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Subdued mood on the markets

The first rate hike in the United States has finally come within arm’s reach. Meanwhile, the picture in the rest of the world remains too mixed to warrant any tapering of monetary easing. The coming year will be characterized by this divergence.

In Brief

  • - The global economy should continue to grow at a slow pace.

  • - Economic differences within the Eurozone remain large and support a continuation of accommodative monetary policy.

  • - In Japan, the inflation target rate of 2% is still remote.

  • - Emerging-market debt has risen strongly since 2007 but the probability of a global crisis remains low.

  • - China’s central bank faces some difficult policy decisions.

  • - The share of dividends in equity returns is rising world-wide.

  • - In 2016, currency trends may be worth considering when structuring portfolios.

" The pace of growth in emerging markets has decelerated, while advanced markets have set out on a moderate growth path. One thing is for sure: the positive momentum from monetary policies is waning. "

Diverging monetary policies

It sounds too good to be true. Almost like a fairytale. The Unites States has finally reached a turning point on its long path out of the financial crisis. The U.S. Federal Reserve Board (Fed) has increasingly loudly and clearly signaled an imminent rise of official rates. Global financial markets seem to be unconcerned – and are probably right. At least for the time being.

Let’s look back how everything started: On October 8, 2008, roughly three weeks after the Lehman default, the European Central Bank (ECB), the Fed and the central banks of Canada, the United Kingdom, Sweden and Switzerland simultaneously cut official rates. The central banks thus gave a clear message that they would tackle this global crisis through joint action.

Since then, much has changed, some of it for the better. The U.S. unemployment rate should drop below five percent pretty soon. The Non-Accelerating Inflation Rate of Unemployment (NAIRU), below which point wages – and in their wake inflation – start to rise, is drawing nigh.

Unemployment rates in the United States

Declining unemployment
The official unemployment rate in the United States amounts to 5%, slightly above the Fed’s 4.9% estimate of NAIRU. The U6 unemployment rate is also declining rapidly. This also includes persons employed part-time for economic reasons and discouraged workers who want to work but have not recently been looking for work.

For this reason, the first rate hike could well have happened in September 2015, before the Fed decided against a rate hike at the very last moment. This failure of nerve will hardly be repeated. Regarding the U.S. economy, the only remaining counter-argument is the declining labor-force participation rate which, in the last few weeks, has once again sparked off discussions, not least within the Fed. Right before the recession, labor participation amounted to 66%, but now is just 62.5%.1 This might hint at hidden unemployment which, in turn, could mitigate wage pressures. However, labor participation has been declining over more than a decade, leaving structural factors as more likely culprits (such as the retirement of baby boomers).

Diverging developments in industrialized countries

Of course, the Fed is no longer exclusively focused on the United States and the rest of the world is presenting a rather mixed picture. Let’s start with the advanced economies.

The unemployment rate should remain very high in the Eurozone, even if it declines considerably next year in line with expectations. This alone would be enough to prevent the ECB from raising interest rates. Another factor discouraging a rate rise will be the huge differences among Eurozone countries regarding unemployment and growth.

Global overview of growth and unemployment

Recovery in the advanced economies
Economic growth is set to recover in the industrialized countries in 2016. An acceleration is likely to occur in all major economies except for the United Kingdom. However, this is likely to lead to appreciably lower unemployment only in the United States and the Eurozone.

Growth and unemployment in the Eurozone

Mixed picture
While growth and unemployment are at least trending in the right direction in the Eurozone, there are major discrepancies between individual countries. In other words: the Eurozone is far from converging – which continues to make common monetary policy a tricky task.

Since October, the ECB has openly considered a prolongation and expansion of its asset purchase program, i.e. quantitative easing (QE). In the Eurozone, higher interest rates are clearly a long way off. Instead, a further cut of already negative rates on bank deposits is on the agenda. Inflation expectations remain weak, although there are increasing signs of progress in other areas (such as Eurozone purchasing manager indices and consumer sentiment). Wages are slowly accelerating. The expansion of credit and money supply measures are also supportive. The euro should continue to depreciate versus the U.S. dollar – to the benefit of European exports.

Structural reforms in the Eurozone periphery are showing their first signs of success. The number of economies that are growing is increasing, broadening the basis of economic recovery. Gross-domestic-product (GDP) component performance is also positive: private consumption, government expenditure, exports and investment have all contributed to economic growth in 2015. Lower oil prices hamper inflation, while at the same time benefiting current-account positions and growth. So there is a good chance of moderate growth continuing in the Eurozone in 2016.

