Mid 2016 Financial Markets Update

First, the global GDP growth numbers: I have turned to the World Bank's Global Economic Prospects, published in June. The outlook has now turned even more gloomy with most numbers being revised down from January's report. The world's GDP growth for 2015 is still estimated to have been 2.4%, but the forecast for 2016 has now been revised down to 2.4% from 2.9% previously. They still have hopes for >3% growth in 2017-2018, but I posit that as an unlikely outcome given the looming recession in the US. Taking also in account the slowing growth of population (1.2% per year) and similar meager productivity improvements (also ca 1.2%), it is difficult to see how 3+% growth can be sustained in the future without radical technological innovations. The media is buzzing with talk about the future fully automated society, but it has not shown up in the labor productivity statistics yet. The everlasting optimism of the World Bank is evident when plotting the forward guidance over several years. If the guidance is biased, the picture tends to look like an hedgehog:

The Hedgehog shape is certainly there for the World Bank's economists as well. In every new forecast in the last three years, the return to "normal" economic growth of 3% has continuously been pushed forward a few years and the upper numbers revised down. My more sober baseline expectation for the economic growth is instead the population growth +1% extra for productivity improvement (based on recent numbers). It is depicted as the dashed line.

Secondly, the world's stock markets: in the previous market update, I speculated that the markets were bent on a correction, which did occur during January and February, but since then they have rebounded back to the late-2015 levels. The Brexit triggered a sell-off starting on June 24th, but the FTSE All-world Index is still up about 2% so far this year.

The markets are still below the peak in the 2015, so the overall picture is that of a sideways market treading water. Given that the markets tend to be forwarding looking, it indicates flat or slowing economic conditions for 2017. That being said, it is important to remember that +2% for 2016H1 is actually a bullish development, given the present high valuation of the stock markets. A compounded 4% advance for 2016 should be fully acceptable return when bond yields are close to zero.

In the European context, the Brexit hit the European banking system especially hard. It will be interesting to see, in retrospective, if this was an event similar to the fall of Bear Stearns, which triggered a further chain of events. I speculate that the first one might have been the 150 billion euro government liquidity guarantees to Italian banks announced on June 30th. But in the medium term, I am not certain that the contagion will spread to the US or Chinese stock markets just yet. The way I see it, a truly market defining event needs to be something more substantial, which fundamentally changes the outlook for growth or liquidity. It could be a global coordinated change of central bank policy, enactments of massive fiscal stimulus, the failure of a big bank, or perhaps a surprise in the US presidential elections.

Thirdly, interest rates and bonds: close to one quarter of the global bond market is now trading with zero yields, effectively under central bank control. The share grew bigger during 2016, and I am starting to wonder for how long the quantitative easing can be sustained? Eventually, something will have to give in. So naturally, bonds become one of the better asset classes in 2016H1, global bond funds typically advanced 7% or so, due to declining yields. Only commodities performed better. I follow the US 13 weeks (^IRX) and 10 year government bond rates (^TNX) and the 10 year rate has continued to decline from 2.2% in the end of 2015 to 1.5% now. If the yields continue to sink at its current pace, US will have negative interest rates in 2018, just like Europe and Japan. So while there is talk of future inflation from the Federal Reserve, it does not show in the bond prices (partly due to their own market actions).

Many eyes and ears have been on the Federal Reserve and their interest rate policy during the first half of 2016. The Fed has announced a quite aggressive interest rate path aiming for 1.375% policy rate at the end of 2016. That looked reasonable, given the trend in the IRX from Oct 2015 to Feb 2016 where short-term market rates advanced about 0.1% per month, as can be seen in the figure below:

In reality the upward move lost its momentum after February and since then, the IRX has oscillated around the current 0.025% target, which explains the Fed's reluctancy to raise interest rates. I still think it is a sign of strength that US short-term interest rates have been non-negative for more than half a year now. Notwithstanding the collapsing long-term rates, it is a much better than the situation in other developed markets and it explains the attractiveness of the US dollar.