January Newsletter: "Predictions" for 2016

Posted by Alex Frey (@alexhfrey )

One of my favorite rituals of the new year in the financial world is the rush of fearless (or stupid?) "predictions" that inevitably pop up from the financial press. I enjoy it more for the theater than the substance -- the fact of the matter is that studies show that the vast majority of these predictions turn out totally wrong. But that doesn't stop the fearless predictors from carrying on with (mis-placed) confidence and bravado again the next year.

Those of you who are familiar with our philosophy know that we don’t make predictions, so we are saved from the annual exercise of looking back at everything that we got wrong. But as explained last year, we do find it a fruitful exercise around this time of the year to “predict” what we should be paying attention to in the coming year. First, let's look at how our “predictions” for last year turned out.

What will happen in Japan?

The first issue that we suggested that you pay special attention to in 2015 was the results from one of the great monetary policy experiments of our time. In an attempt to shake the Japanese economy out of its 25 year malaise, the Japanese central bank was engaging in massive quantitative easing (buying bonds to expand the money supply, bring down interest rates, and move the economy away from deflation). Figure 1 shows that the central bank continued this experiment in 2015. The assets of the bank have expanded continuously during the year. Now the European central bank is doing the same thing, as shown in Figure 2. 

While the final verdict of this one might have to wait another year (or more), the initial results of the great experiment are a tad prosaic (nothing spectacular has happened, either good or bad), they are also a bit disappointing. Figure 3 shows that the consumer price index has been basically stable for the past year (the central bank would like to see a small positive rate of inflation), and Figure 4 shows that the growth rate of the gross domestic product (GDP) has remained very low. Meanwhile, the Japanese government has been adding debt in an effort to provide a fiscal stimulus to the economy, although the rate of debt increase has slowed significantly as shown in Figure 5. 

While the Japanese experiment may seem to be failing, one should remember that Japan has a shrinking work force and a rapidly aging population. These factors greatly restrict growth. Also, unemployment in Japan is quite low, currently about 3.6%. Most countries would be extremely happy to have such a low unemployment rate. So, we should wait before declaring the Japanese experiment to be a failure. Also the spectacular debt collapse that many have been predicting for years appears to be closer to happening now than it has at any point in the past. So overall, this experiment will bear continued watching in 2016.


Figure 1: Total assets of the central bank of Japan


Figure 2: Central bank assets for the Euro area.


Figure 3: Consumer Price Index for Japan


Figure 4: GDP growth rate for Japan


Figure 5: Japanese gross government debt

Where does the price of oil stabilize?

The second thing we suggested that you pay close attention to in 2015 was where the price of oil might stabilize. At this, we can claim some success – the price of oil has been a key story in 2015. On the other hand, we are still not clear on where it will settle over the long term.
To the surprise of many, the prices of oil and natural gas have collapsed over the last year and a half. We wrote a longer commentary about this in our June newsletter. The price of Brent oil during 2015 is shown in Figure 6. It seemed for a while that oil might stabilize at a price of around $60/barrel, but since then it has dropped below 30 (as we write, the price is ~$28/barrel). The drop in the price has been driven to a great extent by U.S. production, which increased rapidly in the years from 2008 to 2014 as a result of the new fracking technology. The economic slowdown in China and Europe has also had an effect on reducing demand. OPEC might have been expected to cut production in order to stabilize prices, but Saudi Arabia has refused to go along. They are either trying to drive the U.S. frackers out of business, or they are trying to protect their market share from potential rivals (such as Iran). U.S. production has begun to drop as the low prices have drastically reduced the number of new wells being drilled, but Iran will soon be adding a new supply to the market. In the near term, it is possible that the new Iranian production will drive prices lower, but we suspect that there will be some recovery in 2016. However, fracking will probably put a floor on prices for a number of years to come. For stocks, the lower prices are obviously bad for the energy sector, but they are positive for consumers and many other companies.


Figure 6: The price of U.S. Brent oil

Is the Fed able to raise interest rates?