Component contributions to GDP growth in the Eurozone

Drivers of growth
Consumption has developed into an ever stronger driver of growth in the Eurozone. Also positive are improved current accounts, but investment continues to be low.

The main cyclical risks may be political in 2016. The wave of immigration from Middle Eastern countries might well be an economic opportunity for Europe as a whole and for Germany in particular over the medium term. In the short term it will, however, put additional strain on political cohesion within the Eurozone. Risks from terrorist attacks remain, as the past weeks have sadly shown. Another risk surrounds armed conflicts in the Middle-East region. An expansion of these conflicts could trigger oil-supply disruptions and erratic oil prices.

Japan as an example

All in all, seven years after the onset of the financial crisis, the Eurozone and most other industrialized countries are still growing only slowly. Debts triggered the financial crisis. These debts must be reduced now, resulting in lower demand. A new credit cycle can only be started after the balance sheets of corporations, private households and states have been cleansed – as Japan has already demonstrated several times in the past 25 years.

At least, the Japanese unemployment rate has now dropped to extremely low levels. The number of job seekers is declining – which is not surprising, given the shrinking population. New staff are, however, not very much in demand either, so that wages are stagnating. Consumer sentiment has slightly worsened in the last few months and consumer spending has flattened. This and lower commodity prices will lead to consumer prices increasing by merely 0.8% in 2016 (Deutsche AWM forecast). The BOJ’s inflation target of 2% remains far off.

Haruhiko Kuroda, governor of the Japanese central bank, therefore announced in November 2015 that the Bank of Japan (BOJ) would stick to its asset purchase program to the tune of 80 trillion Japanese yen a year. This massive QE program has significantly diminished the yen’s external value. Exports to the United States will thus remain one of the major drivers of Japanese growth.

Japanese wage index for wages agreed upon and paid1

Stagnating wages
Wage growth in Japan remains weak despite low unemployment.

Inflation development in Japan

Low price pressures
Moderate wage growth and low oil prices explain why prices are hardly rising despite monetary easing. The core inflation rate (excluding energy) at least signals an end to Japan’s deflation.

Fed versus the rest of the world?

The ECB and BOJ both are not alone in sticking to their path of cheap money. Instead, the Fed’s looming hike looks a bit like American exceptionalism. Seven of the major central banks have continued monetary easing or will start it soon. Recently, the People’s Bank of China (PBoC) cut rates. Shortly afterwards, the Swedish Riksbank announced the expansion of its QE program. Although the central banks of Australia and New Zealand have not taken any action, they have signaled further monetary easing. Much of the industrialized world is unlikely to see unemployment shrink significantly next year. The two exceptions are the United States and the Eurozone.

Against this background, the imminent rate decision of the Fed somewhat resembles the fairytale of Snow White and the seven dwarfs. Alas, there is no econometric model yet with a prediction accuracy remotely approaching the magic mirror of the wicked queen! But if we asked: “Mirror, mirror on the wall: who's the fairest of them all?”the answer would clearly be: the U.S. economy.

Futures markets have already anticipated most of the likely impact of monetary-policy divergence. After all, it is not unusual for the world’s major central banks not to be moving in the same direction. Monetary-policy interventions around the globe during the last few years have only made us believe they are.

Under normal circumstances, in a currency system with flexible exchange rates, central banks pursue an autonomous monetary policy, geared towards the needs of the respective currency area. Joint actions are only taken when a shockwave spreads throughout the world economy, as was the case during the financial crisis. For the time being, no such shockwave is in sight. Among market participants, the most commonly cited source of trouble is emerging markets. This anxiety is based on the high indebtedness of emerging markets, most obviously in China.

In-depth look at debts

For years, ultra-expansionary monetary policies of the advanced economies have driven international investors to ever more exotic places in search of higher returns, not least in the emerging markets. Two more reasons why emerging markets have increasingly attracted foreign capital in the last few years have been higher growth rates than in the industrialized world and the resilience of these countries during the most recent crises. Memories of past crises, such as the Asian crisis in the late 1990s, had encouraged several emerging-market governments to purposefully avoid foreign debt and current-account deficits and to build up foreign-exchange reserves instead. When the financial crisis started in the developed markets in 2007, emerging markets were well prepared.

Since 2007, emerging-market debt has drastically increased, however. In retrospect, one thing has become clear: During the last decade, the debt issue has turned from a U.S. problem into a global challenge. The Bank for International Settlements (BIS) has compiled and published a data set on the development of debt in the non-financial sector. This data set comprises twelve advanced and 15 emerging-market economies.2 Based on harmonized data, these new data series now help us to analyze the development of debt in advanced and emerging economies.

