Fed has no incentive to surprise investors in the current environment. EM currencies continue to break down (Brazil is seemingly entering a full-blown crisis). The ECB (please see yesterday’s Insight) has taken a more dovish turn, which implies further dollar strength if the Fed does not back off: a very unwelcome development for U.S. exporters and multinationals. In addition, inflation is slipping away from the Fed’s target (to the downside), which means that, at a minimum, monetary policymakers will face a communication challenge if they raise rates now.

Indeed, the bond market is pricing roughly a 35% probability of a rate hike in September. If the probability was 50% or higher, we expect the Fed would go ahead. But given the fragilities listed above, the Fed will not be keen to deliver a hike that the bond market is ill-prepared for. With two weeks to go, and all of the “A” indicators already released, there isn’t much information that could trigger the bond market to re-price higher September rate hike odds.

Whether financial markets celebrate the “delay” or not, we believe will depend on the press conference and “dots”. Stay tuned.

Same Macro Headwinds

New York Fed Governor Dudley’s comments yesterday underscored what we already know: that the Fed is unlikely to lift interest rates while markets panic. But ultimately, the same global macro headwinds, and poor final demand conditions persist.



Dudley’s soothing words, along with a late day surge in Chinese equity prices, has shifted investor sentiment in a positive direction for now. But we maintain that the dynamics of the global economy have not materially changed. The Fed backing off from September could give financial markets some breathing room, but unless the dollar weakens substantially, the poor U.S. profit picture is unchanged.

In addition, DM equity markets are no longer ignoring the risks from China and EM. As highlighted in the next Insights, our EM strategists believe the EM selloff has further to run, implying that a cautious DM approach is still warranted.