A Most Peculiar Year

March 2, 2016

Face it, anticipating the movements of currencies has never been intuitive, and it’s hard to recall a time quite as confusing as the present.  The United States, Britain, eurozone, Japan, China and Brazil each face economic and political crossroads of enormous importance.

United States:  The presidential primaries have highlighted an extremely high level of voter anger.  It seems paradoxical since the last recession ended over six and a half years ago, the rate of unemployment is below 5.0%, and the post-Great Recession fiscal deficit has shrunk far further and faster than predicted.  Anger has fixated on the ultra-skewed distribution of GDP growth, a trend that has in fact been decades in the making.  If for illustrative purposes only ten people in the land received all the incremental GDP of the past decade or two, then the American Dream is dead for all intent and purposes. With interest rates near zero, U.S. labor productivity was unchanged in 2013 and rose just 0.7% in 2014, 0.6% in 2015 and 0.6% over the past four reported quarters.  Now the Federal Reserve is trying to raise rates, and there’s great uneasiness in the markets that the experiment could fail.  The economics of America is putting great strain on the politics of America.  Is it not unthinkable to imagine that if the Republican front-runner is elected president that the 2016 election might be the country’s last free election?  It’s a step into the unknown that strikes fear, and all this in the advanced economy that is presumably positioned best for the period ahead.

China:  According to official data, the world’s second largest economy downshifted from growth of 11.8% in the year to the first quarter of 2010 to 6.8% in the four quarters through 4Q15.  Those figures aren’t believed by private analysts, who suspect growth in 2016 will be lucky to reach 5.0%.  However necessary a Chinese economic transformation may be, that kind of deceleration will continue to be enormously disruptive. 

Japan:  Abenomics isn’t working as hoped.  2% core inflation wasn’t secured by April 2015 as intended and probably will still be elusive in a sustained way past year 2020 when the summer Olympic Games will be hosted in Japan.  If the economy were growing faster, sub-target inflation wouldn’t be so bad.  But Japanese real GDP has expanded just 0.4% per year over the past ten years and 0.7% per annum over the last 20 years.  Until the late 1980s, Japanese growth was so muscular that sub-3% GDP growth was considered a recession there, so no wonder the Nikkei-225 present level of 16,747 is still 57% below its peak at the end of 1989.  The Bank of Japan’s quantitative monetary stimulus has been greater in relative size than any other central bank, and Japan’s fiscal debt dwarfs other government’s deficits in relative size.  The biggest nightmare for Japan watchers is whether its experience might foreshadow what could be coming to China.

Euroland:  Continental Europe’s shared currency was a big mistake with no predetermined escape strategy if it failed.  A common shared fiscal policy didn’t follow the establishment of a one-size-fits-all monetary policy and a single currency.  A progression of initiatives by the ECB has not raised inflation to the target of below but close to 2.0%, and that central bank has followed Japan into the rabbit hole of deepening negative interest rates.  GDP is at best muddling, and consumer prices in the year to February posted a drop of 0.3%.  In the best of times, dealing with the flood of Middle Eastern migrants would be daunting.  These are not good times, and the only strong leader in the region, Angela Merkel, has seen her popularity as German Chancellor erode seriously over this issue.

Britain:  A referendum on June 23rd to decide if the U.K. remains part of the European Union threatens to change the economy profoundly.  Financial services represent a much higher share of the British economy than that sector does in most other countries, and no money center is bigger in foreign exchange than London.  The dollar’s 4.8% rise against sterling since end-2015 almost matches its full-2015 advance.  There’s talk that a decision to leave the EU could drive the pound down to dollar parity, breaking below the early-1985 all-time low of $1.0345.  A “yes” vote, by contrast, would elicit enormous market relief.

Brazil:  Even more than China, Brazil has become the poster child for emerging economies that have gone terribly wrong.  Not so long ago, Brazil had been sufficiently dynamic to get lumped with China, India and Russia in the BRIC group.  Last month when the OECD released new quarterly growth forecasts, projected global GDP growth got revised 0.3 percentage points lower to 3.0%, but Brazil took a much greater hit.  GDP there is now projected to shrink 4.0% this year, inconceivable for a nation hosting the tourism-boosting summer Olympic Games, versus a forecast drop of 1.2% predicted only three months earlier.  For 2017, the OECD now anticipates no growth in Brazil, down from a forecast rise of 1.8% predicted back in November.   The real has been in free fall, and the central bank has had to raise interest rates to counter accelerating inflation.

World Manufacturing:  J.P. Morgan’s monthly global purchasing managers index printed at 50.0 in February, 0.9 points less than in January.  50.0 is the dividing line between expansion and contraction, and February’s level was the lowest in 39 months.  Manufacturing is sucking wind all over.

Oil:  The dive of oil from a triple-digit high in June 2014 to a low last month of just over $26 has been a catalyst for general market volatility, deficient inflation, and flagging economic growth.  In the stampede for asset safety, another commodity, gold, has become the ultimate haven, jumping more than $100 per ounce in February alone.  In perhaps the greatest irony in this peculiar, yet still young year of 2016, the low price of energy is encouraging greater usage of all sources, especially fossil fuels.  The U.S. election of 2016 may offer the last chance to save the planet from catastrophic harm, yet as things are shaping up in the race, environment is taking a backseat to personality issues. 

The Dollar:  I learned long ago that currencies do not march to a drum intended to deliver the greatest good.  Among the majors, the dollar this year has been most weak against the yen, falling marginally over 5.0%.  Still battling the specter of deflation, Japan can ill-afford an appreciating currency, but there it is.  The dollar is also 2.7% softer against its Canadian counterpart.  The greenback soared 19% in 2015 against the loonie last year, so this year’s action hardly changes the Canadian dollar’s big picture.  The dollar rose 4.6% against the renminbi and on balance has tacked on another 0.9% this year.  The depreciation of sterling has already been noted.  One of the bigger surprises of the year involves a mere 0.3% net rise against the euro after double-digit dollar appreciation between end-2014 and end-2015.  The Swiss franc and Aussie dollar are likewise hardly changed in 2016. 

The Fed’s March Decision:  Two weeks ago, a second rate hike this month seemed remote.  While considerable arguments can still be made in favor of delay, the possibility of a tightening now carries greater plausibility, and the dollar’s performance is one reason for this.  The dollar has been more mixed in 2016 than 2015, and this inflection point can be seen in monthly averages of EUR/USD, which are documented in a table from this recent update on Currency Thoughts.  More importantly, net exports as a component has exerted only marginal drag on U.S. real GDP lately, amounting to 0.25 percentage points (ppts) of growth last quarter and 0.26 ppts in 3Q.  Net exports in 2Q15 actually enhanced the GDP growth rate by 0.18 ppts.  Fed officials have in the past express some concern that dollar appreciation could blunt the upturn in inflation and depress economic growth.  For now, that doesn’t appear to be happening.

The formidable known unknowns of 2016 are enough to scare off the faint of heart from participation in the market place.  And we haven’t even addressed the unknown unknowns, which tend to correlate positively with a rise in bad possibilities.  Good luck.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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