China: Growth And Policy

China’s economic growth looks set to finish 2015 once again below the official target, for the second consecutive year.


The growth slowdown is partially attributable to natural economic factors such as weakened global demand and excess capacity in some domestic sectors that have restricted private sector capital spending. Policymakers should also share the blame, as policy settings were kept too tight for too long. Indeed, the authorities for a long time had viewed the policy-induced slowdown as part of the “new normal” and failed to correct policy.

Throughout 2015, the broader policy stance has become increasingly accommodative. On the monetary front, the benchmark lending rate has been lowered by 125 basis points in the past 12 months. Fiscally, the government deficit has remained largely unchanged since 2009, and has only begun to break out in recent months. The latest RMB policy change is also within the authorities’ broader attempts to rescue growth. What does this mean for stocks? Please see the next Insight, Chinese Shares After The Boom-Bust.

FOMC Takes The First Step, What Next?

Now that the FOMC has finally pulled the trigger, the key questions surround the pace of rate hikes and whether or not the Fed’s reaction function has changed.


It finally happened. The Fed took the first step in the tightening process, after years of speculation, debate and angst. Now the focus shifts to the pace of rate hikes. Fed Chair Yellen emphasizes that she will proceed “gradually”, as specified by the ‘dot plot’. The problem is that investors appear to believe that “gradual” means something much slower. The median ‘dots’ foresee four quarter-point rate hikes in each of 2016 and 2017, compared to half that amount implied by the bond market.

How will this gap in expectations be resolved? If the FOMC proceeds with regular rate hikes in line with the ‘dots’ next year, then it will not be long before market expectations for 2017 and 2018 move up toward the Fed’s projection. This process is likely to be disruptive for risk assets, and is one reason why we are cautious on equities.

Another key question is whether or not the FOMC has adjusted its reaction function with respect to incoming economic data. The Fed has been focused almost exclusively on the labor market in the lead up to the first rate hike. However, this week’s FOMC Statement and Yellen’s press conference suggested that, going forward, the evolution of underlying PCE inflation will play an important role in determining the pace of rate hikes.

Determining the underlying trend will require stripping out the “temporary” effects of shifts in oil prices and the dollar. If the underlying inflation rate trends up in line with the Fed’s projection over the course of next year, then the FOMC will feel justified in lifting rates by 100 basis points in 2016 (assuming that underlying economic growth is stable and there is no financial crisis inside or outside the U.S.).

A slower pace of rate hikes would be justified if the trends in wage growth and underlying inflation disappoint Fed expectations, because that would imply that the economy is not as close to full employment as policymakers thought.

Bottom Line: Equities weathered the first rate hike well so far, but the market is still at risk. Watch U.S. wages and measures of underlying consumer price inflation.

Inflation Implications Of The Commodity Carnage

Despite our view that inflation will be very benign in the developed world, inflation expectations are too low in the U.S. and too high elsewhere.


In an earlier Insight we showed our Global Fixed Income Strategy service’s projections for the evolution of headline inflation in the major countries based on the assumption that the currency and oil effects in inflation unwind over the next year (service sector inflation is implicitly assumed to be unchanged). It is not surprising that after incorporating the latest figures for oil prices and exchange rates, the projection for headline inflation is revised lower in most cases. The forward CPI swap curves shifted down a little as well in some cases.

Nonetheless, the broad story is unchanged: market expectations for inflation over the next year are too low in the U.S. Expectations are too high outside the U.S., unless significant home-grown inflationary pressure emerges.

Our global fixed income strategists extended their research with import price models. As before, the projection is based on unchanged commodity prices and currencies from today’s levels.

The current (negative) contribution from import prices to U.S. inflation has been huge, at 2 percentage points. The U.S. consumer goods price index has the highest sensitivity to changes in import prices of the major countries. However, if the dollar and commodity prices stabilize, the contribution to inflation will move close to zero by the end of 2016. This would add back almost 2 percentage points to headline CPI inflation, taking it well above current market expectations.

Outside the U.S., inflation expectations are too high, please see the next Insight, (Part II) Inflation Implications Of The Commodity Carnage.

Global Equities: Caution Warranted

According to our Global Investment Strategy service, increasing macro risks against a backdrop of elevated valuations warrant a more cautious stance (neutral allocation) on global equities:


  • The probability of a December hike has tracked the steepness of the OIS curve. In essence, by signaling to markets its intention to hike rates in a few weeks, the Fed has pushed forward the timing of future rate hikes. Given that the Fed’s “dots” are still a fair bit higher than current market expectations, the risk is that rate expectations will continue to adjust upwards, tightening financial conditions in the process. Such an outcome would be bad news for stocks.
  • A strong greenback and an increasingly hawkish Fed is bad news for emerging markets, given that over 80% of EM foreign-currency debt is denominated in U.S. dollars. If emerging markets were on solid footing, this might not be much of a problem; unfortunately, they are not. The ratio of private-sector debt-to-GDP has doubled since 2001. Remarkably, debt levels continue to rise in most emerging economies. If things are tough now, imagine how tough they will be when debt begins to decline. Reducing debt in a smooth and orderly manner is hard enough in advanced economies with their strong economic institutions; it is virtually impossible to pull off in emerging markets. According to ourGlobal Investment Strategy service, there is a high probability that shocks from the EM world will spill over into developed markets.
  • Apart from the impact of Fed hikes and emerging market stress, the potential for a growth slowdown in Europe is another reason that makes us increasingly worried about the outlook for global equities.

Government Spending In The Euro Area

According to our European Investment Strategy service, government spending might give the euro area economy some much-needed support over the coming quarters – particularly relative to other major economies like the U.K., U.S. and Japan.


In the near term, the refugee crisis and counter-terrorism security provide a clear and urgent rationale for more government spending. Although such spending means that euro area governments will stray from the Commission’s official deficit targets, Brussels has nonetheless given its tacit approval. Brussels is showing leniency because, after five years of centrally-imposed austerity, the euro area is now close to a structural budget balance. Even the individual country structural deficits in France (-2.5%), Italy (-0.6%) and Spain (-2.3%) are now smaller than those in the U.K. (-3.6%), the U.S. (-3.1%) and Japan (-5.5%).

To get to this near-balance in its structural budget, the euro area has gone through extended austerity: most recently, three back-to-back years of a negative fiscal impulse, based on government spending. The good news is that this pain is about to end. The IMF forecasts the euro area fiscal impulse to stabilize in 2016 and turn positive in 2017. Any additional spending on the refugee crisis and counter-terrorism security will simply accelerate this rebound in government spending.

Interestingly, the opposite is true in the U.S. The economy has benefited from three back-to-back years of a strongly positive fiscal impulse. But according to the IMF forecasts, the fiscal impulse is about to turn negative through 2016-2017.

Bottom Line: The euro area has a lot more fiscal stimulus bullets left compared with other major economies.