This has also been a key story for 2015, and one that comes with a more definitive answer: yes. We had a longer commentary on this in our December newsletter. We now know that the Fed, as expected, raised rates in December for the first time in eight years. In a way, this is positive news because it indicates that the Fed thinks the American economy is strong enough to withstand a rate increase. It also refutes many commentators who had argued that this would fundamentally never happen – that QE would continue indefinitely.   

Many other central banks are stimulating weak economies by cutting rates and pursuing quantitative easing. The U.S. move should strengthen the dollar, which will make prices lower for imported goods but will make things harder for U. S. exporters. Guidance from the Fed indicates that they may push rates up by a full percentage point in 2016, but that will depend on their assessment of the economy as the year progresses. The future course of rates is very uncertain, and it would not surprise us if the Fed delayed further increases. Growth rates in Europe and Japan are low, and some developing countries are in recession. Also, growth in China appears to be slowing. These head winds could bring about a slowdown in the U.S. and force the Fed to change course. So, the issue for 2016 will be whether the Fed continues to raise rates. As we commented in the December newsletter, higher rates are generally negative for stocks, but the correlation is not strong and stocks often rise for a considerable time after rates begin to rise.

Is this (2015) the year we learn the Euros fate?

It may have been, or it may still be too early to tell. As 2015 got underway, the Euro (the common currency of many European Union countries) was in trouble. Greece had built up too much Euro denominated debt and couldn’t afford to pay the interest. Other Euro countries had forced Greece to accept severe austerity as the price of a loan. The Greek voters, rebelling against austerity, elected a government that said it would abandon austerity. It appeared that Greece might default on its debt and be forced to withdraw from the Euro. Once this precedent was established, there was fear that other countries with high debt, such as Spain and Portugal, might follow, and the Euro zone might collapse.

As it turned out, the new Greek government capitulated and accepted the harsh terms for a new loan. For the moment, the issue has fallen out of the news, but it isn’t clear if Greece will be able to work itself out of the deep hole it is in. Unemployment has begun to fall slightly, but is still 24.6%, about the same as the U.S. at the peak of the Great Depression in the 1930s. For the first nine months of 2015, the Greek budget was still in deficit, but the deficit has declined markedly from just a few years ago, and the economy grew very slightly. In the meantime, two other Eurozone countries, Spain and France, are running budget deficits that are more than 3% of GDP. As we approach 2016, things look better for Greece and the Euro, but the debt issue will continue to be a concern.

What new issues should we be watching?

Probably the biggest issue facing the world economy in 2016 is: What is happening in China? For many years, the Chinese economy has been growing at a remarkable rate, as shown in Figure 7. For the ten years between 2002 and 2011, the growth rate averaged greater than 10%. To support this growth rate, China needed to import prodigious quantities of oil and metals, and Chinese demand drove commodity prices higher. Now, things appear to have changed in China. The government reported a growth rate of 7.0% in the second quarter of this year and 6.9% in the third. This would still be a very impressive growth rate, but some people are skeptical of the statistics. The Economist magazine reports that electric power consumption in China has risen only 0.1% this year, and imports have fallen 18% (by value) in the past year. This would seem to imply that the economy is growing slowly if at all. But, the Chinese economy is also making the transition from an industrial, export based economy to a service economy. As it does so, the raw materials and power required per unit output will decline. The question is whether they will be able to sustain growth based on internal, domestic demand. If growth in China slows significantly, it will be bad news for many developing countries.


Figure 7: Growth rate of the Chinese GDP to 2012

We hope that you follow these issues closely throughout the year. Remember that an IvyVest Portfolio gives you broad diversification, which is your best defense against the uncertainty of world events. And our dynamic allocation model attempts to keep you out of the worst bear markets, which is how an investor following our model would have seen a maximum “draw-down” of only 15% since 1900 – less than half that experience in a static “balanced” portfolio of equities and bonds.

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By Alex Frey