10 core truths Goldman Sachs believes will persist in 2016
It is becoming something of a ritual that markets are especially uncertain in the first quarter. Part of this has to do with seasonality in US data, which tend to look weak around the turn of the year. But other things are exacerbating the risk sell-off. These are fears that China is in the midst of an uncontrolled run on its currency, a view we strongly reject, and concern that the ECB and the BoJ are backing away from their pursuit of higher inflation.
With so much uncertainty, this is a list of core "truths," which we think will prevail and dictate market direction this year.
1. Much more US outperformance than priced. Behind all the short term worries lurks one meta-fact that is overlooked. The Dollar has appreciated 26 percent versus the majors over the last two years, but US growth has stayed above trend. There is little doubt that net exports and inflation have suffered, but the resilience of the economy suggests that underlying momentum on both the growth and inflation fronts is better than priced, especially now that front-end interest rates have priced out so much tightening.
2. The ECB and BoJ will ease more. In the wake of recent disappointments, markets worry that the ECB and BoJ are reneging on their commitments to boost inflation, which has been weighing on risk. Both central banks have progressively cut their 2016 core CPI forecasts, fanning fears that they are "terming out" their inflation targets. Indeed, our European economics team forecasts core HICP at 1.0 percent this year, below the 1.3 percent ECB forecast, an illustration of the downside risk to an already low number. For both the ECB and BoJ, we expect more stimulus as opposed to reneging, which is the basis for our 12-month view of $/JPY at 130 and EUR/$ at 0.95.
3 central banks will get over their fear of floating. Fear of floating among the G-3 central banks has a price, which is that it de-stabilizes risk, inadvertently tightening financial conditions. One example is the September FOMC, which exacerbated market anxiety over China with its focus on financial conditions. Another is the December ECB, where concern over excessive Euro weakening was reportedly one driver for not taking more aggressive action. Both times, equity market declines caused financial conditions to tighten, making efforts to manage G-3 exchange rates counterproductive. We see the G-3 central banks accepting more Dollar strength as the lesser of two evils.
4. Low inflation for longer in the Euro zone. Much of the discussion over low inflation in the Euro zone revolves around global themes, including falling commodity prices and the slowdown in EM. But ongoing structural reforms in periphery countries mean that price and wage levels are likely to keep falling, imparting a deflationary bias to the region, which is distinct from global developments.
5. The BoJ is the ultimate QE warrior. Quantitative easing aims to boost growth via a portfolio shift out of the safe haven asset into risk assets. The QQE program has aggressively flattened and stabilized the JGB yield curve, encouraging that shift, such that $/JPY sees "autonomous" moves up when risk appetite is good, for example in the summer of 2014 (the move from 102 to 109) and May 2015 (the move from 120 to 125). EUR/$ has not benefitted from similar portfolio shifts because Bunds - the safe haven asset in the Euro zone - have been too volatile.
6. Negative interest rates are over-rated. We estimate that a 10 bps (surprise) deposit cut is worth two big figures in EUR/$, based on intra-day moves when surprise deposit cuts were announced (Sep. 4, 2014 and Oct. 22, 2015). This means that the bulk of the decline in EUR/$ stems from ECB balance sheet expansion and long-term interest differentials not front-end rates. Our forecast for EUR/$ down anticipates a shift in emphasis back to asset purchases from depo cuts.
7. The Dollar is a "risk-on" safe haven currency. The correlation of the Dollar with risk has flipped from negative to positive in recent years. This switch reflects rate differentials, rather than a loss of safe haven status. Negative growth shocks, real or perceived, cause markets to price out monetary tightening in the US, such that rate differentials move against the Dollar. The positive correlation of USD with risk is therefore really a reflection of US cyclical outperformance.
8. Near term pain, long term gain for USD from low oil. Falling oil prices have negative fall-out on economic activity in the short run, weighing on the Dollar by way of rate differentials. But the US remains a net oil importer, so that low for long in oil prices is fundamentally a Dollar positive, once near-term effects drop out. By way of illustration, it was the oil super cycle that derailed the Dollar-positive impulse from rising rate differentials in 2004-08.
9. China's balance of payments is under control. There is a lot of anxiety that the pick-up in capital outflows represents a run on the RMB, making a large devaluation all but inevitable. However, a key reason that outflows were so large in 2015 was that August and December saw the RMB fix weaker, which caused (heavily expectation-based) outflows to pick up. With a current account surplus of perhaps as much as $400 bn this year, China's balance of payments can absorb a sizeable level of outflows before reserve drawdowns become necessary.
10. It is not in China's interest to destabilize the world. China is a net exporter, i.e., it depends more than other countries on sound global growth. It is therefore hardly in China's interest to unsettle markets and derail the world economy. Recent developments most likely point to a greater desire to see flexibility in the exchange rate and a closer link to fundamentals (which includes a shift in focus to a trade-weighted exchange rate), rather than unilateral devaluation.
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