According to this data set, the debt of private households, corporations and states increased by 28.9% to $118.75 trillion in the advanced economies. During the same period, nominal GDP grew by 13.6% in these advanced economies (in U.S.-dollar terms), which puts the rising debt into perspective. In emerging-market economies, nominal GDP grew by 92.5%. Debt, however, tripled to $37.73 trillion, so that debt in relation to GDP has risen dramatically.

GDP in advanced and emerging-market economies

Flattening GDP
The emerging-market economies analyzed by the BIS excelled with very high GDP growth rates from 2009 to 2011. From 2012 onwards, GDP growth in emerging-market economies weakened. Their growth advantage eroded.

The development of debt ratios

Growing debt burdens
Debt has been growing more than twice as fast as GDP in emerging-market economies. As a consequence, the debt ratio, i.e. debt in relation to GDP, increased by 55.9% in emerging-market economies, and by 13.6% in advanced economies, between 2007 and 2014.

In emerging economies, debt in relation to GDP is still far lower than in advanced economies. But the prosperity level is lower there, too. This lower prosperity not only reduces the borrowing capacity but also the capacity to sustain debt in emerging markets.

Prosperity and debt compared

This correlation becomes very evident when the debt ratio in relation to GDP is compared with debt relative to GDP per capita. One major reason is that in the case of a low GDP per capita, incomes only slightly exceed the subsistence level. Saving ratios are correspondingly low. The same holds true for the creditworthiness of large parts of the population. Developing economies additionally often lack a working financial and legal system.

Increasing debt often goes hand in hand with an economic catchup process. Even the least developed nations, people often have de-facto valuable assets but their property may be legally insecure and their access to the financial system is too much restricted to borrow against these assets. So they have no possibility of investing. If this situation is successfully changed, a positive cycle can be started. Investment, for example in seed, increases productivity and prosperity. Higher prosperity, in turn, fosters further investment fueling GDP growth. The bottom line? Poverty dramatically falls, as Peruvian economist Hernando de Soto convincingly described in his book “The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else” published back in 2000 – and as could have been observed in several emerging markets since then.

GDP per person and debt ratio in 2014

Prosperity and debt
China, Greece, Portugal, Japan and Ireland are all highly indebted. India too has a heavy debt burden compared to per-capita income. Germany, the Czech Republic and Saudi Arabia are moderately indebted. In the Eurozone’s periphery countries, the burden of debt has been alleviated by adjustments of the terms and conditions of borrowing.

Of course, this positive cycle has its limits. The larger the capital stock, the lower the growth in returns on additional investment. Due to this decreasing marginal return on investment, debt in relation to GDP should grow at a slower pace once a certain prosperity level is reached.

However, some emerging markets, particularly China, went into the opposite direction. China recorded the by far highest debt increase among the emerging markets. In 2007, China was still quite close to the trend line. Based on 2014 figures and due to the rapid increase of debt, the country is now way off the trend line (see chart "GDP per person and debt ratio in 2014"). China’s debt has increased significantly.

Changes of debts and GDP

Countries in comparison
This comparison shows that China accounts for an enormous share in the increase of debt and GDP among emerging-market economies. China accounts for roughly 75% of the increase in emerging-market debt between 2007 and 2014.

Increase of debt and GDP

Heavyweight of China
In emerging markets ex China, debt has risen somewhat faster than GDP. China, by contrast, has experienced an enormous increase of debt in relation to GDP. The biggest emerging-market country thus became the major driver of the increase in debt in relation to GDP.

Debt grew particularly rapidly in China’s business sector, mainly due to borrowing by large and rather inefficient state-owned enterprises. Most of the money was probably spent on rather futile investment projects. The combination of inefficient investment and higher debt is now hampering growth, which had already been constrained by a labor force that has started to shrink.

Much will therefore depend on how China tackles its debt problem. The number of possibilities is limited. The country could resort to financial repression in order to reduce its debt, to the eventual detriment of many small savers. China’s business sector has already repeatedly followed this path to master debt crises in the past. However, this solution drives capital abroad and leads to a devaluation of the renminbi – after the liberalization measures of the last few years, this would likely be at a much faster pace than in previous crises. The central bank could intervene in order to defend its exchange-rate target. However, this would entail a rapid melt-down of foreign-currency reserves.

For the time being, the government in Beijing has decided in favor of harsher capital controls. Financial repression would counteract the PBoC’s objective of freer movement of capital. But whether this path will be as easy as it was in the past is still an open question. China’s economy has meanwhile become part and parcel of the world economy, which has made it more difficult to control cash flows abroad. If capital started to flow out massively in the wake of financial repression, the PBoC could defend the renminbi’s exchange rate, which is pegged to the U.S. dollar, by intervening on the currency market. This should work at least for the time being, although the PBoC has lost some credibility during the last few months.

