Three Things That Matter Most to Markets in 2016: U.S. Interest Rates, Oil Prices, and China

 

JANUARY 6, 2016 [U.S. INTEREST RATES, OIL, CHINA]
Charles Wilson, PhD


All three are linked, and hit inflection points in 2015. They all will play key roles in global growth and market performance again this year, but their respective impacts will differ from years past.

For most of the last decade, three factors have mattered most to the global economy: U.S. growth and interest rate levels; oil prices; and China. We expect them to again play a key role in the global growth outlook and the trajectory of markets, although their specific impacts may be different than in past years. All three hit major inflection points over the last 12 months. China’s slowdown prompted authorities to cut the country’s key interest rate five times and banks’ statutory reserves four times. Oil prices continued their precipitous slide begun in mid-2014 with a second slip from $70 per barrel to the mid $30s over the second half of 2015 due to U.S. dollar strength and general oversupply. And the end of 2015 brought a major shift in U.S. monetary policy—the end to seven years of zero interest rates. Our thoughts on these three important variables heading into 2016:

  1. U.S. interest rates – Market expectations for future Federal Reserve rate hikes and the path predicted by the dot plots (the future rate targets of Fed monetary policy committee members) have been slowly converging toward a more dovish outlook. As long as the U.S. economy continues its current slow but steady course, it's likely current expectations are met and we see a few small rate hikes in 2016. Without an uptick in inflation expectations—something hard to imagine during a period of continued dollar strength—the Fed is unlikely to raise rates aggressively. Furthermore, if the U.S. economy proves weaker than expected, perhaps due to continued strength in the dollar and its impact on exports, we would expect the Fed to delay raising rates. The current trajectory indicated by market expectations or even a slightly more dovish trajectory could lead to dollar stabilization and perhaps more U.S. investor interest in foreign assets. It’s highly possible dollar strengthening has run its course, but it all hinges on the resilience of the U.S. economic recovery and market expectations for the trajectory of the Fed rate cycle.
  2. Oil – Crude prices have been under downward pressure for nearly 18 months due to rapid growth in supply from non-Organization of Petroleum Exporting Countries and the strategy of top OPEC producer Saudi Arabia to favor market share over price support via output cuts. Current projections for global supply and demand indicate that oil inventories in Organization for Economic Co-operation and Development (OECD) member countries should continue to build through at least the third quarter of 2016, despite a dramatic drop in the U.S. onshore rig count. Normally, falling rig counts would lead to a major decline in U.S. onshore production over the following 12 months. The key point to watch for will be the peak in OECD inventories. Two factors that could lead to oil upside before the peak would be a change in Saudi Arabia’s strategy to subordinate price to market share (something that appears unlikely at this point), or a clear indication that the expected 2016 U.S. production decline would exceed current estimates of 500,000 to 800,000 barrels per day (also hard to imagine based on the current rig count and heightened focus on the most efficient wells).
  3. China – China’s slow transition from an investment-led to a consumption-driven economy has been more difficult than expected. It’s worth noting the remarkable resolve Chinese policy makers have shown as they continue to support the transition, despite the sharper-than-expected growth slowdown. China’s leadership is well aware that turning back to old-growth methods based on easy credit and unnecessary infrastructure programs would be a major setback for the reform movement. Despite their decision not to resort to the old toolkit, some things can be done to cushion the slowdown and push credit to the most productive sectors. Over the course of the last 18 months, we have seen several adjustments to the bank reserve requirement ratio and interest rates. While this is an important step for liberalizing the cost of credit within the domestic economy, it’s done very little to boost liquidity in light of recent capital flight following weaker-than-expected growth numbers and a general willingness to let the yuan weaken. Today, China has some of the highest levels of real interest rates and reserve requirement ratios in the world. A weaker yuan will help the level of real interest rates through inflation, which could also help the corporate investment outlook. Additional interest rate and reserve requirement cuts could also help domestic liquidity, especially if they are targeted as we have seen in some of the recent policy moves.

In the past, all three factors have been inextricably linked. For example, low U.S. interest rates led to elevated consumption, which drove demand for Chinese exports and commodity-intensive infrastructure investments. Looked at differently, a weak dollar—usually driven by low U.S. interest rates—led to elevated commodity prices, which forced the search for lower production costs in places such as China, which also benefitted from its effective peg to the weak U.S. currency. Today, China and oil prices, while still clearly important to global economic growth, are more independent in nature. Global trade is less important than ever to the future growth of the Chinese economy. It’s up to China to recapitalize its banking system and spur domestic consumption through appropriate means. The price of oil, while influenced by the dollar, appears to be trading on fundamental oversupply, rather than other influences. We simply have too much oil right now.

U.S. interest rates remain very important to global growth in part due to the dollar’s status as the world’s most important reserve currency. Perhaps by the next crisis, the role of the dollar will be somewhat less influential, considering the inclusion this coming October of the yuan into the reserve currency club. But for now, the dollar remains the primary way trade is done. The unknown and unintended impact of a stronger dollar has created widespread risk aversion in anticipation of higher interest rates. The implications of the conclusion to this unprecedented experiment in monetary policy are difficult to grasp and have left many assuming the worst. If markets have to climb a wall of worry in their push upward, there is more than enough worry to go around. It’s hard to know at this point if it’s just worry, but we should know before long. Several of these indicators are binary in nature and the implications of each outcome could be wildly different, depending on the ultimate direction and the following policy response. To prepare for the array of potential outcomes, we continue to emphasize diversification across geographies, sectors, and currencies in order to minimize adverse impacts related to hard-to-predict macroeconomic or policy driven factors.

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