Saturation continuation: excess supply will shape markets in 2016
The main drivers of the global economy during 2015 will continue to shape the macroeconomic environment in 2016 and beyond.
In particular, we live in an age of oversupply-of debt, labor, and regulatory directives—and central bankers are the only policymakers currently poised to provide sufficient stimulus to generate demand.
The oversupply of debt is constraining the ability of most governments to generate demand through fiscal stimulus. Central banks have stepped in to fill the void with significant monetary easing, which has led to an oversupply of liquidity in the macroeconomic system. The result has been a huge compression in government borrowing costs and a depreciation of every major currency relative to the U.S. dollar, given the U.S. Federal Reserve's (Fed's) monetary tightening. While there's unprecedented liquidity in the macroeconomic system, there's a dearth of liquidity in the markets. This is due to an abundance of regulation in the wake of the global financial crisis. Finally, there's an oversupply of labor globally, which means little upward pressure on wages, and therefore on inflation. In all likelihood, we'll continue to live in a low growth, low rate, low inflation environment for the next five years or more.
U.S. economy remains out in front
The global recovery in 2016 will continue to be driven primarily by the United States. The current U.S. recovery—like virtually all recoveries throughout the country's history—is supported primarily by consumer demand. As households continue to deleverage and repair their balance sheets, lower oil prices will eventually start to feed into better retail sales toward the end of the year. We believe the housing market is in the first half of its recovery and will continue to gather steam through 2016. One part of this recovery that's been deficient has been capital expenditures. Rather than investing in expensive machinery, companies are electing to hire cheap labor, a decision that can be easily reversed. This could be one reason why productivity growth in the United States has been, and will continue to be, sluggish. The Fed will most likely continue to hike rates very gradually in 2016, potentially by an additional 50 to 75 basis points. As short-term yields increase, long-term yields should remain low, resulting in a flattening of the U.S. Treasury yield curve.
Macro-level risks include China's trade-offs
The greatest risk to the global economic recovery is China. Beijing is currently trying to rebalance its economic growth model away from investment and toward consumption. At the same time, it aims to open up its capital account. In this, China faces a predicament: The government would like to see interest rates fall and the currency depreciate, but it can't open up the capital account at the same time or it will risk sparking massive capital outflows. In our view, there's a political commitment toward rebalancing the economy and opening up the capital account, but both will happen by evolution, not revolution. Both processes will be heavily managed by the Chinese government and will take much longer to achieve than most analysts are currently predicting.
European solidarity is at risk
Additional risks to the global economy lie in the eurozone. The refugee crisis is likely to seriously undermine European solidarity in 2016 and beyond. This will make it more difficult for policymakers to row in the same direction, either to address a problem with a weaker country in the eurozone or to devise a European-level migration policy. Policymakers have already failed to come to a consensus on how to resettle refugees from Greece and Italy throughout the eurozone; instead, the larger countries overruled the smaller ones in imposing resettlement targets. This will call the willingness to participate in the European project into question among member states. Furthermore, if the Schengen Agreement—the elimination of passport and other border controls between member countries—collapses and national borders are resurrected, as seems likely, it will fundamentally undermine one of the central tenets of the European Union-the freedom of movement of labor, capital, and goods. It will also provide a headwind to growth, as many European supply chains are well integrated throughout Central and Eastern Europe. The refugee crisis may provide a short-term stimulus to European growth as governments spend more on defense, construction, and education, but over the medium term, the crisis will either be a boon to European growth or a social and political debacle-the outcome rests on how quickly refugees can be integrated into European labor markets.