No global emerging-market crisis on the horizon

China is another excellent example of how debt can be a particular problem if creditors are external. Two extreme examples from the rich world are Japan and Greece. The Japanese population continues to lend to its government although the public debt ratio is very high and continues to increase. Since Japan’s economy records a positive current-account balance, the government is not reliant on foreign money. By contrast, Greece cannot finance its current-account deficit without capital from abroad. In recent years, the Greek population proved unwilling to lend money to its government or to keep its money in local financial institutions. More and more euros were either stored at home or taken abroad.

Total debt, foreign debt and reserves in focus

Low risk
Foreign debt in relation to GDP is rather low in many emerging markets. Additionally, most emerging markets have built up higher foreign-exchange and gold reserves. Some countries are, however, reliant on foreign capital, creating higher risks for investors.

Against this background, worries of a global emerging-market debt crisis seem to be overdone. The most recent emerging-market crisis started in Thailand in 1997 before spreading to South-East Asia and from 1998 finally to Russia, Brazil and Argentina. This time there are only few emerging-market countries with a similarly high reliance on foreign capital as in 1997. Furthermore, the lion’s share of debt is denominated in local currencies and currency pegs are less common. This, at least, mitigates the pain of currency depreciation, as already seen in Turkey and South Africa. Turmoil in individual emerging markets looks unlikely to transform into a global crisis in 2016, even if the pull effect of higher U.S. interest rates could accelerate capital flight from emerging markets.

All said and done, what remains? Slow global economic growth should continue for the time being. However, the world has not experienced any permanent reduction of risks in the last few years. Growing and shifting debt demonstrates that risks have simply been redistributed. This may all go well for some time to come. But it is far from a fairytale ending of “and they lived happily ever after”.

Subdued mood on the markets

Not only emerging-market debt has been on the rise during this cycle. A similar mechanism could be observed almost across all asset classes in the industrialized economies. Low interest rates and QE have driven prices of “safe” bonds higher, thus lowering returns. This, in turn, has encouraged investors to take on ever riskier investments in search of positive returns in real terms, i.e. after adjusting for inflation. The consequences of ultra-expansionary monetary policies: a general rally of government, mortgage and corporate bonds as well as of equities and real estate.

That means that, since 2009, individual asset classes have experienced periods of high price gains. But they may now be approaching the limits of this process. Significant price gains in the first two quarters of 2015 had pushed bond and equity valuations to high levels, increasing the risk of volatility on global capital markets.

So-called flash crashes – short-term setbacks with heightened short-term volatility – have already happened in 2015. But markets usually calmed down quickly thanks to continuing accommodative monetary policies. Long-term volatility remained low. For the most part, this is likely to continue in 2016. Short and violent storms are possible, fading as quickly as they started. The New Year will therefore give rise to some tactical challenges.

We expect positive, if moderate, total returns for equities.3 Dividend payments should thus account for a larger share of overall equity earnings. It is a positive that dividends tend to follow earnings, implying that earnings growth experienced in 2015 should feed into higher dividends in 2016. Corporate earnings are expected to continue rising in 2016. It is another positive aspect that almost all sectors are expected to benefit from earnings gains in 2016. The corporate sector appears to be in decent shape.

Since the majority of central banks will continue monetary easing, the bond sector should also perform well. 10-year government-bond yields should only slightly increase. The ECB’s QE will dampen yield gains on the bond market. The imminent U.S. rate hike should strengthen the U.S. dollar, burdening U.S. exports. Further rate hikes by the Fed will therefore be slow and moderate. U.S. government-bond yields are not expected to experience any major yield changes.

The diverging monetary paths pursued by central banks from 2016 onwards will put the U.S. dollar even more into focus. It should strengthen further in 2016, not least versus the euro. In times of low returns and diverging monetary policies, investors will be well advised in 2016 to consider currency trends as part of portfolio structuring. This will be even more important for emerging-market investments where careful country-by-country analysis is also likely to be vital.


1 U.S. Bureau of Labor Statistics, as of 11/2015


2 The debt data set published by the BIS in September 2015 comprises the advanced economies of Australia, Canada, Denmark, the Eurozone (also the individual countries), Hong Kong, Japan, Norway, Singapore, South Korea, Sweden, Switzerland, the United Kingdom and the United States. It additionally covers the emerging-market economies of Argentina, Brazil, China, the Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Poland, Russia, Saudi Arabia, Thailand, Turkey and South Africa.


3 Deutsche AWM forecast as of 11/2015

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