The monetary illusion is drawing to a close

Didier Saint Georges, member of the Carmignac Investment Committee comments on the gradual normalisation of monetary policy.

Markets awaken
Anesthetised by six years of ultra-loose monetary policy, the markets were generally able to continue ignoring economic reality in 2015 and remain focused on flows. Owing mostly to the single currency’s depreciation, the European equity markets posted some of the world’s best market performances (in euro), despite the disappointing economic progress from this region.

Expressed in dollars, however, the European markets barely surpassed the very mediocre performance of the US S&P 500 (-0.7%) in 2015. With regard to bonds, the only investors to enjoy spectacular performances were those who gambled mainly on debt issued by Greece and Ukraine, which gained between 28% and 38% over the year, but also came very close to defaulting.

Nevertheless, the weaknesses we had previously identified last year in the wonderful world of central-bank-administered markets began to make an initial appearance. In 2015, it was impossible for investors to ignore the consequences for the equity and credit markets stemming from years of overinvestment in the US energy sector. With central banks becoming increasingly restricted in their stimulus policies, 2016 is likely to be the year when the markets awaken to economic reality.

Reminder of the fragility of the markets
The market fragility of concern to us lies mainly in the growing lack of flexibility, i.e. the ability to absorb any shocks, which affects most of the global economy. This fragility stems from the debt levels of governments, corporations and individuals, which the central banks have been perpetuating through massive subsidies since 2009. Since 2000, (public and private) indebtedness has risen from 200% to 280% in the United States, 420% to 510% in Japan, 180% to 320% in Greece, 180% to 400% in Spain and 120% to 300% in China. These levels drain potential growth, which in its weakened state in turn prevents debt ratios from falling. The vicious circle is under way, making the economy highly vulnerable to the next cyclical slowdown, just as it exposes it to any increase in the cost of money.

Collision course
These two pitfalls are now coming into view at the same time, which makes the central banks’ task all the more difficult: they are caught between the need to keep nominal interest rates very low and the need to maintain their credibility after years of monetary creation,responsible for financial asset bubbles, poor capital allocation and widening social inequalities.

As such, a year after putting a stop to its quantitative easing, the Federal Reserve has just initiated its first cycle of monetary tightening since 2004, with the first signs of pressure on wages starting to appear. And should energy prices eventually stabilise in 2016, inflation expectations might then well be reversed, compounding pressure on the Fed. In Europe as in Japan, central banks have started to baulk at the idea of further intervention.

At the same time, though, after six years of expansion, US manufacturing indicators have dropped to recession levels while spending on services has also begun to fall. China is still slowing as well. The economic cycle and interest rate cycles are set to collide. The monetary illusion is drawing to a close.

Safe haven in Europe?
A cyclical lag meant that Europe was one of the few places in the world to show economic improvement in 2015. Even so, despite a 50% drop in energy costs, historically low interest rates and a 25% drop in the value in the euro, annual growth only reached about 1.5%, which is not enough to stabilise debt and kick-start employment. And this performance was ultimately achieved at a time when the German powerhouse started to loose steam – loss of productivity momentum, decrease in profitability, exposure to the global cycle – and began to encounter its first political difficulties, namely tension in the ruling coalition over immigration policy. As such, Europe enters 2016 in a fragile economic position, which in turn raises the issue of its political vulnerability, as the European project surely cannot afford to suffer a Japanese-style “lost decade”.

The emerging world: investors’ bogeyman
China, and in its wake the whole of the global economy, is still paying the price of the huge economic stimulus programme of 2008, which saved the country from catastrophic economic collapse, but only at the cost of excessive lending growth and a production capacity surplus that remains to this day. The economic shift towards tertiary activity has already brought down commodity prices and affected the whole of the emerging world to varying degrees.

However, it also makes many industries worldwide less profitable by contributing significantly to the global capacity surplus. Much like the United States, but to an even greater extent, China is also facing the risk that it will struggle to fully protect its services sector from the effects of an industrial slowdown in 2016. The Chinese authorities’ intention to stabilise this slowdown through accommodative monetary and fiscal policies will have to overcome the outflow of capital out of the country, which has become a steady stream since August, as well as bank balance sheets riddled with non-performing assets. To solve this tricky problem, China may well have to abandon its much trumpeted goal of maintaining a stable currency. A substantial devaluation of the renminbi would ease its own economic burden, but hasten the export of its industrial overcapacity problems to the rest of the world, emerging and developed countries alike.

2016, or the year when markets awaken
Now that central banks have used up most of their options for intervention, and with the banking sector remaining inhibited by an extremely restrictive regulatory environment, investors will be in the front line to deal with heightened market risks. At the same time, liquidity has dried up for all asset classes under the very influence of the central banks’ repeated intervention, making volatility spikes increasingly erratic. As a result, when the high price of “risk-free” assets deprives said assets of their reliable safe haven status, risk management will require the use of very active, targeted hedging strategies.

These will, in turn, make it possible to be opportunistic when market capitulation presents exceptional entry points for anyone who managed to keep a medium-term view. Precursors of these developments are already visible in the oil sector and for certain emerging market assets, including bonds.

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