Fiscal Policy In The Spotlight

Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar’s swoon is ending: Go short EUR/USD with a target of parity by the end of the year.

To access the full report entitled “Fiscal Policy In The Spotlight”, please click here.

The Signal From Commodities

Concerns over the Chinese economy, a withdrawal of speculative demand, and strong supply growth have all weighed on commodity prices over the past few months. All three of these forces should ebb over the coming months, providing a more benign cyclical backdrop for commodities and commodity-related investment plays.

To access the full report entitled “The Signal From Commodities”, please click here.

Stuck In A Rut

Mr X. – more conflicted than ever about the 2016 outlook – poses some tough questions to BCA’s editorial board.

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook.

This year, he rightly pointed out that extreme monetary policies continue to create major economic and financial distortions that ultimately will have significant unintended negative consequences. As well, he forced us to acknowledge that there has again been little progress in reducing elevated debt levels around the world. Meanwhile, economic growth remains dangerously fragile and deflation is a risk.

Indeed, we were not able to assuage Mr. X’s fears.

We wish we had grounds for being more optimistic, but it is a challenging investing environment. A more positive stance on risk assets would be warranted should the corporate earnings outlook improve significantly, though the odds of that seem low at the moment. The other way to improve future return prospects is for asset prices to decline and establish attractive valuations. That is enough of a threat to warn against an aggressive investment stance and is why we recommend no more than a benchmark weighting in equities. And we would not argue strongly against a modest underweight.

To read the edited transcript of our recent conversation, please click here: Stuck In A Rut.

U.K. And U.S. Economic Similarities Are Striking

U.K. and U.S. economies are at a similar stage of the cycle, but terminal rates are very different.

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The acceleration in U.K. wage growth amid low unemployment and dismal productivity growth reminds us of another economy. The similarities with the U.S. are striking, extending to the current level of real GDP growth, consumer spending, consumer confidence, the rate of home price appreciation, and employment growth.

These similarities make one wonder why the OIS curve in the U.K. is so much lower than in the U.S. The BoE’s lift-off date discounted in the market is not far behind that in the U.S. However, the BoE is expected to tighten at a slower pace than the Fed, and to a much lower terminal rate. In 2020, the central bank policy rate is expected to be about a percentage point lower in the U.K. than in the U.S. After adjusting for expected inflation, the gap between the policy rates is expected to be even greater in real terms. The BoE’s real Bank Rate is expected to still be negative in 2030! Our global fixed income strategists see no reason for the long-term equilibrium rates in these two economies to be that far apart.

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On a shorter-term horizon, expectations for depressed real rates versus the U.S. over the next few years likely reflect the view that the U.K. economy is much more globally exposed and integrated with the euro area than the U.S. This means that Governor Carney will be more constrained in raising rates, since a stronger pound would undermine the UK economy a lot more than a stronger dollar would damage the U.S. The potential risk of economic fallout in the broader Eurozone if Greece eventually exits the currency union also hangs over the U.K.

Moreover, PM Cameron’s latest budget calls for years of painful belt-tightening beginning in FY2016, creating a strong headwind for growth. Please see the next Insight, (Part II) U.K.: Fiscal And Monetary Policies.

Oil: Supply-Demand Imbalance

The rate of growth in demand for petroleum products is sputtering outside the U.S.

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In Emerging Markets (EM) economies, demand growth, which we proxy using non-OECD liquid fuels consumption, was up a little over 2% year-on-year (yoy) in May. However, when China’s 3.2% p.a. growth is stripped out, EM demand growth falls to just 1.7% yoy. In addition, the rate of change in annual EM growth is negative, meaning growth is slowing.

Demand for petroleum products in Developed Markets (DM), which we proxy using OECD fuels consumption, is up a little over 1% yoy. When U.S. performance is stripped out, DM demand actually contracted almost 1% yoy in May, leaving world demand growth at 1.1% yoy. By comparison, world production is up more than 3% yoy, and stands at about 96 million bbl/day (mm b/d).

This supply-demand imbalance will continue to keep inventories high globally, as can be seen in the implied stock change and balances forecast by the U.S. EIA. If anything, the EIA’s expectations understate the potential physical imbalance next year, if Iran’s production can ramp at anything close to what officials there claim – i.e., up to 1 mm b/d of additional production, once sanctions are removed.

Market expectations for the incremental supply coming on out of Iran range between 500 thousand to 800 thousand bbl/day (kb/d) beginning later this year, following the successful conclusion of negotiations between Iran and the P5+1 states over Iran’s nuclear program. This, too, may understate the incremental supply forthcoming following the conclusion of the negotiations, given Iran’s floating storage is estimated at up to 40 million barrels. The floating storage can be brought to market immediately, provided buyers can be lined up.

On the demand side, weaker EM growth will weigh on oil demand globally. Please see the next Insight, (Part II) Oil: Supply-Demand Imbalance.